Actual and potential growth on a production possibility frontier

Overview

Economy record actual growth without any potential growth, potential growth not automatically produce actual growth and production possibility frontier relate to the long-run aggregate supply curve.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Describe how to draw a production possibility frontier and state what each part of it represents.

   Model answer

   Draw two axes representing two goods or two categories of good, for example capital goods on the vertical axis and consumer goods on the horizontal axis. The frontier is a curve running from a point on the vertical axis to a point on the horizontal axis, bowed outwards from the origin. Every point on the curve shows a combination of the two goods that can be produced when all resources are fully and efficiently employed. Points inside the curve are attainable but involve unemployed or inefficiently used resources; points beyond it cannot be reached with current resources and technology.

2. 2

   Define actual economic growth and show how it appears on a production possibility frontier.

   Model answer

   Actual growth is an increase in the real output the economy is currently producing. On a production possibility frontier with capital goods on the vertical axis and consumer goods on the horizontal axis, it is shown as a movement from a point inside the frontier to a point closer to it, or onto it. The economy is producing more of both goods than before, but the frontier itself has not moved: the gain comes from bringing idle resources into use rather than from acquiring more resources.

3. 3

   Define potential economic growth and show how it appears on a production possibility frontier.

   Model answer

   Potential growth is an increase in the maximum output the economy is capable of producing. On a diagram with capital goods on the vertical axis and consumer goods on the horizontal axis, it is shown as an outward shift of the whole frontier away from the origin. Combinations that were previously unattainable become attainable. The shift is caused by an increase in the quantity or quality of the factors of production, or by improved technology, and it does not by itself guarantee that the extra capacity is used.

4. 4

   Why can an economy record actual growth without any potential growth, and what limits this?

   Model answer

   If the economy is operating inside its frontier because of unemployed labour and idle capital, output can rise simply by putting those resources to work, moving the production point towards the frontier without shifting it. This is how recovery from a recession occurs. The limit is the frontier itself: once the economy reaches it, all resources are employed and no further increase in output is possible without shifting the frontier outwards. Growth that relies on closing the gap therefore has a definite end point.

5. 5

   Why does potential growth not automatically produce actual growth?

   Model answer

   An outward shift of the frontier increases what the economy could produce, but the economy produces what is demanded, not what is possible. If aggregate demand does not rise to match the new capacity, the economy simply operates further inside the enlarged frontier, so the additional capacity shows up as unemployment and idle capital rather than as extra output. Realising potential growth therefore requires demand to grow alongside supply.

6. 6

   An economy chooses a point on its frontier with a high proportion of capital goods rather than consumer goods. Explain the consequence for the position of the frontier in future.

   Model answer

   Capital goods are used to produce other goods, so devoting more current resources to producing them enlarges the capital stock available in future periods. With more machinery, equipment and infrastructure, the economy can produce more of everything later, so the frontier shifts outwards further and faster than it would have done. The cost is that fewer consumer goods are available now, so present living standards are lower. This is the trade-off between present and future consumption, shown as a movement along today's frontier that determines the position of tomorrow's.

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