Archive for the 'Production possibilities curve' Category

Sep 02 2010

“Guns vs. Butter” – The PPC and tradeoffs in the real world

School kids feel the bite of high food prices – May. 5, 2008

A classic method of teaching the basic economic concept of the production possibilities curve is to illustrate the relationship between a nation’s decision to invest in military goods versus civilian goods. The model typically includes two “products” that a nation can choose to invest in: guns and butter. The specific goods themselves are not so important, rather what they are meant to represent: the tradeoff any nation faces between allocating more of its scarce resources towards national defense versus goods and services that benefit the nation’s consumers.


Today the United States faces a very real version of the old “guns vs. butter” model. Rising global food prices have put public school districts in a bind: how to feed kids nutritious meals as the prices ingredients has risen at unprecedented rates:

Rising food prices are making it harder for schools to cook up ways to give kids the nutrition they need.

Right now, they’re taking shortcuts and shuffling ingredients to make up the difference, but that’s only a short-term solution with long-term consequences on the horizon.

“I’ve been in school service for 27 years and this is the worst it’s ever been,” said Sara Gasiorowski, food service director for Wayne Township Schools in Indianapolis. “I have never seen food prices jump up so far…”

Food prices nationwide have risen 4.5% between March 2007 and March 2008, according to the Bureau of Labor Statistics’ Consumer Price Index, with flour and eggs rising even more dramatically than milk. Grumbles said milk prices in her district are up 22% from last year, which means an increase of 3.5 cents for each of the federally required 16,000 half-pints she provides every day.

“For every penny on a carton of milk, it costs me $30,000 a year,” she said. “That’s $105,000 extra on my food bill.”

Flour prices have roughly doubled over the last year, according to Grumbles, to $19 per 50-pound bag. To make up for the difference, she substitutes canned peaches for fresh apples “to save a couple pennies” per meal, or she uses ground beef in place of chicken.

Unfortunately, federal funding for school lunches has increased at a much slower rate than cost to districts of providing those meals:

Federal reimbursement programs cover all or part of school districts’ lunch tabs. Congress lifts reimbursement rates every year, but Gasiorowski said it hasn’t been enough: “We need to be looking at an increase of 12% to 15%, instead of our usual annual increase of 2 or 3%.”

The current federal reimbursement program is based on household incomes; the poorest American students receive $2.47 of federal funding towards their “free lunches”, while students from the highest income bracket only receive $0.23 per meal. The problem is, the average school lunch now costs $3.10, so these days no one is actually receiving a “free lunch”, not even the poorest American students.

This article struck me in that is truly does illustrate the concept of tradeoffs as illustrated in the production possibilities curve. Society must allocate its scarce resources towards the goods and services it deems most desirable based on the needs of its citizens. Complications arise in this basic model, however, when government is involved.

The commitment to subsidizing school lunches is based on the idea that if the responsibility of feeding American school children were left to the free market, resources would surely be underallocated towards nutritious meals, representing a market failure. School lunches are a merit good, meaning they would be underprovided by the free market, since without public provision and support, millions of American children would come to school every day without nutritious meals to get them through the day.

National defense is another service that governments find it necessary to provide.  If it were left completely up to the free market, national defense would probably not be provided at all. Instead, only individuals who could afford it would hire private security forces to protect their property. To protect a whole nation, however, government provision of defense is a necessity.

Clearly, both “guns” and “butter” create benefits for society. Among the countless other goods and services the government provides or supports the provision of, the United States faces a tradeoff arising from the scarce resources at the government’s disposal. Currently, the US government spends far more on  its military ($660 billion in 2010!) than it does on lunches for American school children. Clearly, military spending is necessary, but it may be that in the tradeoff between these two important services more resources should be allocated towards “butter” at a period in the US economy when low income households are finding it harder than ever to provide their children with one of life’s most basic necessities, nutritious food.

Discussion Questions:

  1. What do “guns and butter” represent on the PPC above? Why have economists found it useful to use these two goods on their analysis of the tradeoffs faced by nations?
  2. Why doesn’t the United States just make all school lunches FREE for all American school children? Wouldn’t that make sense? Give an economic argument against this suggestion.
  3. Why does the government feel it necessary to allocate any resources towards school lunches? Shouldn’t the government just let American families provide their own children with lunch?
  4. Say the US government decided to increase its provision of both national defense and school lunches, without reducing its provision of some other good or service. How would it do this? Why wouldn’t the government do this?

Update: I received an email message from a reader about the above blog post:

I have to say that your “guns and butter” diagram is “interesting.” I am not clear on why the United States should spend vastly more on school lunches than on defending the free world While government provided school lunches may have a place, most Americans feed their own children and do not depend on Federal financing.

Where did you get the notion that feeding our children would be “under-provided by the free market”

Here was my reply to this reader. I’m posting it here because I want to make it clear the the diagram above is not meant to make any political statement about US military spending:

Hello,

Actually, the PPC was included simply to illustrate the basic tradeoff that society faces when it chooses how to allocate its scarce resources.

Having taught at least for a short while in public schools, I can say that nutritious lunches are definitely “underprovided” by the free market, that is, many students in poor communities in America depend on the “free and reduced” lunches that are provided through federal and state funding programs… I once volunteer taught in a poor Elementary School in Spokane, Washington where 40% of the students ate only two meals a day, both provided free by the school district: one at 8 in the morning, one at noon. Many of these children had parents who were poor, unemployed, often addicted to drugs, who failed to put any food on the table whatsoever.

