1. 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

2. 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

3. Today’s Objectives Production Possibilities Frontier Gains from Trade
A building block to the study of trade
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?

4. 1. The PPF

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6. 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:
Resource: 48 hours of weekend time
All used for producing one of two goods:
Studying Econ
Studying Quant
Econ 48 48
Quant 6

7. A (slightly) more realistic example…
Let’s assume that:
We live in a world where only two goods can be produced
Computers and wheat
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
The technology is given by:
Producing 1 computer requires 100 hours labor
Producing 1 ton of wheat requires 10 hours labor

8. How many computers and how much wheat can society produce?E D C B A
Wheat
Computers
Production
Employment of labor hours
50,000
500
50,000
40,000
10,000
25,000
1,000
400
Suggestion:
Show first row. Explain how we get the production numbers from the employment numbers. Then, show the rest of the employment numbers, and give students 3 minutes to compute the production numbers for each employment allocation.
2,500
250
4,000
100
5,000 8

9. Graphically… E D C B A Point on graph Production Com-puters Wheat A
500 B
400
1,000 C
250
2,500 D
100
4,000 E
5,000 E D C B A 9

10. 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?
This exercise leads students to discover for themselves that points under the PPF are possible but inefficient, while points above it are not possible.

11. 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. F

12. 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. G

13. The PPF, in Summary…. E D G C F B A Points on the PPF (like A – E)
possible
efficient: all resources are fully utilized
Points under the PPF (like F)
not efficient: some resources underutilized (e.g., workers unemployed, factories idle)
Points above the PPF (like G)
not possible E D G C F B A 13

14. 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 14

15. The PPF and Opportunity Cost
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.
–1000
slope =
= –10
100
Here, the “rise” is a negative number, because, as you move to the right, the line falls (meaning wheat output is reduced).
Moving to the right involves shifting resources from the production of wheat (which causes wheat output to fall) to the production of computers (which causes computer production to rise). Producing an additional computer requires the resources that would otherwise produce 10 tons of wheat.
Here, the opportunity cost of 1 computer is 10 tons of wheat. 15

16. In which country is the opportunity cost of cloth lower?
STUDENTS’ TURN: PPF and opportunity cost
In which country is the opportunity cost of cloth lower?
FRANCE
ENGLAND
This exercise reinforces the material on the preceding slide. It is especially useful if you plan to cover Chapter 3 (Interdependence and the Gains from Trade) after completing Chapter 2. 16

17. Answer England, because its PPF is not as steep as France’s. FRANCE
There are two ways to get the answer.
The hard way is to compute the slope of both PPFs. The slope of France’s PPF equals -600/300 = -2, meaning that France must give up two units of wine to get an additional unit of cloth. The slope of England’s PPF = -200/300 = -2/3, meaning that England only must sacrifice 2/3 of a unit of wine to get an additional unit of cloth. Thus, the opportunity cost of cloth is lower in England than France.
The question, however, does not ask for the numerical values of the opportunity cost of cloth in the two countries. It only asks which country has a lower opportunity cost of cloth.
There is an easy way to determine the answer. Students must remember that the slope of the PPF equals the opportunity cost of the good measured on the horizontal axis. Then, students can simply “eyeball” the two PPFs to determine which is steepest. From the graphs show, it’s pretty easy to see that England’s PPF isn’t as steep, and therefore the opportunity cost of cloth is lower in England than in France. 17

18. 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 18

19. Note 2: The Shape of the PPF
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.
If opportunity cost of a good rises as the economy produces more of the good, PPF is bow-shaped.
For now, we will assume straight line
Mountain Bikes
Beer 19

20. 2. Gains from Trade

21. 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
The lessons illustrated by this international trade example also apply to trade between two individual producers. Note that this chapter in the textbook does the reverse: It develops the lessons in the context of an example involving two individual producers, and then states that the lessons also apply to international trade. So, between this PowerPoint and the textbook chapter, students will see the same concepts and lessons developed in two different but entirely consistent approaches and examples.
The example here is highly contrived and unrealistic in order to illustrate complex concepts as simply as possible. The example has some qualities that make it especially valuable:
* The two goods are fundamentally different (one is agricultural, the other manufactured), which makes gains from trade based on comparative advantage very likely. An example using more similar goods, say laptop computers and MP3 players, would not be appropriate for this chapter because it would more likely give rise to inter-industry trade, and the gains would likely arise from a source other than comparative advantage (probably increasing returns to scale).
* In the example here, it turns out that the U.S. has an absolute advantage in both goods, yet both countries gain from trade. Students see, therefore, that comparative advantage, not absolute advantage, is what’s necessary for trade to be mutually beneficial.
* In the real world, one often sees gains from trade based on comparative advantage occurring between countries that are very different – such as between rich industrialized countries and poor developing countries. This example shows that trade based on comparative advantage can also occur between countries that are at similar levels of industrialization and income. (Of course, the U.S. and Japan are very different; but they are far more similar than are, say, the U.S. and Botswana.) 21

