Transcript 3_ppf_and_trade

of Microeconomics
3. The Production Possibilities
Frontier
and Gains From Trade*
Akos Lada
July 22nd 2014
* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint
How economists think…
• Economics as the study of how society manages scarce
resources
• The principles of how people make decisions
• People face trade-offs
• The cost of something is what you give up to get it
(opportunity cost)
• Rational people think at the margin
• People respond to incentives
• Economics as a science
• The use of assumptions and models
Today’s Objectives
1. Production Possibilities Frontier
 A building block to the study of trade
2. Gains from Trade
 Why does it make sense to buy, sell, and trade?
 Why don’t we all make our own clothes?
 Can we all gain from trade?
1. The PPF
http://live.wsj.com/video/could-ralph-lauren-makeolympic-uniforms-in-us/F99C8D13-4329-4BAC-93E68B766B427C76.html#!F99C8D13-4329-4BAC-93E68B766B427C76
The Production Possibilities Frontier
The Production Possibilities Frontier (PPF) is a graph that
shows the combinations of two goods the economy can possibly
produce given the available resources and the available
technology
A very simple example:
Econ
48
 Resource: 48 hours of weekend time
 All used for producing one of two goods:
 Studying Econ
 Studying Quant
48 Quant
A (slightly) more realistic example…
Let’s assume that:
1. We live in a world where only two goods can be produced

Computers and wheat
2. The goods are made using only one factor of production
(input)


Labor (people’s work)
Limited amount of labor available, 50,000 labor hours per month
3. The technology is given by:


