the production possibility model, trade, and...

The Production Possibility Model, Trade, and Globalization 2

The Production Possibility Model,

Trade, and Globalization

No one ever saw a dog make a fair and

deliberate exchange of one bone for another

with another dog .

— Adam Smith

CHAPTER 2

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


The Production Possibilities Model

• A production possibility table lists a choice’s opportunity cost by summarizing what alternative outputs you can achieve with your inputs

• An output is a result of an activity

• An input is what you put into the production process to achieve an output

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Guns Butter

0 10

1 15

2 0


The Production Possibilities Model

• A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs

• It is a graphical representation of the opportunity cost concept that uses twogoods

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Production Possibilities Curve

• The PPC is based on these assumptions:

• Resources are fixed

• All resources are fully employed (used)

• Only two things can be produced

• Technology is fixed


Graphing the PPC• PPC runs between extremes of

producing only one item or the other

• Data is plotted on a graph; the lines connected between the points is the PPC

• Shows maximum number of one item relative to other item

• PPC shows the opportunity cost of each choice

• More of one product means less of the other: tradeoff


Graphing the PPC

• Commonly, a PPC is depicted with two goods: guns and butter

• Guns represents military goods

• Butter represents consumer goods


PPC Efficient and Inefficient Points

• An efficient point is any point along the curve

• Productive efficiency is achieving as much output as possible from a given amount of inputs or resources

McGraw-Hill/Irwin Colander, Economics 7


PPC Efficient and Inefficient Points

• An inefficient point any point inside the curve

• This means resources are being underutilized or not being used efficiently

• An unattainable point is one beyond the curve

• It cannot currently be achieved unless there is an increase in technology or additional resources become available



Draw the Graph: PPC Showing Efficient and Inefficient Points

• A: Point of efficiency (anywhere on the curve)

• B: Point of inefficiency (underproducing or underutilization of resources

• C: Unattainable (beyond the curve)

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Butter

Guns

•

• B

• C

A


Why is the PPC a Curve?

• Law of increasing opportunity costs

• As production switches from one product to another, more resources are needed to increase production of second product

• Reasons for increasing cost of making more of one product

• Need new resources, machines, or factories

• Must retrain workers


Why can the PPC also be a straight line?

The PPC can be a straight line to represent a constant opportunity cost

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Butter

Guns

A

B


Opportunity Cost and Tradeoff

• What is the difference between opportunity cost and tradeoff?

• Tradeoff: to produce more guns, you have to produce less butter

• Opportunity cost: the specific number of butter you give up to produce more guns


Butter

Guns

•

• B

A


Shifting the PPC

An increase in technology or an increase in resources

Technological increase for one good

Guns

Butter

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More guns and butter can be produced

Guns

ButterMore guns can be produced based on better technology


Comparative Advantage

• We cannot produce everything efficiently

• A resource has comparative advantage if it has the ability to be better suited to the production of one good than another; it can be produced at the lowest opportunity cost

• Countries should specialize in the good that is “cheaper” for them to produce (lower opportunity cost) and trade for goods that they have a higher opportunity cost to produce

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Comparative Advantage

• According to Adam Smith, the market guides us like an invisible hand to produce goods in which we have a comparative advantage



The Benefits from Trade

Chocolate (tons)

Textiles (yds)

Without trade, each country can only consume those

combinations of goods along their PPCs

• When people freely enter into trade, both parties can be expected to benefit from trade

5,000

4,000

3,000

2,000

1,000

2 3 4 51

Belgium

Pakistan

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The Benefits from Trade

Chocolate (tons)

Textiles (yds) If each country specializes according to comparative advantage and trades,

they can consume beyond their PPCs5,000

4,000

3,000

2,000

1,000

2 3 4 51

Belgium

Pakistan

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Absolute and Comparative Advantage

• Absolute Advantage: the producer that can produce the most output

• Comparative Advantage: the producer with the lowest opportunity cost


Determining Comparative Advantage: The Output Method

Output Questions:

• OOO=Output: Other goes Over


Determining Comparative Advantage The Output Method

• Mexico can produce 60 avocados if it uses its entire labor force. Or, Mexico can produce 15 soybeans if it uses its entire labor force.

• The U.S. can produce 90 avocados if it uses its entire labor force. Or, the U.S. can produce 30 soybeans if it uses its entire labor force.

