Production Possibility Frontier, Opportunity Cost and Specialisation

Economics deals with the problem of optimizing the use of scarce resources to achieve the best possible returns from them. To achieve the best possible results, it analyses various alternative methods of using the resources. During this study, we come across various terms like Production Possibility Frontier (PPF), Comparative Advantage, Opportunity Cost, Economic Efficiency, Specialization, and Absolute Advantage, etc.

Let us study these economic concepts one by one.

Production Possibility Frontier (PPF)

Any country or region must produce and provide a number of products and goods to meet the needs of its people. But normally the resources of any given place or country do not allow it to produce all its requirements in abundance. Some items may be produced in larger quantities, whereas other items may be produced in smaller quantities and at higher costs. All this depends on the availability of resources and the costs involved in turning those resources into end products.

For example, let us suppose two items produced by a country, say steel and petroleum. Steel is easily produced in large quantities due to the availability of vast reserves of iron ore. But petroleum is being produced in smaller quantities and, that too, at high cost, due to shortage of resources and drilling problems at deep levels.

If the country has to produce both items, with the help of its other fixed resources remaining the same, like manpower, technology, and working capital, it becomes necessary for the country to figure out how much quantity of these products can be produced so that it may use the available resources to their optimum possible benefits.

Suppose the country in our study can invest an equal amount of money in the production of steel and petroleum products. As a result, it can produce 1 million MT of steel and half a million kiloliters of petrol (when equally invested and other factors are completely utilised). Now, if the steel production is surplus, the country may want to divert the investment in steel to petroleum products to meet the shortage of petrol. 

Suppose the cost of production per MT of steel is $800 and that of petrol is $1000. So when diverting funds to producing petrol, you need an additional $200 for each KL of extra petrol.

If you can reduce 5lac MT of steel, you will be able to produce another 4lac KL of petrol. Or, if you forego 2.5lac MT of steel, then you get 2lac KL petrol approximately.

If represented in a graph, the picture will be like this.

Category 1 is steel, and Category 2 is petrol.

• Series 1 line shows that if steel is produced 10 lac MT, Petrol production is 5 lac KL.
• Series 2 line shows Steel production as 5 lac MT and petrol as 9 lac KL.
• Series 3 line shows Steel as 7.5 lac MT and Petrol as 7 lac KL.

All three lines are intersecting at a point of 7.2 (approx), which may be the production possibility frontier for these two products. 

This is the best possible combination for producing the two goods economically by using the available resources to their optimal maximum advantage. So, you can produce 7.2 LMT of steel and 7.2 LKL of petrol approximately to reach PPF.

This is when you are contemplating only two products. 

But in actuality, there will be a lot of goods produced, and decision-making will be much more tedious and require much more prudence than a simple chart.

Thus, the applications of the Production Possibility Frontier determine the production structure for any country or firm.

Comparative Advantage

Comparative advantage refers to the process of adapting to the production of those goods and services which can be economically beneficial and feasible compared to other items, both in terms of available resources and the cost factor. In this approach, you will be analysing the various factors related to production among available options. Any country or business can produce only certain goods and services beneficially with its available resources. If it indulges in producing all items, its economy will dwindle. In the above example of steel and petroleum, we can see that concentrating on steel production is more beneficial than producing both items. Petroleum or petrol can be more beneficially imported from another country where it is available cheaper by exchanging with steel than producing it at high costs domestically and wasting the resources. So it is comparatively advantageous to produce more steel in this case.

Opportunity Cost

By opportunity, it is meant that you are given an opportunity to select among two or more items to satisfy an immediate need with your available resources. For example, you have, say, Rs.1000/- with you and you are in need of both shoes and a branded shirt. But when you enquire at the stores, you may realize that you can procure only one item with your money. So you will have to decide which is more important for you, purchase that item, and postpone the other item until next shopping. So, in this instance, if you opt for the shoes by foregoing the shirt, the opportunity cost of the shoes is the shirt. Economists study these statistics and the driving reasons behind these decisions of consumers to set guidelines for markets.

