1. THE PRODUCTION POSSIBILITY MODEL, TRADE, AND GLOBALIZATION
Chapter 2
THE PRODUCTION POSSIBILITY MODEL, TRADE, AND GLOBALIZATION

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.

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.

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.

5. A Production Possibilities Curve for an Individual
Hours of study
Grade in
Hours of study
Grade in
in history
history
in economics
economics
A: 20 hours of economics,
0 hours of history 20 98 40 A 19 96 1 43
100 18 94 2 46 17 92 3 49 B 16 90 4 52 88 15 88 5 55 14 86 6 58
Economics grade 13 84 7 61 12 82 8 64 C
E: 20 hours of
history,
0 hours of
economics 11 80 9 67 70 10 78 10 70 9 76 1 1 73 8 74 12 76 7 72 13 79 6 70 14 82 5 68 15 85 D 4 66 16 88 46 E 3 64 17 91 40 2 62 18 94 58 66 78 94 98 1 60 19 97
History grade 58 20
100

6. Increasing Marginal Opportunity Cost
Slope is flat at A. Low
opportunity cost of guns. A
The principle of increasing marginal
opportunity cost states that opportunity costs
increase as you produce more of one product.
Butter
Slope is steep at B. High opportunity cost of guns. B
Guns

7. A Production Possibilities Table for Society
% of resources
devoted to
production
of guns
Number
of butter
Pounds
Row 20 40 60 80
100 4 7 9 1 12 15 14 5 A B C D E F

8. PPC for Society A 4 guns 1 pound of butter 15 B 14 3 guns
2 pounds of butter C 12 D 9
Butter E 5
1 gun
5 pounds of butter F 4 7 9 11 12
Guns

9. Efficiency and Inefficiency10
Unattainable point 8 C D 6
Efficient
points
Guns B 4 A
Inefficient
point 2 8 10
Butter

10. Biased Technological Change
Shifts in the PPC
Neutral Technological Change
Biased Technological Change C
Butter
Butter C B A D B A
Guns
Guns

11. 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.

12. 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.

13. Growth in the Past Two Millennia
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
2010
1500
1000
500
(in 1990 international dollars)
Per capita income

14. (in thousands of yards)
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). 5 D 4
Pakistan
(in thousands of yards)
Textiles 3 A 2 1
Belgium B E
Chocolate (in tons)

15. (in thousands of yards)
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). 5 D 4
Pakistan
(in thousands of yards)
Textiles 3 A C 2
Belgium 1 B E
Chocolate (in tons)

16. (in thousands of yards)
Summary of Trade
For Pakistan the opportunity cost of one ton of chocolate
is 4000 yards of textiles. 4 3 2 1 5
Chocolate (in tons)
(in thousands of yards)
Textiles
Belgium
Pakistan A B C E D
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).
If both countries divide what is jointly
produced evenly, they will both be
consuming at point C, beyond both
countries’ PPC.

17. Comparative Advantage and the Combined PPCF 5
The combined PPC is the curve connecting points F, H, and G. 4 H 3
The slope of the combined PPC is determined by the country with the lowest opportunity cost.
Pakistan
(in thousands of yards)
Textiles 2
Belgium 1 G
Chocolate (in tons)

18. 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.

19. 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.

20. Globalization
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.

21. 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.

22. 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.

23. Summary
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.

24. Summary
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.

25. Review Question 2-1 Given the following PPC A B C D E Computers 1 2 31 2 3 4
Books
100 90 70 40
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.

26. 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.