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«Conflict economics contributes to an understanding of violent conflict in two important ways. First, it applies economic analysis to diverse ...»

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According to the law of diminishing returns, as the amount of an input increases (holding the other input fixed), after some point its marginal productivity will diminish. For example, if LM is raised to 144 and KM held fixed at 9, the marginal product of labor in the military industry diminishes from 7.5 to 6.25 units. Note that this means that even though the total

2.1. Production Possibilities Model 17 output is now larger, the addition to the output is now smaller. Now consider increasing both inputs at the same time. For example, suppose both inputs are doubled, so that output becomes M ¼ 50(200)0.5(18)0.5 ¼ 3,000 units. Doubling both inputs causes output to exactly double, which is known as constant returns to scale. For the Cobb-Douglas production function, constant returns to scale exists when a þ b ¼ 1. If a þ b 1, doubling inputs causes output to more than double, which is known as increasing returns to scale. If a þ b 1, doubling inputs causes output to less than double, which is called decreasing returns to scale.

Production Possibilities Frontier In economics, the fundamental fact of nature is scarcity, whereby individuals, groups, and nations have limited resources and technology to produce goods and services to meet peoples’ virtually unlimited wants.

Assume that the labor and capital employed in the military and civilian

sectors equal the total labor and capital available to the economy, L and K:

L ¼ L M þ LC ð2:5Þ K ¼ KM þ KC : ð2:6Þ The scarcity of labor and capital is reflected in equations (2.5) and (2.6), while the technological limits to production of goods for given input combinations are implied by the production functions (2.3) and (2.4).

Technological limitations in production and scarcity of inputs imply a production possibilities frontier (PPF) such as that shown in Figure 2.1.

Points on or within the PPF constitute the attainable region, which includes all combinations of guns (M) and butter (C) that are possible to produce within an economy.

The PPF in Figure 2.1 depicts the fundamental notion of scarcity in two ways. First, all combinations of guns and butter above the PPF lie in the unattainable region, meaning they cannot be produced given the available resources and technology. Second, the slope of the PPF is negative, meaning there exists a production trade-off between the two goods. At any point on the PPF, say point A, the only way to obtain more guns (moving to point B, say) is to give up some butter. When production is on the frontier, gaining more of one good requires giving up or forgoing some of the other good. This trade-off is captured by the concept of opportunity cost. In Figure 2.1, the opportunity cost of an increase in guns from m1 to m2 is the c1 – c2 units of butter given up. Note that the PPF in Figure 2.1 is bowed out. This indicates that the opportunity cost of a good will increase 18 Production Possibilities and the Guns versus Butter Trade-Off

–  –  –

as more of the good is acquired. For example, in moving from point B to point E, even more units of butter must be given up for an equal increment of guns than when moving from point A to point B. Economists believe that PPFs are usually bowed out because resources shifted from the production of one good to another tend not to be equally adaptable.

As depicted by the PPF, many alternative production points exist; hence, choice is inescapable. Among the thousands of goods and services that might be produced in a modern economy, decisions must somehow be made about what quantities of which goods will be produced, what combinations of inputs will be used, where the goods will be produced, how the goods will be distributed, and how all of these things will be coordinated and adjusted as technology, resources, and peoples’ preferences change over time. Different nations have different economic systems for addressing these issues. In the United States and many European nations, there is substantial private ownership of property and a reliance on markets (supply and demand) to coordinate economic activity.

In North Korea and Cuba, most property is not privately owned, and economic activity is directed by state central planning. Other economies have somewhat limited private property yet a significant role for markets (e.g., China).

2.1. Production Possibilities Model 19 Figure 2.1 can also be used to understand the concepts of productive and allocative efficiency. Productive efficiency occurs when inputs are fully employed, so that equations (2.5) and (2.6) hold, and maximum output is produced from those inputs based on available technology, so that equations (2.3) and (2.4) hold. When productive efficiency is achieved, the economy operates at some point on the PPF. If the economy fails to employ all resources fully and productively, then it operates at a point inside the PPF, which is called productive inefficiency. Allocative efficiency, also known as Pareto efficiency, occurs when it is not possible to improve one individual’s or group’s well-being without hurting another’s.

For example, suppose the economy is operating at point B in Figure 2.1, which is productively efficient. Now assume that the movement from point B to point A makes everyone better off, but that any further move from point A will leave at least one person worse off. This would imply that B is productively efficient but not allocatively efficient, whereas A is both productively and allocatively efficient.

