Question

A trade-off is involved when a greater share of output is committed to the production of investment goods. Using production possibility frontiers to show the economic growth of an economy in which consumption share of output falls but total consumption stays constant. Explain your answer.

Answer 1

Economic growth

Economic growth has two meanings:

Firstly, and most commonly, growth is defined as an increase in the output that an economy produces over a period of time, the minimum being two consecutive quarters.

The second meaning of economic growth is an increase in what an economy can produce if it is using all its scarce resources. An increase in an economy’s productive potential can be shown by an outward shift in the economy’s production possibility frontier (PPF).

The simplest way to show economic growth is to bundle all goods into two basic categories, consumer and capital goods. An outward shift of a PPF means that an economy has increased its capacity to produce.

Growth creates:-

When using a PPF, growth is defined as an increase in potential output over time, and illustrated by an outward shift in the curve. An outward shift of a PPF means that an economy has increased its capacity to produce all goods

A division of labour, and specialisation, can considerably improve productive capacity, and shift the PPF outwards.

Growth in the size of the working population enables an economy to increase its potential output.

An inward shift of a PPF

A PPF will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce resources. This reduces an economy’s productive potential.

Investment

If an economy chooses to produce more capital goods than consumer goods, at point A in the diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B.

There is a trade-off between the short and the long run. In the short run, the economy must use resources to produce capital rather than consumer goods. Standards of living are reduced in the short run, as resources are diverted away from private consumption. However, in the longer run the increased investment in capital goods enables more output of consumer goods to be produced. This means that standards of living can increase by more than they would have if the economy had not made the short-term sacrifice