In other words, I do think that nutritious meals are a “merit good” which by definition is one that is underprovided by the free market, therefore requires subsidies from the government. Otherwise, why would the government offer such subsidies at all, if these meals were something the free market could adequately provide on its own?

Again, I was not making any political statement with the graph, only pointing out the basic economic concept of tradeoffs and the idea that society must allocate its scarce resources towards an “optimal” combination of goods and services. The article indicates that in this time of rising food prices, not enough of America’s resources are going towards providing nutritious meals for school children, indicating that a movement along the PPC might be in order. The degree of such a move is irrelevant, only the fact that a movement must occur if nutritious meals are to continue to be provided. In fact, the x-axis could have represented any other public good the government provides for society, I chose “military spending” so that the current example was consistent with the classic example of “guns vs. butter”.

Hope that clears things up… Best regards,

Jason

41 responses so far

Sep 15 2009

Guns and Butter – a dangerous combination

Indexed » Blog Archive » Resources were not allocated efficiently

Econ students and teachers alike should appreciate this Venn Diagram. What happens when a nation chooses a point on its production possibilities curve somewhere between “guns” and “butter”? Answer, “Accidental shooting”… GET IT?

The punchline: “Resources were not allocated efficiently”

No responses yet

Feb 14 2009

Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?

CBO Director’s Blog » Macroeconomic Effects of the Senate Stimulus Legislation

The February 9th edition of the excellent NPR show, Planet Money reported on a letter sent from the director of the Congressional Budget Office to the Senate, forecasting the short-run and long-run macroeconomic effects of the House Stimulus Package.

It turns out the director of the CBO has his own blog on which he published his letter to the Senate. Here are some highlights:

CBO estimates that the Senate legislation would raise output by between 1.4 percent and 4.1 percent by the fourth quarter of 2009; by between 1.2 percent and 3.6 percent by the fourth quarter of 2010; and by between 0.4 percent and 1.2 percent by the fourth quarter of 2011. CBO estimates that the legislation would raise employment by 0.9 million to 2.5 million at the end of 2009; 1.3 million to 3.9 million at the end of 2010; and 0.6 million to 1.9 million at the end of 2011…

Most of the budgetary effects of the Senate legislation would occur over the next few years. Even if the fiscal stimulus persisted, however, the short-run effects on output that operate by increasing demand for goods and services would eventually fade away. In the long run, the economy produces close to its potential output on average, and that potential level is determined by the stock of productive capital, the supply of labor, and productivity. Short-run stimulative policies can affect long-run output by influencing those three factors, although such effects would generally be smaller than the short-run impact of those policies on demand.

In contrast to its positive near-term macroeconomic effects, the Senate legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt.  To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

The negative effect of crowding out could be offset somewhat by a positive long-term effect on the economy of some provisions—such as funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run. CBO estimated that such provisions account for roughly one-quarter of the legislation’s budgetary cost. Including the effects of both crowding out of private investment (which would reduce output in the long run) and possibly productive government investment (which could increase output), CBO estimates that by 2019 the Senate legislation would reduce GDP by 0.1 percent to 0.3 percent on net.

The fascinating thing about this letter from the Congressional Budget Office to the Senate is that it mentions so many of the Macroeconomic principles we teach in both AP and IB Economics.

  • The nation’s potential output (PPC) is “determined by the stock of productive capital, the supply of labor, and productivity”.
  • Fiscal stimulus’ effects, while possibly significant in the short-run, may result in less long-run growth due to “crowding-out” of private investment as the public puts its savings into government debt and takes it out of the market for loanable funds.
  • A stimulus package should be made up of “funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run.” The negative effects of crowding-out could be offset through responsible government spending.

I find this letter to be surprisingly positive. The short-run forecast seems optimistic: as much as 3.6% GDP growth and as many as 3.9 million new jobs by the end of 2010. The negative growth effects of the stimulus resulting from increased government debt and the subsequent “crowding-out” of private investment are not predicted to set in until 2019.

I always tell my students that humans are “short-run creatures living in a long-run world”. I have to admit, this short-run creature is inclined to think that a stimulus package that puts nearly 4 million people to work and turns the US Economy back onto a path towards growth within two years is probably worth the long-run risk of sluggish growth ten years down the road due to the decline in private investment resulting from the debt-financed spending today.

This letter from the CBO also seems to address a debate recently undertaken in the AP Economics teacher email list: whether deficit-financed government spending affects the supply of or the demand for loanable funds in the economy.

To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.

This passage from the director’s letter indicates that it is the supply, not the demand for loanable funds that shifts, driving up real interest rates in the economy. Savers will take their money out of banks and other lending institutions and put it in government bonds, reducing the amount of capital available for private investment. This can be illustrated as a leftward shift of the supply of loanable funds.

Discussion questions:

  1. In evaluating the use of expansionary fiscal policy, we learn in IB Economics that the crowding-out of private investment will reduce the expansionary effect of increased government spending. Is crowding-out a problem during a recession? Why or why not?
  2. Discuss the following statement: “In order to finance its budget deficit, the US government must borrow from the private sector.” How does the government borrow from the American people?
  3. Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run? Discuss.

200 responses so far