The Production Possibility Model, Trade, and Globalization No one ever saw a dog make a fair and deliberate exchange of one bone for another with another dog. — Adam Smith CHAPTER 2 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

The Production Possibilities Model An output is a result of an activity An input is what you put in production process to achieve an output A production possibility table lists the opportunity cost of alternative outputs that can be achieve with your inputs. The production possibilities model can be presented in both a table and in a graph 2-2

The Production Possibilities Model It is a graphical representation of the opportunity cost concept A production possibility curve (PPC) shows the maximum combination of outputs that can be obtained from a given number of inputs 2-3

A Production Possibilities Curve History grade hrs for each History and Econ Econ Grade hrs for Econ and 4 hrs for History There is a limit to what you can achieve, given existing institutions, resources, and technology Every choice you make has an opportunity cost PPC subjects and 20 hours of study time

for Susan’s grades in English and Economics (10 hrs of study) A AB B C C D D Expected grade in Economics 101 Expected grade in English 101 Production Possibilities Curve F F Production Possibilities Curve ( PPC ) If she spends most of her time studying economics, she can earn an A in economics … and a D in English. If she splits her time between the two, she can earn a B in Economics and English. If she spends most of her time studying English, she can earn a D in Economics … and an A in English. Mapping out all the possibilities of how Susan can divide her time (limited resources) between these activities shows us her Production Possibilities Curve ( PPC ).

Increasing Marginal Opportunity Cost Guns Butter Slope is flat at A This means there is a low opportunity cost to produce more guns A The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on the activity B Slope is steep at B This means there is a high opportunity cost to produce more guns 2-6

Comparative Advantage A resource (or geographical area) has comparative advantage if it has the ability to be better suited to the production of one good than another The reason the opportunity cost of guns increases as we produce more guns is that some resources have comparative advantage over other resources 2-7

Trade and Comparative Advantage According to Adam Smith, humankind’s proclivity to trade leads to individuals using their 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 2-8

The Benefits from Trade Chocolate (tons) Textiles (yds) If each country specializes according to comparative advantage and trades, they can consume beyond their PPCs 5,000 4,000 3,000 2,000 1, Belgium Pakistan Why should Pakistan specialize in textiles and Belgium specialize in chocolates? 2-9

Comparative Advantage and the Combined PPC Chocolate (tons) Textiles (yds) 5,000 4,000 3,000 2,000 1, Belgium Pakistan Combined PPC with trade The slope of the combined PPC is determined by the country with the lowest opportunity cost Pakistan + Belgium 2-10

2-11 Areca Guns Butter Bonsai Guns Butter

Application: U.S. Textile Production and Trade The gains from trade are higher wages for workers in Bangladesh and lower-priced cloth for U.S. consumers 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 2-12

Outsourcing, Trade and Comparative Advantage The U.S. has comparative advantage in technology, institutional structure, and specialized knowledge Outsourcing is the relocation of production once done in the United States to foreign countries Outsourcing occurs because many other countries have a comparative advantage in labor costs 2-13

Outsourcing, Trade and Comparative Advantage The global economy increases the number of competitors and this increased competition can be a negative effect of globalization Globalization is the increasing integration of economies, cultures, and institutions across the world A positive effect of globalization is that it provides larger markets than the domestic economy 2-14

Outsourcing, Trade and Comparative Advantage 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 The U.S. comparative advantage in innovation results in higher wages in the U.S. As industries mature, they move to lower wage countries Exchange Rates and Comparative Advantage 2-15

Outsourcing, Trade and Comparative Advantage 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 The law of one price is the wages of equal workers in one country will not differ significantly from the wages of workers in another institutionally similar country The Law of One Price The reality is that the citizens in the U.S. has been living better than it could have otherwise because of trade and outsourcing 2-16