Economic Efficiency

Economic efficiency is a situation where the economy has attained its best results. If a country could produce all its requirements with its available resources without leaving any bad effects on the economy, it is said to have attained economic efficiency. It is a situation where the country can meet all the needs of its society and people at affordable costs and without any loss to the exchequer. This kind of efficiency is possible when the country is rich in all kinds of resources and technology, etc.

Specialization

Specialization implies reaping the benefits of specialized skills by producing certain goods more abundantly and at lower cost than other countries. Normally, no country or business can produce all goods and services equally well. It may produce some goods very efficiently and in abundance, whereas producing other goods or services may require more resources and effort, with much smaller output. So it will be advantageous for that country to specialize in those goods and services it can produce in greater abundance, and to do so easily and at lower cost. This is possible because it has vast resources and advanced technology for producing certain items. It can concentrate on those items only and reap the advantage of specialization by producing more goods and exporting them to other countries, from which it can import other requirements at cheaper rates than it could have produced them. So specialization improves trading relations between countries and boosts the economy.

Absolute Advantage

Sometimes, a country may be so positioned that it will be rich in all kinds of resources and technology skills by default. In such cases, the country is said to be in absolute advantage as compared to others in the production of any type of goods and services. It may be a rare case.

To sum up, a country's economy will generally benefit if it focuses on specific products and services, using the PPF, comparative advantage, and specialization. In this way, it can use its resources efficiently to achieve optimal outcomes at comparatively low costs and maintain sufficient stock levels. It can export excess goods and services and import other essential goods and services at affordable rates through trade. In this way, it can improve its economy.

Notion of Scarcity and Effects on Economy

Scarcity is a state of the economy where the available goods, services, or resources are unable to meet all the needs and requirements of the public. It is a case of insufficiency. 

People's requirements are larger than the available resources of the country, or that particular economy.

It is a condition of insufficient stock, insufficient production, and insufficient availability of all resources or funds.

Factors Contributing to Scarcity

• It is geographically situated in a way that it is resourceless by default.
• Lack of technology and mining facilities to unearth the resources and produce the end products.
• Ever-increasing population, with no corresponding improvement in production and services.
• Impact of natural calamities destroying resources and production.
• Lack of efficient planning and management.

So you can see that scarcity of resources is both geographical and man-made. 

It is either a natural element or weakness of that country and may also be due to chaos in their administration.

Solutions to the Problem of Scarcity

If the problem is due to natural elements such as being destined by default to be poor in natural resources, then we may not be able to solve it easily.

The available options are either to import raw materials and resources from other countries and produce finished goods in your country, or to import finished goods directly from there.

You should consider the cost factor to be economical. If the cost of production from importing raw materials and turning them into finished goods is lower or equal to the cost of imported finished goods, then you can opt for importing the raw materials and producing them at your end, as it has the benefit of giving employment to your workforce. 

If, on the other hand, you realize that the cost of importing finished goods is much lower, then you should import the finished goods to tackle the situation.

In case the scarcity is due to reasons other than natural elements:

Given the country's scarce resources, there are many factors that require deep understanding and analysis before identifying and formulating solutions.

• In case of floods, rains, and droughts that destroy stocks and resources, you must consider solutions to tackle the problem. Collecting statistics on the frequency and periodicity of these calamities can help you formulate preventive measures, such as constructing dams and reservoirs, adopting rainwater harvesting and irrigation canal techniques, and building water reservoirs and ponds to store water for off-season use. These measures can help address scarcity to a significant extent.
• If the problem is man-made, such as population growth or congestion in certain areas, scarcity can be addressed by controlling population growth or by increasing the production and supply of goods through transportation and transhipment from other places.
• Inefficiency in management and administration can be resolved through proper training programs and active participation by workers and management to remove bottlenecks.
• Proper cost control studies and analysis can reduce funding problems that may contribute to scarcity if left uncontrolled.

From the above analysis, you can realise that the notion of scarcity is both natural and artificial. Artificial in the sense that it is created due to improper planning and administration and lack of knowledge. 

