McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. THE PRODUCTION POSSIBILITY MODEL, TRADE, AND GLOBALIZATION THE PRODUCTION POSSIBILITY MODEL, TRADE, AND GLOBALIZATION Chapter 2

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-2 Today’s lecture will: Demonstrate opportunity costs with a production possibilities curve. Discuss the principle of increasing marginal opportunity cost. Relate the concept of comparative advantage to the production possibilities curve.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-3 Today’s lecture will: Show how comparative advantage and trade can allow countries to consume beyond their production possibilities. Explain how globalization and outsourcing are part of a global process guided by the law of one price.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-4 The Production Possibilities Model A production possibilities curve illustrates opportunity cost by showing trade-offs among choices we make. It measures the maximum number of outputs that can be achieved from a given number of inputs.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved A Production Possibilities Curve for an Individual Economics grade History grade E: 20 hours of history, 0 hours of economics E D C B A: 20 hours of economics, 0 hours of history A Hours of study in history Grade in history Hours of study in economics Grade in economics

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-6 Increasing Marginal Opportunity Cost Butter Slope is flat at A. Low opportunity cost of guns. Slope is steep at B. High opportunity cost of guns. Guns B A The principle of increasing marginal opportunity cost states that opportunity costs increase as you produce more of one product.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-7 A Production Possibilities Table for Society % of resources devoted to production of guns Number of guns % of resources devoted to production of butter Pounds of butterRow A B C D E F

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-8 PPC for Society 1211 A Butter Guns gun 5 pounds of butter guns 2 pounds of butter B C D E F guns 1 pound of butter

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-9 Efficiency and Inefficiency Guns Butter CD A B Efficient points Inefficient point Unattainable point

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Shifts in the PPC Neutral Technological Change Butter A Guns 0 Biased Technological Change 0 B Butter Guns C B D C A

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Distribution and Production Efficiency The PPC focuses on productive efficiency and ignores distribution. In our society, more is generally preferred to less and many policies have relatively small distributional effects.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Trade and Comparative Advantage The PPC is bowed because individuals specialize in the production of goods for which they have a comparative advantage. For a society to produce on its PPC, individuals must produce those goods for which they have a comparative advantage and trade for other goods. According to Adam Smith, humankind’s proclivity to trade leads to individuals using their comparative advantage.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Growth in the Past Two Millennia $6,000 $5,000 $4,000 $3,000 $2,000 $1, Per capita income (in 1990 international dollars)

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Gains from Trade Without trade they can only consume only those combinations of goods along their PPCs, such as point A (Pakistan) and point B (Belgium) Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan A B E D

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Gains from Trade If they specialize and trade, they can consume outside of their individual PPCs. Each country can consume 2,000 tons of fabric and 2 tons of chocolate (point C) Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan A B C E D

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Summary of Trade For Pakistan the opportunity cost of one ton of chocolate is 4000 yards of textiles. For Belgium the opportunity cost of one ton of chocolate is 250 yards of textiles. Belgium has the comparative advantage in chocolate and specializes producing 4 tons (point E). Pakistan has the comparative advantage in textiles and specializes producing 4000 yards (point D) Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan A B C E D If both countries divide what is jointly produced evenly, they will both be consuming at point C, beyond both countries’ PPC.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Comparative Advantage and the Combined PPC Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan H F G The slope of the combined PPC is determined by the country with the lowest opportunity cost. The combined PPC is the curve connecting points F, H, and G.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved U.S. Textile Production and Trade Two hundred years ago, the U.S. had a comparative advantage in textile production. Now countries with cheaper labor, such as Bangladesh, have the comparative advantage in textiles. The gains from trade are higher wages for workers in Bangladesh and lower-priced cloth for U.S. consumers.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Outsourcing and Globalization Outsourcing is the relocation of production once done in the U.S. to foreign countries. Outsourcing occurs because many other countries have a comparative advantage in labor costs. The U.S. has a comparative advantage in technology, institutional structure, and specialized knowledge.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-20Globalization Globalization is the increasing integration of economies, cultures, and institutions across the world. The positive effect of globalization is that it provides larger markets than the domestic economy. Increased competition can be a negative effect of globalization.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Exchange Rates and Comparative Advantage The U.S. comparative advantage in innovation results in higher wages in the U.S. As industries mature, they move to lower wage countries. In order to regain our comparative advantage, the U.S. exchange rate will decline and foreign wages will increase to make U.S. exports cheaper and imports to the U.S. more expensive.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Law of One Price The law of one price – the wages of equal workers in one country will not differ significantly from the wages of workers in another institutionally similar country. If the U.S. loses its comparative advantage based on technology and institutional structure, U.S. wages will decrease relative to wages in many other countries.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-23Summary The production possibilities curve (PPC) measures the maximum combination of outputs that can be obtained from a given number of inputs. According to the principle of increasing marginal opportunity cost, as production of one good increases, we must give up ever-increasing quantities of something else. Points inside the PPC are inefficient, points along the PPC are efficient, and points outside the PPC are unattainable.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-24Summary The rise of markets, specialization, trade, and competition have contributed to significant increases in output. By specializing in producing those goods for which one has a comparative advantage (lowest opportunity cost) one can produce the greatest amount of goods with which to trade. Specialization and trade shift the PPC out. We live in an ever-increasingly global economy. Both outsourcing and insourcing occur, based on comparative advantage.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Review Question 2-1 Given the following PPC ABCDE Computers01234 Books What is the marginal opportunity cost of the third computer? To produce the third computer, production moves from alternative C to D. The marginal opportunity cost of the third computer is 70 – 40 = 30 books.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Review Question 2-2 Suppose that the U.S. can produce 80 computer chips or 80 video games in one hour. Japan can produce 40 computer chips or 80 video games in one hour. What is the opportunity cost of computer chips in each country? In which product should each country specialize? In the U.S. the cost of 1 computer chip is 80/80 = 1 video game. In Japan the cost of 1 computer chip is 80/40 = 2 video games. The U.S. should specialize in computer chips and Japan should specialize in video games.