• Let’s write this in a chart format




1. Which country has an absolute advantage in producing avocados? Explain.

• U.S.: it produces more avocados than Mexico (90 vs. 60)

Avocados Soybeans

Mexico 60 15

U.S. 90 30



2. Which country has an absolute advantage in producing soybeans? Explain.

• U.S.: it produces more soybeans than Mexico (30 vs. 15)

Avocados Soybeans

Mexico 60 15

U.S. 90 30



3. Which country has a comparative advantage in producing avocados? Explain.

• Mexico; it can produce them at a lower opportunity cost, 1/4 soybean for Mexico vs. 1/3 soybean for the U.S.

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A



4. Which country has a comparative advantage in producing soybeans? Explain.

• The U.S.; it can produce them at a lower opportunity cost; 3 avocados for the U.S. vs. 4 for Mexico.

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A


Terms of Trade

Terms of trade refers to trade that is mutually beneficially to both countries.

• The U.S. has a comparative advantage in soybeans. It would specialize in soybeans if it could get more than 3 avocados through trade.

• Mexico has a comparative advantage in avocados. It would specialize in avocados if it could get one soybean for less than 4 avocados through trade.

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A


Terms of Trade

What would be an acceptable term of trade for soybeans?

• Anywhere between 3 and 4 avocados

• 1 soybean for 3.5 avocados: this would allow the U.S. to get 3.5 avocados from Mexico by sending 1 soybean to Mexico.

• This would allow Mexico to obtain 1 ton of soybeans for 3.5 avocados, a lower opportunity cost (on their own they would have to give up 4 avocados to produce 1 soybean).

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A


Determining Comparative Advantage: The Input Method

Input Questions

• IOU= Input: Other goes Under

• Usually the amount of hours (or labor) to produce something



1. Which country has an absolute advantage in producing cars? Explain.

• Mexico; it can produce 4 cars while the U.S. can produce 2

Car (in hours) Machines (in hours)

Mexico 4 2

U.S. 2 6



2. Which country has an absolute advantage in producing machines?

• The U.S.; it can produce 6 machines while Mexico can produce 2


Mexico 4 2

U.S. 2 6



3. Which country has a comparative advantage in producing cars? Explain.

• The U.S. has a comparative advantage in cars because it can produce them with a lower opportunity cost (1/3 machine for the U.S. vs. 2 machines for Mexico).


Mexico 4 1C=2M 2 1M=1/2C

U.S. 2 1C=1/3M 6 1M=3C



4. Which country has a comparative advantage in producing machines?

• Mexico has a comparative advantage in machines because it can produce them with a lower opportunity cost (1/2 car for Mexico vs. 3 cars for the U.S.).



U.S. 2 1C=1/3M 6 1M=3C


Terms of Trade

5. What would be terms of trade for machines?

• Anywhere between ½ car and 3 cars.

• Mexico has the comparative advantage in machines. It would specialize in machines if it could get more than ½ car through trade.

• The U.S. has the comparative advantage in cars. It would specialize in cars if it could get one machine for less than 3 cars through trade.



U.S. 2 1C=1/3M 6 1M=3C


Outsourcing, Trade, and Comparative Advantage

• Outsourcing: relocating production once done in the U.S.to foreign countries

• WHY?: Comparative advantage

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Outsourcing, Trade, and Comparative Advantage

• Globalization: the integration of economies, cultures, and institutions across the world

• Provides larger markets than the domestic economy (positive)

• Increases the number of competitors (negative)

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The Law of One Price

• The law of one price: states the wages of equal workers in one country will not differ significantly from the wages of workers in another similar country

• If the U.S. loses its comparative advantage based on technology and institutional structure, U.S. wages will decrease relative to wages in many other countries

• In reality, we do better due to trade and outsourcing

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Chapter Summary

• The production possibility curve embodies the opportunity cost concept

• Increasing marginal opportunity cost exists

• Trade allows people to use their comparative advantage and shifts out society’s combined production possibility curve

• Efficient, inefficient and unattainable points on the PPC

• Through specialization and trade, countries can increase consumption

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Chapter Summary

• The typical outward bow of the PPC is the result of comparative advantage and trade

• Because many goods are cheaper to produce in foreign countries, production of goods formerly in the U.S. is being outsourced

• Outsourcing is the product of the law of one price

• Globalization is the increasing integration of economies, cultures, and institutions across the world

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