In some cases, scarcity may be intentionally created through corrupt methods to create black marketeering. 

But normally scarcity can be resolved through better planning and administration. 

Better planning is possible through an in-depth review of all the economic factors prevailing in the relevant environments and through formulating suitable principles and norms for application under particular conditions and situations.

Two branches of Economics: Macroeconomics and Microeconomics

There are two approaches to studying economics, or two branches of economics. They are Macroeconomics and Microeconomics. Both approaches are closely related and intertwined. Let me explain in detail-

Macroeconomics

Macroeconomics is the study of a country's or the world's economy as a whole unit. It mainly concentrates on government policies, dealing with the allocation of scarce resources to achieve maximum production and development in the economy. 

It deals with the country's available resources, demand trends of its population, available technology and infrastructure, manpower, and brainpower. It studies available options in achieving targeted goals, etc. It tries to propose policies and decisions to improve the economy, based on surveys and assumptions or conclusions drawn from these studies.

For example, take the power sector in India. Power is generated either by using coal or water. Coal is becoming exhausted due to the long-term draining of coal fields. Now the reserves are found at very deep levels of coalfields, and mining them is becoming a very tedious job. 

As a result, coal prices have increased enormously, and power generation costs have also become very high. In hydel power, we are facing the same problems. Water sources are drying up. The construction of dams has also become problematic, as people living in those areas are strongly opposing the projects as they are afraid of losing their livelihoods and homes. The government has to tackle these issues patiently and prudently. So all these matters are to be studied with great analysis and research to arrive at decisions.

Their research has led to the utilisation of alternative sources of generating power like solar power. But solar power generation involves too much investment, and its cost of production is also very high at present.

Macroeconomics deals with all such problems. It studies all issues very closely and carefully, and advises the governing bodies on the best possible solutions.

Microeconomics

Now, coming to microeconomics, it mainly deals with the study of individuals, or firms, or companies in their reactions and habits under particular economic circumstances. 

Microeconomics observes people and societies and studies their actions in pursuing their wants among various available options to tally with their limited resources. It studies how a person under a particular level of income reacts to certain changes in products and supplies, or to changes in prices. or in their income levels. 

It observes how he adjusts his wants by satisfying only certain needs and suppressing the others. In other words, microeconomics studies which needs he gives more preference by leaving behind the other needs for a later time. 

It also observes the degree of preference or the order of preference in which he satisfies his needs. If he gives more or most preference to particular wants, why is he giving that much degree of preference to that want over all others, and which want he will satisfy next to it and so on. All these things are studied very minutely to understand consumer behaviour.

Microeconomics formulates some conclusions and laws according to this behaviour of individuals. 

It sets assumptions and predictions that at such and such a level of income people will act like this, and they will react to some changes in prices or supplies in such and such a manner. 

These predictions will guide the marketing people in selling their products or manufacturing them according to the tastes and preferences of consumers.

In a nutshell

• Economics, with the application of both these microeconomic and macroeconomic approaches, tries to solve all economic problems for improving the overall economy of the people.
• It acts as an important tool in dealing with consumer behaviour and marketing behaviour. 
• It helps in setting standards and guidelines for governments and markets in dealing with the problems of scarce resources and increasing demands. 
• It tries to bridge the gap between production and demand and maintain a level of equilibrium as far as possible.

What is Economics: Definition and Importance

Definition of Economics
Economics can be defined as the science of wealth and material welfare of society.
To be straightforward, let us come directly to the point-

• Economics is a scientific study of the allocation of scarce resources to their best uses.
• To economise is to save or utilise for maximum possible satisfaction out of those scarce resources.
• Economics is the study of wealth, material welfare of society, and human behaviour related to these concepts of wealth and material welfare.
• Wealth is not simply money. Wealth refers to everything from natural resources to manufactured or produced products, and material welfare is the allocation and distribution of these resources (including wealth) among society.

Need for Economics

Our world is full of resources. But either they are scarce and insufficient to meet all our demands, or we are unable to extract or produce them in sufficient quantities to meet all our requirements. So our demands are always higher than the resources available to us at any point in time. 

