Principles and Intermediate Microeconomics review: remembering the PPF and

Indifference curves

In the course of this class, we will look at several theories that posit a reason for international trade.
These will include differences in technologies, amount of resources, offshoring costs, and
proximity of countries to one another.

We begin with differences in technology, but before we continue, we will look at some familiar
concepts.

1. Production Possibilities frontier: This graph shows possible combinations of goods

produced when all resources are completely and efficiently utilized. (The PPF can also be
represented by an equation)

The slope of the PPF at each point along the curve gives the trade-off between the two goods at
that point.

This tradeoff is known as the opportunity cost of production. It is also true that the absolute value
of the slope of the PPF is the opportunity cost of producing one unit of the good labelled on the x-
axis, while the inverse of the absolute value of the slope is the opportunity cost of producing one
unit of the good on the Y-axis.

A country that has the best technology for producing a good is said to have ABSOLUTE
ADVANTAGE in the production of that good. If a country however can produce a good cheaper
than others, it is said to have COMPARATIVE ADVANTAGE. Suppose there are two countries
A and B, and the opportunity cost for producing one unit of food in both countries is 0.5 and 0.7
respectively. Since 0.5 < 0.7, country A has the comparative advantage in the production of food.
Furthermore, if clothing is the other good produced in these countries, the opportunity cost of
producing one unit of food in both countries are 1/0.5 and 1/0.7 respectively.
Since 1/0.5 = 2 > 1/0.7=1.4286, Country B has the comparative advantage in the production of
clothing. In Summary, the country with the smaller opportunity cost has the comparative advantage
in the production of that good.

Class Problem 1

Suppose the following

Country A: 𝑃𝑃𝐹𝐴 : 𝐶 = 1000 − 50𝐹

Country B: 𝑃𝑃𝐹𝐵 : 𝐶 = 3000 − 100𝐹

Which country has

i. Absolute advantage in clothes production?

ii. Absolute advantage in Food production?
iii. Comparative advantage in Food production?
iv. Comparative advantage in clothes production?

Steps:

1. Find Maximum clothes and food each country can produce, i.e. what can be produced when
all resources are devoted to the production of just one of the goods
2. Plot these as the corners on the straight line PPF
3. Find the slopes of both PPFs for both countries
4. Find the inverse of the slopes for both countries
5. Compare slopes to determine comparative advantage.

[Solution]

See Video titled class problems 1 and 2

2. Indifference curves

Suppose each individual derives utility solely from the consumption of two goods: Food and
clothes. An indifference curve shows the combination of the amount of goods that provide the
same utility

A and B are different combinations of food and clothes that give the same utility if consumed

U 3 is the highest level of utility, which implies that a rational person, should they be able, will
choose to consume at point D (the combination of food and clothes that provide the highest
POSSIBLE utility). The higher the indifference curve, the better off the individual. The slope of
the indifference curve represents the rate of substitution between the two goods, while keeping
utility constant. This is known as the MARGINAL RATE OF SUBSTITUTION.

Suppose we aggregate the indifference curves (Preferences) of all individuals in an economy to

obtain one representative economy wide indifference curve. If we introduce this representative
indifference curve to the PPF, the point where the slope of the PPF is equal to the marginal rate of
substitution is the optimal point of production for a closed economy.
X and Y are different combinations of food and clothes that give different utilities. Since 𝑈2 is the
higher level of utility, a rational person will choose point Z.

The Ricardian Model

This model was proposed by David Ricardo (1772 – 1823). The primary assumption in this model
is that labor is the only factor of production.

Assumptions of the Model

1. Two Trading partners; Home and Foreign

2. Two goods: Wheat and Clothing
3. One Factor of production: Labor
4. Constant marginal product of labor: This implies no diminishing marginal returns to
production.
5. A combination of assumptions 3 and 4 imply a straight line PPF for each country.

The Home Country

Suppose in this country, one worker can produce either 4 bushels of wheat or 2 yards of cloth per
work hour and that all workers are identical in this respect, i.e. there is no specialist that can
produce more or an unskilled worker that can produce less. (constant marginal returns
assumption). Adding one more worker to the wheat industry implies that the output of wheat
increases by 4 bushels and adding one more worker to the clothing industry increases output by 2
yards always. Recall that the change in output given a change in labor is referred to as the marginal
product of labor MPL

∆𝑄
𝑀𝑃𝐿 =
∆𝐿
This implies that 𝑀𝑃𝐿𝑤 = 4 and 𝑀𝑃𝐿𝐶 = 2. Suppose also that we have a constant total labor supply
𝐿̅ = 25. If all resources are dedicated to producing wheat, the total number of bushels produced

𝑄𝑊 = 25 × 4 = 100

Similarly, the quantity of clothes produced

𝑄𝐶 = 25 × 2 = 50

Thus the PPF is shown below

The slope of the PPF =− 50⁄100 = − 1⁄2

This implies that the opportunity cost of producing one bushel of wheat is 0.5 while the opportunity
cost of producing clothes is 1/0.5 = 2.

