FYI: Who Studies Economics?

Ronald Reagan, President of the United States Barbara Boxer, U.S. Senator Sandra Day-OConnor, 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

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.
Employment of labor hours Computers A 50,000 Wheat 0 Production Computers 500 Wheat 0

B
C D E

40,000
25,000 10,000 0

10,000
25,000 40,000 50,000

400
250 100 0

1,000
2,500 4,000 5,000

PPF Example
Point on Comgraph puters Wheat A B C 500 400 250 0 1,000 2,500 Production
Wheat (tons) 6,000 5,000 4,000 3,000 2,000 1,000 0 0

E D

C
B A
100 200 300 400 500 600 Computers

D
E

100
0

4,000
5,000

ACTIVE LEARNING

Points off the PPF

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?
4

ACTIVE LEARNING

Answers
Point F:
100 computers, 3000 tons wheat
Wheat (tons) 6,000 5,000 4,000 3,000 2,000 1,000 0 0 100 200 300 400 500 600 Computers
5

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.

ACTIVE LEARNING

Answers
Point G:
300 computers, 3500 tons wheat

Wheat (tons) 6,000 5,000 4,000 3,000 2,000 1,000 0 0 100 200 300 400 500 600 Computers
6

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

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

Wheat (tons) 6,000 5,000 4,000 3,000 2,000 1,000 0 0 100 200 300 400 500 600 Computers

1000 slope = = 10 100

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

ACTIVE LEARNING

PPF and Opportunity Cost

In which country is the opportunity cost of cloth lower?
FRANCE
Wine 600 500 400 300 200 100 0 0 100 200 300 400 Cloth
Wine 600 500 400 300 200 100 0 0 100 200 300 400

ENGLAND

Cloth10

ACTIVE LEARNING

Answers
England, because its PPF is not as steep as Frances.
FRANCE
Wine 600 500 400 300 200 100 0 0 100 200 300 400 Cloth
Wine 600 500 400 300 200 100 0 0 100 200 300 400

ENGLAND

Cloth11

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.
Wheat (tons) 6,000 5,000 4,000 3,000 2,000 1,000 0 0 100 200 300 400 500 600 Computers

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

As the economy shifts resources from beer to mountain bikes:
Beer

PPF becomes
steeper

opp. cost of
mountain bikes increases
Mountain Bikes

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 Beer A

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

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.
Beer

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

B

Mountain Bikes

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 answers the following 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 hair gel from you rely on Cleveland, OH many people cell phone from around from Taiwan the world, most of whom dress shirt youve never met, from China to provide you with the goods coffee from and services Kenya you enjoy.

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.

Wheat (tons) 5,000 4,000 3,000 2,000

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.

1,000
0

Computers
100 200 300 400 500

Wheat (tons) 5,000 4,000 3,000 2,000

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 consume 250 computers and 2500 tons of wheat.

1,000
0

Computers
100 200 300 400 500

EX

Derive Japans PPF

Use the following information to draw Japans 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.

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Japans PPF
Wheat (tons) 2,000

Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF.

1,000

Computers
100 200 300

Japan Without Trade

Wheat (tons) 2,000

Suppose Japan uses half its labor to produce each good. Then it will produce and consume 120 computers and 600 tons of wheat.

1,000

Computers
100 200 300

Consumption With and Without Trade

Without trade, U.S. consumers get 250 computers
and 2500 tons wheat. Japanese consumers get 120 computers and 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.

EX2

Production under trade

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 Japans PPF.
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U.S. Production With Trade (before)

Wheat (tons) 5,000 4,000 3,000 2,000

Producing 3400 tons of wheat requires 34,000 labor hours. The remaining 16,000 labor hours are used to produce 160 computers.

1,000
0

Computers
100 200 300 400 500

Japans Production w/ Trade (before)

Wheat (tons) 2,000

Producing 240 computers requires all of Japans 30,000 labor hours. So, Japan would produce 0 tons of wheat.

1,000

Computers
100 200 300

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.

EX3

Consumption under trade

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.)

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 Japans PPF.

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U.S. Consumption With Trade (after)

Wheat (tons) 5,000 4,000 3,000 2,000 computers produced 160 + imported 110 wheat 3400 0

exported
= amount consumed

0
270

700
2700

1,000
0

Computers
100 200 300 400 500

Japans Consumption w/ Trade (after)

Wheat (tons) 2,000 produced + imported exported = amount consumed computers 240 0 110 130 wheat 0 700 0 700

1,000

Computers
100 200 300

Trade Makes Both Countries Better Off

U.S.
consumption without trade computers wheat 250 2,500 consumption gains from with trade trade 270 2,700 20 200

Japan
consumption without trade computers wheat 120 600 consumption gains from with trade trade 130 700 10 100

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 worlds 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.

EX4

Absolute & comparative advantage

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?

44

EX4

Answers
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:

Argentinas 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.

Brazils opp. cost of wine is five pounds of

coffee.
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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.

SUMMARY
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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