Here is where the need for economy arises.

If we had been bestowed with an abundance of resources that can last forever, there would have been no need for economics. 

But the fact is that we are short of supply and so unable to satisfy all our demands. 

So, we are forced to cut back our needs to match the supply. 

We have to choose among our multiple needs and try to satisfy the most urgent needs first. 

Economics studies this behavioral pattern of people in choosing among needs and sets guidelines for the economic system as a whole.

Objective of Economics

The main objective of economics is to study this problem of scarce available resources and the always mounting needs of people to suggest some positive solution. 

The economists keep a watch on the behavioral patterns of consumers and the public and, after much analysis, arrive at some conclusions regarding projections of people's behavior under certain stimulated conditions. These conclusions are then submitted to the government and the financial/ banking institutions for framing their economic policies.

Example:

For example, suppose a person with a certain income of Rs.50,000 per month pays a monthly rent of Rs.10,000, electricity bill of Rs.2,000, internet/ phone bill Rs.1,500, maintenance Rs.1,500, housemaid payment Rs.2,000, medicines Rs.5,000, provisions Rs.5,000, gas refil Rs.1,000, milk Rs.2,000, vegetables/ fruits Rs.1,500, petrol Rs.10,000, and invests Rs.5,000 each month. 

In this manner, his total monthly expenses amounted to Rs.46,500.

Now, he will be left with Rs.3,500 for other expenses. 

He may have to choose between buying a set of clothes or watching a movie with friends, or partying on the weekend within that balance amount. 

He can not meet all three needs from the leftover balance simultaneously. He will have to choose which need to satisfy first.

He can buy clothes one month, watch the movie in another month, and party in yet another month. He will have to plan in this way and adjust his needs.

Economists study how people make decisions when choosing among options under different circumstances and environments. 

They formulate some general laws based on these behavioural changes and propose reform policies to the institutions. 

They study the effects of increases or decreases in supply and demand, changes in the availability of funds in consumers' pockets, and effects of price changes on demand and supply, etc. 

All these factors are studied by simulating some artificial conditions also for their research purposes.

So, Economics plays an important role in our daily lives, guiding our decisions based on the availability of resources and multiple needs.

How to Know Which Account to be Debited or Credited?

In the Double Entry System, every transaction has two sides. One account is debited, and the other is credited. So when you make some, say 10 entries, there will be 10 debit entries and 10 credit entries. The total of Debits and the total of Credits will tally at the end of any day. If they do not tally, it means the entries are wrong, and you will have to recheck each entry to verify that each Debit received a corresponding Credit.

Now, coming to Debit and Credit, how to know which account should be debited or credited?

The simple rule is Debit all Payments and Credit all Receipts.

Let me clear this point through these simple steps:

DEBITS (Payments)

• Assets: You are making a payment and receiving some asset. Payment may be whole or in parts. But you are paying. So, debit the Asset a/c (e.g., Land, Building, Plant & Machinery, Computer, etc.) or the Advances a/c with the amount paid.
• Purchases of Stock: Here also you are paying for stock items. So debit Stock a/c.
• Expenses: Here you are paying for the travel and tour bills, stationery items, postage and courier charges, etc. So, debit the relevant account heads.
• Adhoc or Advances: Sometimes you pay an amount as advance for any job or contract for executing some work or supplies. Here, you will debit the advances a/c either in the party name or by the Work name.

CREDITS (Receipts)

• Capital or Equity: Your business receives capital or share capital to start and run the business. So, Credit the Capital/Equity a/c or Share Capital a/c.
• Liabilities: You take loans for your business. Your business received the loan. So, credit the Loan a/c.Say SBI loan a/c, ICICI loan a/c, IDBI loan a/c. etc. Further, your business receives money from customers against supplies. So, credit the Customer a/c by his name. 
• Income/Revenue: You sell items or provide services and in return, receive income for those services. So, credit the Sales a/c or othe Other Income a/c. If some interest is received on FDRs or Savings A/C, etc. Credit those Interest Received income accounts.

