FYI: Who Studies Economics? Ronald Reagan, President of the United States Barbara Boxer, U.S. Senator Sandra Day-O’Connor, Former Supreme Court Justice Anthony Zinni, Former General, U.S. Marine Corps Kofi Annan, Former Secretary General, United Nations Meg Witman, Chief Executive Officer, eBay Steve Ballmer, Chief Executive Officer, Microsoft Arnold Schwarzenegger, Governor of California, Actor Ben Stein, Political Speechwriter, Actor, Game Show Host Mick Jagger, Singer for the Rolling Stones John Elway, NFL Quarterback Tiger Woods, Golfer Diane von Furstenburg, Fashion Designer… the list goes

on…1

Our Second Model: The Production Possibilities Frontier The Production Possibilities Frontier (PPF):

a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology

Example: Two goods: computers and wheat One resource: labor (measured in hours) Economy has 50,000 labor hours per month

available for production.

PPF Example Producing one computer requires 100 hours labor. Producing one ton of wheat requires 10 hours labor.

5,0000

4,000100

2,500250

1,000400

50,0000

40,00010,000

25,00025,000

10,00040,000

0500050,000

E

D

C

B

A

WheatComputersWheatComputers

ProductionEmployment of

labor hours

Point on

graph

Production

Com-puters

Wheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,000 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

A

B

C

D

E

PPF Example

A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods?Why or why not?

B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods?

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11

Points off the PPFPoints off the PPF

5

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 11

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Point F:100 computers, 3000 tons wheat

Point F requires 40,000 hours of labor. Possible but not efficient: could get more of either good w/o sacrificing any of the other.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

F

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0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons) Point G:

300 computers, 3500 tons wheat

Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours.

G

The PPF: What We Know So Far

Points on the PPF (like A – E) possible efficient: all resources are fully utilized

Points under the PPF (like F) possible not efficient: some resources underutilized

(e.g., workers unemployed, factories idle)

Points above the PPF (like G) not possible

The PPF and Opportunity Cost

Recall: The opportunity cost of an item is what must be given up to obtain that item.

Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other.

Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.

The slope of the PPF tells you the opportunity cost of one good in terms of the other.

The PPF and Opportunity Cost

The slope of a line equals the “rise over the run,” the amount the line rises when you move to the right by one unit.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

–1000100

slope = = –10

Here, the opportunity cost of a computer is 10 tons of wheat.

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 22

PPF and Opportunity CostPPF and Opportunity Cost

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In which country is the opportunity cost of cloth lower?

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 22

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0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

England, because its PPF is not as steep as France’s.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

Economic Growth and the PPF

With additional resources or an improvement in technology, the economy can produce more computers,

more wheat,

or any combination in between.

Economic growth shifts the PPF outward.

Economic growth shifts the PPF outward.

The Shape of the PPF The PPF could be a straight line, or bow-shaped

Depends on what happens to opportunity cost as economy shifts resources from one industry to the other.

If opp. cost remains constant, PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat.)

If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped.

Why the PPF Might Be Bow-Shaped

Mountain Bikes

Bee

rAs the economy shifts resources from beer to mountain bikes:

PPF becomes steeper

opp. cost of mountain bikes increases

A

Why the PPF Might Be Bow-Shaped

At point A, most workers are producing beer, even those that are better suited to building bikes.

So, do not have to give up much beer to get more bikes.

Mountain Bikes

Bee

r At A, opp. cost of mtn bikes is low.

At A, opp. cost of mtn bikes is low.

B

Why the PPF Might Be Bow-Shaped

At B, most workers are producing bikes. The few left in beer are the best brewers.

Producing more bikes would require shifting some of the best brewers away from beer production, would cause a big drop in beer output. Mountain

Bikes

Bee

r

At B, opp. cost of mtn bikes is high.

At B, opp. cost of mtn bikes is high.

Why the PPF Might Be Bow-Shaped

So, PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other.

The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs

(E.g., different types of land suited for different uses).

The PPF: A Summary The PPF shows all combinations of two goods

that an economy can possibly produce, given its resources and technology.

The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth.

A bow-shaped PPF illustrates the concept of increasing opportunity cost.

In this lecture, we will In this lecture, we will answers the following answers the following questions:questions: Why do people – and nations – choose to be

economically interdependent?

How can trade make everyone better off?

What is absolute advantage? What is comparative advantage? How are these concepts similar? How are they different?

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Interdependence

Every day you rely on

many people from around the world,

most of whom you’ve never met,

to provide you with the goods and services

you enjoy.

coffee from Kenya

dress shirt from China

cell phone from Taiwan

hair gel from Cleveland, OH

Interdependence One of the concepts from Week 1:

Trade can make everyone better off.

We now learn why people – and nations – choose to be interdependent, and how they can gain from trade.

Our Example Two countries: the U.S. and Japan

Two goods: computers and wheat

One resource: labor, measured in hours

We will look at how much of both goods each country produces and consumes if the country chooses to be self-sufficient if it trades with the other country

Production Possibilities in the U.S.

The U.S. has 50,000 hours of labor available for production, per month.

Producing one computer requires 100 hours of labor.

Producing one ton of wheat requires 10 hours of labor.

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000

Computers

Wheat (tons)

The U.S. PPF

The U.S. has enough labor to produce 500 computers,or 5000 tons of wheat,or any combination along the PPF.

