The Production Possibilities Frontier

See pp. 32-38 in Case, Fair, and Oster’s

Principles of Macroeconomics

Adapted from Time and Money:

The Macroeconomics of Capital Structure
by Roger W. Garrison
London: Routledge, 2001

The Consumption-Investment Tradeoff

And the Essence of Economic Growth
2009
In any economy, some resources are

CONSUMPTION
devoted to producing consumables, the
remaining resources being available for
maintaining and expanding the
economy’s productive capacity.
The Production Possibilities Frontier
(PPF) depicts these alternatives during
a given time period, typically one year.
INVESTMENT

The Production Possibilities Frontier

The tradeoff between CONSUMPTION (in the present) and INVESTMENT
(for the future) should be an integral part of our macroeconomic thinking.
Under favorable conditions, a fully employed market economy allocates
resources to both uses, making the most of the trade-off.
A “fully employed market economy” allows for a so-called “natural rate of
unemployment,” which is about five or six percent. That is, frictional and
structural unemployment are characteristic of even a healthy economy.
 A PPF with
If resources were characterized by

CONSUMPTION
heterogeneous
homogeneous
perfect homogeneity, such that each unit inputs
of input is equally suitable for producing
either kind of output (consumption goods
or investment goods), then the PPF
would be linear. But raw materials and
capital equipment are heterogeneous.
Riverboats and river barges are not
readily substitutable one for the other. INVESTMENT

The heterogeneity of equipment and materials implies a convex PPF.

As the tradeoff is made away from consumption and toward more
investment, the scope for still more investment diminishes.
Microeconomists would describe this feature of the PPF in terms of
a diminishing marginal rate of substitution.
 CONSUMPTION
“Investment” in this construction
represents gross investment, which
includes replacement capital.

Typically, the investment needed just

to replace worn out or obsolete
capital is substantial but something
INVESTMENT
less than gross investment. Replacement
Capital
The extent to which gross investment Net Investment
exceeds the “replacement” magnitude
Gross
constitutes net investment and allows Investment
for the expansion of the economy.
Positive net investment means that the economy is growing. The PPF
shifts outward from year to year, permitting increasing levels of both
consumption and investment.
This outward shifting of the PPF represents sustainable economic growth.
 YEAR 4
0
1
2
3
Watch the economy grow.

CONSUMPTION
Four periods of growth are shown—with
consumption, as well as investment,
increasing in each period.
The actual rate of expansion of the PPF
depends upon many factors. For instance,
with economic expansion, more resources
INVESTMENT
are needed for capital replacement. And Replacement
Capital
the desired trade-off between consuming
Net Investment
and investing can itself change as the
Gross
economy generates more wealth. Investment
Watch the economy grow.

CONSUMPTION
Four periods of growth are shown—with
consumption, as well as investment,
increasing in each period.
The actual rate of expansion of the PPF
depends upon many factors. For instance,
with economic expansion, more resources
INVESTMENT
are needed for capital replacement. And
the desired trade-off between consuming Watch the movement
and investing can itself change as the along the PPF.
economy generates more wealth.

Importantly, we note that forgoing some consumption with an eye toward

consuming more in the future triggers a movement along the initial PPF
and hence affects the rate at which the PPF expands outward.
Now watch the economy grow.

CONSUMPTION
YEAR 4
0
1
2
3
Increased thriftiness makes the difference.

Let’s compare the high-growth economy

with the original low-growth economy.

INVESTMENT
 CONSUMPTION

CONSUMPTION
INVESTMENT INVESTMENT

Note the difference that an initial trading off of consumption for investment
makes in the subsequent pattern of consumption and investment.
Without an initial increase in investment, consumption and investment
increase modestly from period to period.
With an initial increase in investment at the expense of consumption, both
consumption and investment increase dramatically from period to period.
By the fourth period, that initial increase in investment pays off as a
higher level of consumption than would otherwise have been possible.
 The time dimension is represented by

CONSUMPTION
the sequence of shifts of the PPF.
We can add to our understanding if we
represent time explicitly on a horizontal
axis and then keep track of consumption
on the vertical axis.

INVESTMENT

Explicitly
In both representations,
tracking the level of
CONSUMPTION

consumption
consumptionover is seen
timetoallows
fall
us
asto
the
seeeconomy
that theistradeoff
adaptingis
essentially
to a higherangrowth
intertemporal
rate, after
tradeoff.
which consumption rises
more rapidly than before…
Consumption in the present
and eventually surpasses the
and near future is traded for
old projected growth path.
consumption in the more
TIME distant future.
There is nothing pre-ordained about

CONSUMPTION
the economy actually having a positive YEAR 4
0
1
2
3
rate of growth.
Suppose that gross investment in the
economy is just enough to replace
worn out and obsolete capital—which
means that net investment is zero.
The levels of consumption and (gross) INVESTMENT
Replacement
investment would be maintained, but Capital
the economy would not grow. Net Investment
Net Investment
=0

Gross
Watch the economy not grow. Gross
Investment
Investment
 CONSUMPTION
YEAR 4
0
1
2
3
In a no-growth economy (meaning no
net investment), would it be possible for
people to increase consumption?
Yes, there is still some scope for
movement along the PPF in the
direction of more consumption and
less investment. INVESTMENT
Replacement
Capital
But what would be the consequences for the PPF in subsequent years?
Watch the economy experience negative growth, i.e., watch it contract.
Gross
Notice that consumption rises initially and then falls as the economy’s
Investment

productive capacity diminishes over time.