So, from the above study, you can see that as a beginner in accounts, it is sufficient that you remember the basic fact "Debit all Payments and Credit all Receipts".

Let us consider an example:

Suppose A invested 10,00,000 to start a business. He rented a shop for 10,000 per month and paid six months' advance. He bought furniture and fittings worth 80,000. Purchased goods (say readymade garments for sale) worth 5,00,000. Employed two workers at a salary of 5,000 each/per month. He sold his goods worth 4,50,000 within a month with a profit of 50,000.

The accounting entries for the above transactions will be as follows:

1. A invested money, and he has to be repaid. His account is credited under Capital a/c by 10,00,000, and the Bank/cash account gets debited (depending upon Cheque or Cash).
2. Rent Account is debited with 10,000, Advance Rent with 50,000, and credit is given to Bank/Cash.
3. Furniture and Fittings is debited with 80,000 and Cash/Bank credited by the same amount.
4. Stores/Stock account is debited with 5,00,000, and Credit is given to Bank/Cash
5. As and when goods are sold, each sale value is credited to the Stock account at the actual purchase price, and the extra (inflated amount) is credited to the Sales Income account.
6. Whenever salary is paid, 10,000 is debited to the Salaries account with credit to Bank/Cash.

Classification of Accounts Based on Accounting Equation Principle

ASSETS = Liabilities + Equity.

Based on this Accounting Equation principle, all accounts have been classified into Five Types of Accounts.

This accounting equation principle assumes that whatever we spend, we spend it from the money we invest in the business, known as Capital/Equity, as well as from the loans we take, known as Liabilities, and from the Income generated by us through the business. So, we spend from these three types of sources. Now, coming to the spending aspect, whatever we may be spending, we spend either for procuring Assets or for running the business through various expenses.

So, according to this notion, Assets + Expenses = Equity + Liabilities + Income

Naturally, the sum total of Assets + Expenses will be equal to the sum total of all Liabilities + Equity + Income. 

• During any year, the excess of Expenses over Income becomes the Loss, and the Excess of Income over Expenses becomes the Profit of the business. 

Ultimately, on finalisation of the Profit and Loss Account, the difference between expenses and income gets added either to Assets or Liabilities. When there is a loss, it is added to the Assets side because it was incurred (and to be recovered from future profits), and the profit is treated as a liability to be paid to the Owner and Shareholders.

  

When it is done, the net effect is Assets = Equity + Liabilities.

This classification into  5 basic types of accounts is derived from the concept of the Trial Balance also. In a Trial balance, you enter all debit balances in the left-hand side column and all credit balances in the right-hand side column. And if a trial balance does not tally, it means that some entry is wrong in your books. This is the inherent principle applied by the Accounting Equation in all books of accounting.

Now let us examine which type of accounts or what kind of elements each group of accounts consists of.

EQUITY
Equity or Capital is the money invested in the business. Any business requires some capital to start with. The businessman invests some money to establish and run the business. It is known as Capital. If it is a big company, it will have many promoters or shareholders in the business, who are allotted shares according to their shares. This is known as share capital or Equity. So accounts maintained under this group include Capital a/c or Proprietor Capital, ShareHolders' money a/c, Equity a/c and Preferential Share a/c, etc.

LIABILITIES

Liabilities are also a kind of investment in the business. For example, you may take a loan to run the business from Banks or Financial Institutions. This money is repayable to them in installments with interest. So it is a liability. Further, you may collect advances from customers for supplying goods or services to them. So it is a liability as you will have to supply to them the goods and services required by them. Another kind of liability is that you will be paying some accrued expenses due for the period up to March, but it is payable after 1st April. As on 31st March, it is a liability for the business. So all these are the company's dues to outsiders. Accounts included under this group are naturally Customers a/c, Loan a/c, Interest payable a/c, Expenses Payable a/c, Bank Overdraft, etc.

ASSETS

Assets are of fixed or permanent nature and of current/ temporary nature. Any business owns Land, Building, Furniture, and Equipment like computers, calculators, printers, etc. These are Fixed Assets as they run for some years. Current Assets are Cash Balance, Bank Balance, Stock-in-trade, Investments, Amounts Receivable, etc. All these are assets to the company.

