How does a rational (core concept 3), profit-maximising producer select the amount of inputs (Land, Labour, Capital) to employ in the production process? Here, as elsewhere, we employ the idea of marginality (core concept 4) using the law of diminishing (marginal) returns. We show (handout 1) how a rational producer employs workers up to the point where the Marginal Value Product (Marginal Product x Price of the good) equals the marginal cost of production. But this is a short run law (because one factor of production, Capital, is fixed). In the long run, with Labour, Land and Capital in variable supply, we use Production Possibility frontiers (PPFs) to demonstrate how the economic growth (productive capacity) of an economy can increase as factor productivity rises (and the PPF moves outwards) – see handout 2 and powerpoint 2. Notice, too, that production possibility curves also demonstrate increasing opportunity costs (core concept 2) – as we move along the frontier from one mix of inputs to another, the rate at which one input is substituted for another increases. The PPF slopes outwards.

It’s easy to muddle up the law of diminishing returns (a short run law) with this principle of increasing opportunity cost (a long run idea relating to PPFs). Bear in mind the eternal economic truth that almost all that matters in the long run, for economic health and well-being, is productivity growth (output per head or Average Product, AP). Why is this? And why has productivity growth in the UK in recent years been so dismal? The Bank of England gives its verdict here.