Specialization and Trade in the Production Possibilities Model The authors of this book produce teaching and research services, and maybe a few vegetables from gardening, but they consume hundreds of other products. Our case is typical of workers in modern economies who specialize in the production of one or a few items and then trade their specialized output (with money facilitating exchange) for the goods they consume. Specialized production and trade is a fundamental aspect of economic life, not only for individuals but also for nations.

In Figure 2.2 we depict specialized production and trade using the production possibilities model. Recall that along a PPF there exists a trade-off between one good and another. This trade-off is internal to the country; that is, within the country’s own production possibilities, it can trade off one good for another as reflected in the slope of its PPF. But there is another possibility available to the country; namely, it can trade some of its output with another country. This is an external exchange possibility. In Figure 2.2 we draw a curved line, known as an indifference curve, tangent to the PPF.

We will discuss indifference curves in more detail in Chapter 3, but for now it is sufficient to say that points along any given indifference curve generate a fixed level of well-being or utility, and that the higher the indifference curve, the greater the well-being or utility. In Figure 2.2, if the nation produces goods only for itself and does not trade, the highest attainable indifference curve is the one that is tangent to the PPF (labeled aa), say at point A. Point A 20 Production Possibilities and the Guns versus Butter Trade-Off

–  –  –

is known as an autarky optimum, because it is where the country would produce to maximize its material well-being in the absence of any external trade. Assume the opportunity cost of military goods in the neighborhood of point A equals –1, meaning that the production of an additional unit of M would cost one unit of C forgone. But suppose that prices on world markets are such that one unit of M could exchange for two units of C. This external terms-of-trade is represented by the line with slope –2 drawn tangent to the PPF at point B. With external trade, the country can achieve a higher indifference curve and therefore a higher level of well-being by following an “economic two-step.” First, it specializes more in the production of M by moving its production point from A to B. Second, it trades away some M in return for some C, arriving at a final consumption point E on the higher indifference curve ee. The distance FE represents the country’s exports of M, while BF represents its imports of C.

Figure 2.2 shows that specialized production and trade allow the country to consume more goods and services than it could produce in isolation.

At consumption point E, the country is consuming a bundle of goods that lies outside the PPF. Although E is an unattainable production point, it is not an unattainable consumption point because of the opportunity presented by external trade. When specializing in a product (good M in this case) that is

2.2. Applications 21 more valued on world markets relative to the opportunity cost of producing it in isolation, the country is operating according to what is known as its comparative advantage. Such specialization increases the value of the country’s production and, through trade, allows the country to reach a higher indifference curve. The increase in the indifference curve from aa to ee is a graphical representation of the gains from trade.

Economic Growth in the Production Possibilities Model Over time, most economies experience an increase in the amount of goods and services that are produced as more labor and capital and better technology become available. This is known as economic growth. For example, since the early 1940s, a growing proportion and number of women have entered the work force in the United States, contributing to its post–World War II growth in gross domestic product (GDP). In some countries, such as Afghanistan prior to the fall of the Taliban in 2002, women have been discouraged or forbidden from paid employment, which tends to depress GDP growth. When new resources or technology become available, the PPF moves outward, causing some previously unattainable production points to become attainable. The PPF does not necessarily shift out equally along the two axes. If resources or technological developments are biased in favor of, say good C, the PPF would shift out more along the C axis than the M axis.

Note also that the PPF can shift in, which constitutes negative economic growth. For example, Hurricane Katrina destroyed lives and capital stock in New Orleans and Southern Mississippi in 2005, causing the PPFs for these local economies to shift inward.

2.2. Applications

Economic Costs of Conflict In Chapter 1 we indicated that violent conflict involves economic costs of three sorts: diversion of resources to defense, destruction of goods and resources, and disruption of present and future economic activities.

Figure 2.3 illustrates these three types of costs in the production possibilities model.

Conflict typically leads to an increase in military production as a proportion of overall production. In panel (a), the increase in military goods relative to civilian goods causes the production point in the economy to move from say A to B. In this case, the increase in “guns” from m1 to m2 occurs at the expense of “butter,” which declines from c1 to c2. In 22 Production Possibilities and the Guns versus Butter Trade-Off

–  –  –

Figure 2.4.

Channels by which defense spending can impact economic growth.

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