INCOME/ REVENUE

Any kind of income received by the business during a particular year is known as its income or revenue for the year. This income is generated through its transactions. So INCOME group includes accounts like Sales a/c, Interest received on Investments, Interest from Bank, Interest received from others like scrap sales, late payment or late supply interest, etc. Profit of the business during the year also is an income and comes under this group.

EXPENDITURE

All expenses incurred for running the business during a particular year are grouped into this group. So this group consists of expenditure heads like Stationery, Printing Charges/ Xerox Charges, Postage/ Courier charges, Tour Exp., Advertisement, Salaries & Allowances, etc. If there is any loss in running the business, it is also an expenditure and comes under this group.

Summary:

• To sum up, there are five major groups or elements of accounts based on the Accounting Equation principle of Classification of Accounts.
• Amounts invested in the business are treated as Equity/ Capital.
• Amounts received from Financiers and other parties as advances against supplies and services are returnable, hence Liabilities of the business.
• Cash and Bank Balances, Investments and Fixed Assets and other Stocks are all Assets of the company.
• All incomes from business transactions for a particular year are INCOME/REVENUE of the business for that particular year, including the profit of that year.
• All expenses spent for running the business during a particular year are Expenses of the business, including loss, if any, for that particular year. 

Types of Accounts: Real, Personal & Nominal Accounts

If you are dealing with accounts, you may notice different types and characteristics of accounts, depending on the nature of the dealings and the degree of physical existence. Accounts are maintained for buildings, land, machinery, furniture, or in the names of persons like X, Y, Z, or under various expense and income heads. For example, food expenses, tour expenses, travel expenses, interest received from the bank, interest paid to the bank, salary income, or salary expenses, etc.

Based upon this varied nature and characteristics of the accounts, all accounts have been classified into three major Groups of Accounts. 

This classification is known as the traditional classification of accounts:

1. Real Accounts
2. Personal Accounts
3. Nominal Accounts

Let us examine each group deeply.

Real Accounts

There are two kinds of approaches to defining the Real Accounts:

1. Physical Existence
2. Permanence in nature

According to the first approach, which goes directly on the meaning of the word "Real", the term Real points to physical existence. So, all those accounts which represent physically existing goods or entities are known as Real Accounts. These include assets and goods, which we can physically feel and touch. 

So, Real Accounts include assets like Land, Building, Furniture, Equipment, Roads, Tools, and all physical store items. 

The second approach of Real Accounts interprets the word "Real" as equal to permanence in nature. This definition is based on the account's periodicity. So, this approach considers all Balance sheet items of a business entity as 'Real' because all balances in these Balance Sheets are carried over from one year to another year. So they are considered to be Permanent Accounts and hence grouped as "Real Accounts". So according to this interpretation, all items of Assets, Liabilities, and Capital are all grouped into Real Accounts.

Personal Accounts

Personal accounts refer to the accounts of people who are somehow related to the business. They include Creditors, Debtors, Shareholders, and partners, etc. Their accounts are maintained in their personal names or the company/firm they belong to.  

But if we adopt the definition of Real Accounts as permanently carried over accounts from one year to another year, then there will be a clash between Personal Accounts and Real Accounts. 

In business, most purchases and sales are done on a credit basis. So there will always be balances outstanding in their accounts at the end of any particular year, which are carried over to the next year as opening balances in their accounts to offset them with payments made or received.

So, it is better to consider physical items as Real accounts and Name accounts as Personal accounts.

Nominal Accounts

All expenditure accounts and income accounts which form a part of the Profit and Loss Account are grouped as Nominal Accounts. They are so called because they are maintained only during that particular year to know the impact of the transactions on the business. The profit or loss of the business is calculated with the help of these accounts. And as soon as the objective is over, all these accounts will be closed in that year itself. Only the net amount of either profit or loss is carried forward to the next year. So these accounts are not permanent in nature. They are only nominal for the time being.