 CONSUMPTION
As in the case of a clockwise movement
along the PPF, we can add to our
understanding of this counterclockwise
movement by representing time
explicitly on a horizontal axis and then
keeping track of consumption on the
vertical axis.
INVESTMENT

In both representations,
CONSUMPTION

consumption
The increase inis consumption
seen to rise
inasthe
thepresent
economy andisnear
adapting
future
to a negative
comes growth rate,
at the expense of a
after which
declining consumption
rate of consumption
indeclines
the more—soon falling
distant below
future.
the initial level.

TIME
CONSUMPTION

If gross investment exceeds

replacement capital, the
economy expands.
TIME
CONSUMPTION

If gross investment falls

short of replacement capital,
the economy contracts.
TIME
 CONSUMPTION
Consider two separate economies,
one large and one small.

On what
Each PPF basis
is broadly
can youdescriptive
make a of
two particular
prediction about
countries
the sizes
at of
thethe
end
of World
two economies,
War II. say, two or three
decades after the war? INVESTMENT

Apart from their differing sizes, one Post-war United States

Japan grew
possibly much difference
relevant faster thanisthe
that

CONSUMPTION
United States—not
the small country’s because
economyithadhad
been
beenbombed,
wrecked but because to
by bombing thea
consumption-investment
much greater extent thantradeoff
the large
incountry’s
post-wareconomy.
Japan was made in
favor of a high level of investment.
In
What
the United
two countries
States,are
the these?
tradeoff
was made in the opposite direction
by the consumption-oriented INVESTMENT

Americans. Post-war Japan

 CONSUMPTION
To this point, we’ve assumed that the
economy is either on its PPF or is being
expeditiously moved by market forces
toward a point on its shifting PPF.
Suppose, though, that during a given
year, some market malfunction (or
some perverse policy) takes the
economy off its PPF. INVESTMENT

If the economy is pushed beyond the PPF, its unemployment rate being
driven below the 5-6 percent band, we say the economy is “overheated.”
Points very far beyond the PPF are simply out of reach (in real terms).
Strong market forces pushing in this direction will impinge on prices
rather than on quantities. The economy will experience price inflation.
And in extreme cases, it can experience hyper-inflation.
 CONSUMPTION
To this point, we’ve assumed that the
economy is either on its PPF or is being
expeditiously moved by market forces
toward a point on its shifting PPF.
Suppose, though, that during a given
year, some market malfunction (or
some perverse policy) takes the
economy off its PPF. INVESTMENT

If the economy is pushed beyond the PPF, its unemployment rate being
driven below the 5-6 percent band, we say the economy is “overheated.”
Points very far beyond the PPF are simply out of reach (in real terms).
Strong market forces pushing in this direction will impinge on prices
rather than on quantities. The economy will experience price inflation.
And in extreme cases, it can experience hyper-inflation.
If the economy is pushed inside its PPF, its unemployment rate rising
above the 5–6 percent band, we say that the economy is in a recession.

If the economy is pushed far inside its PPF for an extended period of
time, we say that the economy is in a depression.
 CONSUMPTION
Notice that, together with the locus of
the fully employed economy, the
various possible market malfunctions
(or consequences of perverse policy)
are arrayed along a linear path:

A depressed economy
A recessed economy INVESTMENT

A fully employed economy Economists who believe that

An over-heated economy “markets
the marketwork” argueisthat
economy
market forces
inherently flawed
canargue
movethat
the
An inflated economy economy
market forces
alongwill
themove
PPF the
in
A hyper-inflated economy response along
economy to changes
the linear
in path
intertemporal
producing periodic
preferences.
bouts of
unemployment and inflation.
What do you suppose is the They argue that movements off
significance of the straight line that They argue
the PPF arethat “stimulus
largely a
passes through these points? packages”
consequence andofprice controls
perverse
are essential to the
macroeconomic economy’s
policy.
macroeconomic health.
The Production Possibilities Frontier

Adapted from Time and Money:

The Macroeconomics of Capital Structure
by Roger W. Garrison
London: Routledge, 2001

The Consumption-Investment Tradeoff

And the Essence of Economic Growth
2009