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000

Computers

Wheat (tons)

The U.S. Without Trade

Suppose the U.S. uses half its labor to produce each of the two goods.

Then it will produce and consume250 computers and

2500 tons of wheat.

Use the following information to draw Japan’s PPF.

Japan has 30,000 hours of labor available for production, per month.

Producing one computer requires 125 hours of labor.

Producing one ton of wheat requires 25 hours of labor.

Your graph should measure computers on the horizontal axis.

EX EX 11

Derive Japan’s PPFDerive Japan’s PPF

27

Computers

Wheat (tons)

2,000

1,000

2000

100 300

Japan’s PPF

Japan has enough labor to produce 240 computers,

or 1200 tons of wheat,

or any combination along the PPF.

Japan Without Trade

Computers

Wheat (tons)

2,000

1,000

2000

100 300

Suppose Japan uses half its labor to produce each good.

Then it will produce and consume120 computers and

600 tons of wheat.

Consumption With and Without Trade Without trade,

U.S. consumers get 250 computers and 2500 tons wheat.

Japanese consumers get 120 computersand 600 tons wheat.

We will compare consumption without trade to consumption with trade.

First, we need to see how much of each good is produced and traded by the two countries.

1. Suppose the U.S. produces 3400 tons of wheat. How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF.

2. Suppose Japan produces 240 computers. How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japan’s PPF.

EXEX22

Production under tradeProduction under trade

31

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000

Computers

Wheat (tons)

U.S. Production With Trade (before)

Producing 3400 tons of wheat requires 34,000 labor hours.

The remaining 16,000 labor hours are used to produce 160 computers.

Japan’s Production w/ Trade (before)

Producing 240 computers requires all of Japan’s 30,000 labor hours.

Computers

Wheat (tons)

2,000

1,000

2000

100 300

So, Japan would produce 0 tons of wheat.

Basic international trade terms Exports:

goods produced domestically and sold abroad

To export means to sell domestically produced goods abroad.

Imports: goods produced abroad and sold domestically

To import means to purchase goods produced in other countries.

EXEX33

Consumption under tradeConsumption under trade

35

How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF.

How much of each good is consumed in Japan? Plot this combination on Japan’s PPF.

Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan.

(So, Japan imports 700 tons wheat and exports 110 computers.)

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000

Computers

Wheat (tons)

U.S. Consumption With Trade (after)

2700270= amount consumed

0110+ imported

7000– exported

3400160produced

wheatcomputers

Japan’s Consumption w/ Trade (after)

Computers

Wheat (tons)

2,000

1,000

2000

100 300

700130= amount consumed

7000+ imported

0110– exported

0240produced

wheatcomputers

Trade Makes Both Countries Better Off

2002,7002,500wheat

20270250computers

gains from trade

consumption with trade

consumption without trade

U.S.

100700600wheat

10130120computers

gains from trade

consumption with trade

consumption without trade

Japan

Where Do These Gains Come From?

Absolute advantage: the ability to produce a good using fewer inputs than another producer

The U.S. has an absolute advantage in wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 in Japan.

If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade.

Where Do These Gains Come From?

Which country has an absolute advantage in computers?

Producing one computer requires 125 labor hours in Japan, but only 100 in the U.S.

The U.S. has an absolute advantage in both goods!

So why does Japan specialize in computers? Why do both countries gain from trade?

Two Measures of the Cost of a Good

Two countries can gain from trade when each specializes in the good it produces at lowest cost.

Absolute advantage measures the cost of a good in terms of the inputs required to produce it.

Recall: Another measure of cost is opportunity cost.

In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer.

Opportunity Cost and Comparative Advantage

Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer

Which country has the comparative advantage in computers?

To answer this, must determine the opp. cost of a computer in each country.

Opportunity Cost and Comparative Advantage

The opp. cost of a computer is

10 tons of wheat in the U.S., because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat.

5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat.

So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage!

Comparative Advantage and Trade

Gains from trade arise from comparative advantage (differences in opportunity costs).

When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.

The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other.

Argentina and Brazil each have 10,000 hours of labor per month.

In Argentina, producing one pound coffee requires 2 hours producing one bottle wine requires 4 hours

In Brazil, producing one pound coffee requires 1 hour producing one bottle wine requires 5 hours

Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine?

EXEX44

Absolute & comparative Absolute & comparative advantageadvantage

45

Brazil has an absolute advantage in coffee:

Producing a pound of coffee requires only one labor-hour in Brazil, but two in Argentina.

Argentina has a comparative advantage in wine:

Argentina’s opp. cost of wine is two pounds of coffee, because the four labor-hours required to produce a bottle of wine could instead produce two pounds of coffee.

Brazil’s opp. cost of wine is five pounds of coffee.

EXEX44

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Unanswered Questions…. We made a lot of assumptions about the

quantities of each good that each country produces, trades, and consumes, and the price at which the countries trade wheat for computers.

In the real world, these quantities and prices would be determined by the preferences of consumers and the technology and resources in both countries.

We will begin to study this in the next week.

For now, though, our goal was merely to see how trade can make everyone better off.

SUMMARYSUMMARY

Interdependence and trade allow everyone to enjoy a greater quantity and variety of goods & services.

Comparative advantage means being able to produce a good at a lower opportunity cost. Absolute advantage means being able to produce a good with fewer inputs.

When people – or countries – specialize in the goods in which they have a comparative advantage, the economic “pie” grows and trade can make everyone better off.

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