Producing 1 computer requires 100 hours labor
Producing 1 ton of wheat requires 10 hours labor
How many computers and how much
wheat can society produce?
Employment of
labor hours
Production
Computers
Wheat
Computers
Wheat
A
50,000
0
500
0
B
40,000
10,000
400
1,000
C
25,000
25,000
250
2,500
D
10,000
40,000
100
4,000
E
0
50,000
0
5,000
Graphically…
Production
Point
on
Comgraph puters Wheat
A
500
0
B
400
1,000
C
250
2,500
D
100
4,000
E
0
5,000
Wheat
(tons)
6,000
5,000
E
D
4,000
3,000
C
2,000
B
1,000
A
0
0
100 200 300 400 500 600
Computers
STUDENTS’ TURN:
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?
Answers
 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.
Wheat
(tons)
6,000
5,000
4,000
3,000
F
2,000
1,000
0
0
100 200 300 400 500 600
Computers
Answers
 Point G:
300 computers,
3500 tons wheat
 Point G requires
65,000 hours
of labor.
Not possible
because
economy
only has
50,000 hours.
Wheat
(tons)
6,000
5,000
4,000
G
3,000
2,000
1,000
0
0
100 200 300 400 500 600
Computers
The PPF, in Summary….
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
Wheat
(tons)
6,000
5,000
E
D
4,000
3,000
F
G
C
2,000
B
1,000
A
0
0
100 200 300 400 500 600
Computers
The PPF and Opportunity Cost
• Recall: The opportunity cost of an item
is what must be given up to obtain it
 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
–1000
slope =
= –10
100
5,000
4,000
3,000
2,000
1,000
0
0
100 200 300 400 500 600
Computers
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
1 computer is
10 tons of wheat.
STUDENTS’ TURN:
PPF and opportunity cost
In which country is the opportunity cost of cloth lower?
FRANCE
ENGLAND
Wine
Wine
600
600
500
500
400
400
300
300
200
200
100
100
0
0
0
100 200 300 400
Cloth
0
100 200 300 400
Cloth16
Answer
England, because its PPF is not as steep as France’s.
FRANCE
ENGLAND
Wine
Wine
600
600
500
500
400
400
300
300
200
200
100
100
0
0
0
100 200 300 400
Cloth
0
100 200 300 400
Cloth17
Note 1: Changes / Shifts in the PPF
• The whole PPF can shift over time as a result
of growth in a factor of production or change
in technology
• If labor increases (but also capital, land
etc)
• If technology changes to allow greater
incremental production of both goods
• That is the process of economic growth!
• The PPF can also pivot
• E.g as a result of a change in technology
that affects the rate at which one of the
goods can be produced but does not
affect the other
Wheat
(tons)
6,000
Wheat
(tons)
6,000
5,000
5,000
4,000
4,000
3,000
3,000
2,000
2,000
1,000
1,000
0
0
0
100 200 300 400 500 600
Computers
0
100 200 300 400 500 600
Computers
• The PPF can 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 opportunity cost remains
constant, PPF is a straight line.
Beer
Note 2: The Shape of the PPF
• If opportunity cost of a good
rises as the economy produces
more of the good, PPF is bowshaped.
• For now, we will assume straight line
Mountain
Bikes
2. Gains from Trade
How can two individuals / firms /
countries gain from trade?
We can answer this with an example of two countries.
Let us assume…
•
Two countries: the U.S. and Japan
•
Two goods: Computers and Wheat
•
One factor of production: Labor
• The U.S. has 50,000 hours of labor for production per month.
• Japan has 30,000 hours of labor for production per month.
•
Technology:
• Producing one computer requires 100 hours of labor in the U.S. and 125 hours
of labor in Japan
• Producing one ton of wheat requires 10 hours of labor in the U.S. and 25 hours
in Japan
Step 1: Determine the production
opportunities of each producer
Shown below are the total amount of labor needed to produce each good
in the U.S. and in Japan and the total amount of each good that can be
produced given the endowment of labor
Labor needed to produce
one:
Total amount that can be
produced:
Computer
Wheat (tons)
Computer
Wheat (tons)
United States
100 hrs
10 hrs
500
5000
Japan
125 hrs
25 hrs
240
1200
Step 2: Determine which producer has
Absolute Advantage in which good(s)
• From this Table we can see that in this example, the U.S. has absolute
advantage in the production of both computers and wheat
• The U.S. is able to produce both computers and wheat using fewer
inputs (labor hours) than Japan
• 100 hrs versus 125 hrs for computers
• 10 hrs versus 25 hrs for wheat
Labor needed to produce
one:
Total amount that can be
produced:
Computer
Wheat (tons)
Computer
Wheat (tons)
United States
100 hrs
10 hrs
500
5000
Japan
125 hrs
25 hrs
240
1200
Step 3: Draw the PPF for each producer U.S.
Wheat (tons)
The U.S. has enough labor to
produce 500 computers,
or 5000 tons of wheat,
or any combination along
the PPF.
5,000
4,000
3,000
2,000
1,000
0
Computers
100
200
300
400
500
Step 3: Draw the PPF for each producer Japan
Japan has enough labor to
produce 240 computers, or
1200 tons of wheat, or any
combination along the PPF.
Wheat
(tons)
2,000
1,000
0
Computers
100
200
300
Step 4: Pick a point of production
without trade (autarky) – U.S.
Wheat (tons)
The point where a country produces in
autarky depends on its preferences
5,000
3,000
• 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
2,000
Key lesson: In autarky, production =
consumption!
4,000
1,000
0
Computers
100
200
300
400
500
Step 4: Pick a point of production
without trade (autarky) – Japan
Wheat
(tons)
• Suppose Japan uses half its labor to
produce each good.
• Then it will produce and consume
120 computers and 600 tons of
wheat.
2,000
Key lesson: In autarky, production =
consumption!
1,000
0
Computers
100
200
300
Step 5: Determine which producer has
Comparative Advantage for which good
• Remember: The slope of the PPF tells you the opportunity cost of one
good in terms of the other
• Comparative advantage is the ability to produce a good at a lower
opportunity cost than another producer
Opportunity Cost of:
Computer
Wheat (ton)
United States
10
1/10
Japan
5
1/5
Step 5: Determine which producer has
Comparative Advantage for which good
•
The U.S. has comparative advantage in wheat and Japan has comparative
advantage in computers
• This is true although the U.S. has absolute advantage in both wheat AND
computers!
Key Lesson: Absolute advantage is not necessary for comparative advantage!
• The direction of trade will be determined by comparative advantage
• The country that has comparative advantage in a good will specialize in that
good and export it
• It will import the good in which it does not have comparative advantage
Step 6: Production with trade
• With trade, each
country doesn’t need to
produce everything it
consumes
• It can instead allocate
more of its factors of
production (in our
example, labor) to the
product in which they
have comparative
advantage
STUDENTS’ TURN:
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 Japan’s PPF.
U.S. Production With Trade
Wheat (tons)
Producing 3400 tons of wheat
requires 34,000 labor hours.
5,000
4,000
The remaining 16,000
labor hours are used to
produce 160 computers.
3,000
2,000
1,000
0
Computers
100
200
300
400
500
Japan’s Production With Trade
Wheat
(tons)
Producing 240 computers
requires all of Japan’s 30,000
labor hours.
2,000
So, Japan would produce
0 tons of wheat.
1,000
0
Computers
100
200
300
Step 7: Determine gains from trade
and their allocation
Consumption in
Autarky
Production
Excess /
Deficit
Production
3,400
tns. of wheat
2500
tns. of wheat
+ 900
tns. of wheat
160
computers
250
computers
- 90
computers
300
more!
0
tns. of wheat
600
tns. of wheat
- 600
tns. of wheat
30
more!
240
computers
120
computers
+ 120
computers
The additional
production can be traded
at a price between the
two opportunity costs
• For this example lets assume that, in addition to fulfilling
autarky consumption levels, the US exchanges 100 tons of
wheat for 20 Japanese computers.
• In total the US exports 700 tons of wheat to Japan and
imports 110 computers from them.
Step 8: Determine Consumption
With Trade – U.S.
Wheat (tons)
computers
produced
160
+ imported
110
5,000
4,000
3,000
– exported
0
700
= amount
consumed
270
2700
2,000
1,000
0
100
200
300
wheat
3400
0
400
500
Computers
Japan’s Consumption With Trade
Wheat
(tons)
produced
+ imported
– exported
= amount
consumed
2,000
1,000
0
computers
240
0
110
wheat
0
700
0
130
700
Computers
100
200
300
Trade Makes Both Countries Better Off!
U.S.
consumption
without trade
consumption
with trade
gains from
trade
computers
250
270
20
wheat
2,500
2,700
200
consumption
without trade
consumption
with trade
gains from
trade
computers
120
130
10
wheat
600
700
100
Japan
In Sum: 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.