Introduction to Macroeconomics

Introduction to Macroeconomics

Chapter 2. Opportunity Cost, Specialization, and Trade

Chapter 2. Opportunity Cost, Specialization, and Trade

• Microeconomics– Specialization by Individuals

• Macroeconomics– Production Possibilities Curve

• Applications

U.S. Trade in Goods, 2000(billions of dollars)

0

100

200

300

400

WesternEurope

Canada Japan Mexico China Others

Imports Exports

Source: U.S. Bureau of Economic Analysis, Survey of Current Business, Table 2, July 2001.

Specialization by Individuals and Exchange

• Reasons for Specialization by individuals (Division of Labor)

• Exchange required

• Costs of exchange

Reasons for Specialization(Division of Labor)

• Increase skill from repetition• Reduce time wasted shifting between

tasks• Incentive to invest resources in developing

specialized tools and machines• Opportunity Cost

Opportunity Cost

The highest valued alternative foregone (given up) in making any choice.

Calculating Opportunity Costs

My Capabilities Your Capabilities

16 coconuts or 12 fish in 1 hour

14 coconuts or 7 fish in 1 hour

My Opportunity

Costs Your Opportunity

Costs

1 coconut = 0.75 fish 1 fish = 1.25 coconuts

1 coconut = 0.5 fish 1 fish = 2 coconuts

Incentive to Specialize

Production in 1 hour Me You Total Without Specialization Coconuts 8 7 15 Fish 6 3.5 9.5 With Specialization Coconuts 0 14 14 Fish 12 0 12

Exchange prices

Opportunity Cost

Me You Market Price

Coconuts 0.75 fish

0.5 fish

Between 0.5 and 0.75

fish

Fish 1.25 coconuts

2.0 coconuts

Between 1.25 and 2.0

coconuts

Costs of Exchange

• Negotiation costs

• Transportation costs

• Artificial barriers to trade (e.g., import tariffs)

U.S. Trade in Goods with Mexico

0

2

4

6

8

10

12

14

16

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Per

cen

t o

f T

ota

l Im

po

rts

or

Exp

ort

s

Imports from Mexico Exports to Mexico

NAFTA

PesoCrisis

Source: U.S. Bureau of Economic Analysis, Survey of Current Business, Table 2, July 2001.

Notes Page

Production Possibilities Curve(PPC)

Identifies all combinations of the maximum amount of any two goods or services that can be produced by a given economy.

Production Possibilities Curve

0

10

20

30

40

50

60

70

80

90

100

0 10 20 30 40 50 60 70 80 90 100

Production of Good A

Pro

du

ctio

n o

f G

oo

d B

A

B

C

D*

*

*

*

PPC Assumptions

• Only 2 goods or services (or aggregates of goods or services) are produced

• Full and efficient use of all available resources

• Supplies of resources (i.e., land, labor, and capital) are fixed

• Technology is held constant

Increase in Available Resourcesor Technology

0

10

20

30

40

50

60

70

0 10 20 30 40 50 60 70

Production of Food

Pro

du

ctio

n o

f C

loth

ing Improvement that benefits

both products. PPC shifts outward (to the right), from PPC1 to PPC2.

PPC1 PPC2

Increase in Available Resourcesor Technology

0

10

20

30

40

50

60

0 10 20 30 40 50 60 70

Production of Food

Pro

du

ctio

n o

f C

loth

ing Improvement that benefits

Food production only.

PPC1 PPC2

Increase in Available Resourcesor Technology

0

10

20

30

40

50

60

70

0 10 20 30 40 50 60 70

Production of Food

Pro

du

ctio

n o

f C

loth

ing

Improvement that benefits clothing production only.

PPC1 PPC2

Opportunity Cost and the PPC

Two important characteristics of the PPC:

• Opportunity Cost - The PPC slopes downward and to the right

• Increasing Opportunity Cost - The PPC is "bowed outward" (concave) from the origin

Increasing Opportunity Cost

0

5

10

15

20

25

30

35

40

45

50

0 5 10 15 20 25 30 35 40 45 50

Production of Food

Pro

du

ctio

n o

f C

loth

ing

As you increase production of food you sacrifice increasing quantities of clothing

Applications

• Scarcity and Choice– the “cruel dilemma” facing less-developed

countries

• Opportunity Costs– staffing professors in two departments

• Specialization– comparing 2 PPCs (comparative vs absolute

advantage)

Scarcity and Choicethe Cruel Dilemma of the Poor

0

10

20

30

40

50

60

0 12 24 36 48

Capital Goods

Co

nsu

mp

tio

n G

oo

ds Subsistence Level

ProductionPossibilitiesCurve

Staffing University Departments

Economics Department Psychology Department

Number ofProfessors

Number of PagesPublished in

JournalsNumber ofProfessors

Number of PagesPublished in

Journals

0 0 5 120

1 30 4 115

2 50 3 100

3 65 2 75

4 75 1 40

5 80 0 0

PPC - Staffing University Departments

0

20

40

60

80

100

120

140

0 30 50 65 75 80

Economics Pages

Psy

cho

log

y P

ages

Comparative and Absolute Advantage

• Absolute Advantage - a person can produce a good or service with fewer resources than can another person

• Comparative Advantage - a person can produce a good or service with lower opportunity cost than can another person

Comparative vs Absolute Advantage

Assumptions:• 2 countries• 2 products• Straight-line PPCs to simplify model

(constant opportunity cost)

Comparative vs Absolute Advantage

0102030405060708090

100110

0 10 20 30 40 50 60 70 80 90

Production of Guns

Pro

du

ctio

n o

f B

utt

er

PPC Country A

PPC Country B

Comparative vs Absolute Advantage

Production of Guns

Production of Butter

Absolute Advantage

Country B Country A

Comparative Advantage

Country B Country A

Comparative vs Absolute Advantage

0102030405060708090

100110

0 10 20 30 40 50 60 70 80 90 100

Production of Guns

Pro

du

ctio

n o

f B

utt

er

PPC Country A

PPC Country B

Comparative vs Absolute Advantage

Production of Guns

Production of Butter

Absolute Advantage

Country A Country A

Comparative Advantage

Country A Country B