A production possibilities curve is crucial for keeping track of your business. It allows you to accurately analyse its productivity.
This allows you to identify problems and recognize any potential improvements. When it comes to production, there are several graphical representations that allow you to balance between the products you produce.
It is generally a good idea to use multiple graphs in order to have a clear overview of your various products. Today we will be discussing the production possibilities curve which allows you to compare two products that share common resources in order to balance the amount of each.
It is a measure of the efficiency of your current operation regarding the available resources and the amount of two products produced. Ensuring that your operation is working at maximum efficiency means that you are utilizing all your resources.
Naturally, this means that you maximize your output (and profits) while minimizing unused resources which might otherwise go to waste. Now, in order to begin, let us understand the production possibilities curve.
What is a Production Possibilities Curve?
The definition of production possibilities curve is a graphical representation combining two products that share common resources in your operation.
It shows the maximum amount output that is possible for both products which you can then compare to your actual output to ensure that there are no inefficiencies occurring. To understand the production possibilities curve, you must consider the opportunity cost.
According to the concept of scarcity, your business only has a limited amount of resources that must be utilized to create your outputs. In order to allocate resources to one production, it must be removed from another.
Likewise, Buying too much material while not outputting all of it into a sell-able product is considered to be a waste of money that could otherwise be used on something else. It is important to know which of your products to prioritize over another one.
For a growing company, that is an incredible loss. Now, let us identify how a production possibilities curve is constructed:
- Each axis has the quantity of one of the common products,
- A table of supposed quantities that your operation can produce is sketched onto the graph.
What are Production Resources?
Resources are anything which is needed to make your products. Naturally, on the one hand this includes raw materials, packaging and any other physical goods you might need to actually create the product itself.
The trickier thing is intangible resources.
An intangible resource is something which you need to create your products, which you can’t actually hold in your hands. This includes:
- Production capacity,
- Equipment and tools,
- Logistics to bring your products to market.
For example, you might have all of the raw materials in the world, but not enough machinery to combine them into a final product.
What are Production Possibility Outputs?
Outputs are much simpler to get your head around. That is, this is the quantity of your products which you can actually create. Again, when you create simple physical products, this is pretty self explanatory.
If you have a service business, or create digital products, things get a little bit trickier.
In this case, the output might be measured in terms of the number of clients or customers you can provide with a service. Alternatively, it might be measured in terms of the number of hours labour you can provide for a project.
Your outputs might also take the form of research and development time, or internal investment.
Take a look at the following table in order to understand the construction of the curve. For simplicity’s sake, let’s assume that your business’s only resource is labour, with a maximum of six workers.
In other words, if you throw all of your resources at one product, you’ll have a maximum output for this, and no output for your other products.
The Pareto Efficiency Principle
A concept that was named after the Italian economist Vilfredo Pareto. It states that any point under this curve is inefficient as you are not utilising your resources to their full potential.
On the other hand, points lying above that curve is impossible as it utilizes more resources than your business has. Based on these findings, if your points lie above the curve, it is likely that there was an error in the report.
For example, you may have miscalculated your resources, or ignored product loss of some kind.
Regarding points that lie below the curve, they show that your business is not working at maximum efficiency which requires immediate attention. Inefficiency is a direct loss of profits and stunt the growth of your business.
How can you fix this? The answer is often to shift your curve to the left or right.
Shift to the Right
This indicates an increase in the capacity of your business’s output. This could be because of the introduction of a new technology that allows for more production or the purchase of more tools needed to produce.
A shift to the right is always a great thing, it indicates that your company’s production line is growing. In simple terms, a shift to the right is the result of an increase in output.
Shift to the Left
This indicates a decrease in the capacity of your business’s output. This could be the result of the loss of some of your resources. It is regarded as a decrease in the output of your business.
Alternatively, this might be a deliberate decrease in your output. For example, you might choose to limit the number of your products on the market in the lead up to a new product launch.
Production Possibility Curve and Economics
Not only is this curve important for internal business affairs. On a larger scale, this curve allows you to identify the current status of your market’s economy.
Say for example you’re responsible for sales for a car brand in a given country.
By applying the amount of a basic product in the market on the x-axis against the amount of a luxury product on the y-axis, the resulting point on the graph represents the current state of the market.
This information is important for your business as it will allow you to know which type of products to focus on producing. It allows you to know the consumer demand which is valuable to the success of your business.
If the point is closer to the x-axis then the demand has shifted towards luxury, indicating that the market is flourishing and there are a lot of potential customers. Similarly, if the point is close to the y-axis then there is a higher demand for basic products.
This indicated that the market’s economy isn’t doing so well and you should focus on essential products since there is no buying power.
Production Possibility Curves in Short
The production possibilities curve is a powerful graphical representation of the theoretical output of your production. It considers two conflicting products and allows you to decide on the perfect balance between them.
Furthermore, your actual product may be represented as a point on that graph in order to allow you to know where your business stands right now in regards to efficiency. In addition, the production possibilities curve can give you a general idea of the status of your potential market.
For example, by comparing luxury to essential goods, you can tell how well the market is doing.
This is not the only available statistical tool, but it can prove quite useful.