Also, since 100 = 𝑀𝑃𝐿𝑤 × 𝐿̅ and 50 = 𝑀𝑃𝐿𝐶 × 𝐿̅

50 𝑀𝑃𝐿 × 𝐿̅ 𝑀𝑃𝐿
0.5 = 100 = 𝑀𝑃𝐿 𝐶× ̅
= 𝑀𝑃𝐿 𝐶
𝑤 𝐿 𝑤

𝑀𝑃𝐿
That is, the opportunity cost of wheat is given by 𝑀𝑃𝐿 𝐶
𝑤

We can think of the PPF of the Home country as the potential supply, to represent the demand, we
introduce the aggregate indifference curve
Where A is Home’s No trade Equilibrium

Class Problem 2:

Using the set up for the home country discussed above,

1. Find the amount of labor hours employed at home’s equilibrium in the wheat production
sector and in the clothing production sector, 𝐿𝑊 and 𝐿𝐶 respectively, given the following
information

𝑀𝑃𝐿𝑤 × 𝐿𝑊 = 50 (From the PPF)

𝑀𝑃𝐿𝐶 × 𝐿𝐶 = 25

2. Verify that this point is on the PPF, in other words, show that all resources are utilized, i.e.
total labor hours in both sectors is equal to total labor at Home.

[Solution]

See Video titled class problems 1 and 2

In perfectly competitive labor markets, firms hire workers up the point where the wage equals the
value of one more hour of production. So at equilibrium,
𝑤𝐶 = 𝑃𝐶 × 𝑀𝑃𝐿𝐶

𝑤𝑊 = 𝑃𝑊 × 𝑀𝑃𝐿𝑊

In this set up, workers will go to whatever industry that pays the most, so if 𝑤𝐶 > 𝑤𝑊 , workers
will move from the wheat industry to the clothing industry and vice versa. This will continue until
𝑤𝐶 = 𝑤𝑊

wC  wW  PC MPLC  PW MPLW

Dividing both sides by PC MPLW , we obtain

PW MPLC 1
 
PC MPLW 2

This says that the relative price of wheat is equal to the opportunity cost of wheat or the absolute
value of the slope of the PPF.

The Foreign Country (* represents the foreign country)

Suppose in foreign

MPL*W  1 , MPL*C  1 , and L *  100

L * MPL*C  100

L * MPL*W  100

Foreign’s PPF is

100
Absolute value of the Slope = 1
100

Opportunity cost of wheat = Opportunity cost of clothes = 1

PW* MPL*C
This implies that  1
PC* MPL*W

Comparing Home and foreign, we find that Home has absolute advantage in the production of both
Clothes and Food. Hoe has comparative advantage in wheat production, while foreign has
comparative advantage in the production of clothes.

Determining the Pattern of International Trade

The differences in “no trade” (autarkic) prices across the countries creates the opportunity for
international trade. Basically, suppliers, now given the opportunity to trade across borders would
like to sell their goods where the prices are higher. As a result, producers of clothes in the foreign
PC*
country where the relative price of clothes  1 would want to export clothes to the home country
PW*
𝑃 PW 1
where the relative price 𝑃 𝐶 = 2, and wheat producers at home where  will want to export
𝑊 PC 2
 PW*
their goods to foreign where  1 . This implies that each country will export the good which it
PC*
has comparative advantage in producing and will import the good which it does not.

As Home exports wheat, the reduction in the quantity at Home causes the price of wheat to rise,
while the influx of wheat in the foreign country causes the price of wheat in foreign to drop. This
implies that the “after trade” price of wheat is between the “no trade” prices of home and foreign
countries. The same arguments can be made for the price of clothes. Suppose the equilibrium after
PWw 2
trade relative world price of wheat w  (This is just an assumption we are making and not
PC 3
something you will be expected to calculate as of yet)

First let’s examine what happens to the production of both goods after borders are opened.

Recall that wC  PC MPLC ; wW  PW MPLW , where MPLW  4 and MPLC  2

wW PW MPLW 2 4 8
     1 which implies that wW  wC
wC PC MPLC 3 2 6

Since wW  wC , workers will leave the clothing industry at home and go to the wheat industry
leading to a complete specialization in wheat production at home. The gains from trade in the
Home country is illustrated below:

A: Home’s initial consumption level (50, 25)

B: Home’s Specialization after opening up to trade (100, 0)

C: Home’s after trade Consumption level (40, 40)

Home moves from A to C on a higher indifference curve showing gains from trade

Similarly, in Foreign,

wW* PW* MPL*W 2 1 2

 *    1
wC* PC MPL*C 3 1 3

This implies that wW*  wC* . As a result, workers move from the wheat industry to the clothes
industry, which in turn implies that the Foreign specializes in clothes production. The gains from
trade is shown below

A*: Foreign’s initial consumption level: (50, 50)

B*: Foreign’s specialization due to trade (0, 100)

C*: Foreign’s after trade consumption level (60, 60)

Foreign also moves from A* to C* on a higher indifference curve which also show gains from
trade.

Determining Wages
In a perfectly competitive labor market, workers are paid the value of their marginal product. This
implies that workers at home are paid a “real” wage of 4 bushels of wheat. They could also sell
2 8
their 4 bushels of wheat in foreign at the new world price and earn  4  yards of cloth.
3 3
Similarly, foreign workers earn 1 yard of cloth and can sell this in the Home country to earn
3 3
1  bushels of wheat.
2 2

Home’s wage is either 4 bushels of wheat or 8/3 yards of cloth

Foreign’s wage is either 3/2 bushels of wheat or 1 yard of cloth.

Looking at the wages, workers in both countries are better off with trade

Determining World Relative Price

We have thus far assumed that the world relative price is 2/3, but this value can be derived. All we
need is a demand and a supply curve. The supply curve here will be Home’s export of wheat and
the demand curve will be Foreign’s import of wheat. See diagrams below
Terms of trade is the price of a country’s exports divided by the price of its imports. Home’s terms
PW P*
of trade is while foreign’s is C*
PC PW