22. 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
The lessons illustrated by this international trade example also apply to trade between two individual producers. Note that this chapter in the textbook does the reverse: It develops the lessons in the context of an example involving two individual producers, and then states that the lessons also apply to international trade. So, between this PowerPoint and the textbook chapter, students will see the same concepts and lessons developed in two different but entirely consistent approaches and examples.
The example here is highly contrived and unrealistic in order to illustrate complex concepts as simply as possible. The example has some qualities that make it especially valuable:
* The two goods are fundamentally different (one is agricultural, the other manufactured), which makes gains from trade based on comparative advantage very likely. An example using more similar goods, say laptop computers and MP3 players, would not be appropriate for this chapter because it would more likely give rise to inter-industry trade, and the gains would likely arise from a source other than comparative advantage (probably increasing returns to scale).
* In the example here, it turns out that the U.S. has an absolute advantage in both goods, yet both countries gain from trade. Students see, therefore, that comparative advantage, not absolute advantage, is what’s necessary for trade to be mutually beneficial.
* In the real world, one often sees gains from trade based on comparative advantage occurring between countries that are very different – such as between rich industrialized countries and poor developing countries. This example shows that trade based on comparative advantage can also occur between countries that are at similar levels of industrialization and income. (Of course, the U.S. and Japan are very different; but they are far more similar than are, say, the U.S. and Botswana.)
Labor needed to produce one:
Total amount that can be produced:
Computer
Wheat (tons)
United States
100 hrs
10 hrs
500
5000
Japan
125 hrs
25 hrs
240
1200 22

23. 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
The lessons illustrated by this international trade example also apply to trade between two individual producers. Note that this chapter in the textbook does the reverse: It develops the lessons in the context of an example involving two individual producers, and then states that the lessons also apply to international trade. So, between this PowerPoint and the textbook chapter, students will see the same concepts and lessons developed in two different but entirely consistent approaches and examples.
The example here is highly contrived and unrealistic in order to illustrate complex concepts as simply as possible. The example has some qualities that make it especially valuable:
* The two goods are fundamentally different (one is agricultural, the other manufactured), which makes gains from trade based on comparative advantage very likely. An example using more similar goods, say laptop computers and MP3 players, would not be appropriate for this chapter because it would more likely give rise to inter-industry trade, and the gains would likely arise from a source other than comparative advantage (probably increasing returns to scale).
* In the example here, it turns out that the U.S. has an absolute advantage in both goods, yet both countries gain from trade. Students see, therefore, that comparative advantage, not absolute advantage, is what’s necessary for trade to be mutually beneficial.
* In the real world, one often sees gains from trade based on comparative advantage occurring between countries that are very different – such as between rich industrialized countries and poor developing countries. This example shows that trade based on comparative advantage can also occur between countries that are at similar levels of industrialization and income. (Of course, the U.S. and Japan are very different; but they are far more similar than are, say, the U.S. and Botswana.)
Labor needed to produce one:
Total amount that can be produced:
Computer
Wheat (tons)
United States
100 hrs
10 hrs
500
5000
Japan
125 hrs
25 hrs
240
1200 23

24. Step 3: Draw the PPF for each producer - U.S.
4,000
100
5,000
2,000
1,000
3,000
500
200
300
400
Computers
Wheat (tons)
The U.S. has enough labor to produce 500 computers,
or 5000 tons of wheat,
or any combination along the PPF.
Deriving the intercepts, or endpoints of the PPF:
The U.S. has 50,000 labor hours.
It takes 100 hours to produce a computer. If the U.S. uses all its labor to produce computers, then it will produce 50,000/100 = 500 computers. Hence, the horizontal intercept is (500 computers, 0 wheat).
It takes 10 hours to produce a ton of wheat. If the U.S. uses all its labor to produce wheat, then it will produce 50,000/10 = 5000 tons of wheat. Hence, the vertical intercept is (0 computers, 5000 tons of wheat).
The PPF is the straight line that connects the two endpoints. 24

25. 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.
Computers
Wheat (tons)
2,000
1,000
200
100
300
Horizontal intercept: (30,000 labor-hours)/(125 hours per computer) = 240 computers.
Vertical intercept: (30,000 labor-hours)/(25 hours per ton of wheat) = 1200 tons of wheat. 25

26. Step 4: Pick a point of production without trade (autarky) – U.S.
4,000
100
5,000
2,000
1,000
3,000
500
200
300
400
Computers
Wheat (tons)
The point where a country produces in autarky depends on its preferences
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
Key lesson: In autarky, production = consumption!
Of course, the U.S. could choose a different point. The actual choice will depend on the preferences of society. (In the following chapter – on supply and demand – we will learn what determines how much of each good society produces.)
Important note for students: Without trade, a country consumes what it produces. 26

27. Step 4: Pick a point of production without trade (autarky) – Japan
Computers
Wheat (tons)
2,000
1,000
200
100
300
Suppose Japan uses half its labor to produce each good.
Then it will produce and consume 120 computers and 600 tons of wheat.
Key lesson: In autarky, production = consumption! 27

28. 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
The US has comparative advantage in wheat (1/10<1/5)
Japan has comparative advantage in computers (5<10)
Opportunity Cost of:
Computer
Wheat (ton)
United States 10
1/10
Japan 5
1/5 28

29. 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 29

30. 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 30

31. STUDENTS’ TURN: Production under trade
1. Suppose the U.S. produces 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.
Give your students a few minutes to solve these problems before showing the answers on the next slides. This will break up the lecture, get the students involved, and give them practice with “word problems.”
It is not necessary that all students finish both problems before moving on. It’s fine if most finish the first, and a few finish the second. However, the second problem is easy for most students.
Note that most students will need a calculator to solve the first problem.

32. U.S. Production With Trade
Computers
Wheat (tons)
4,000
100
5,000
2,000
1,000
3,000
500
200
300
400
Producing 3400 tons of wheat requires 34,000 labor hours.
The remaining 16,000 labor hours are used to produce 160 computers.
Point out to students that the red dot represents the combination (160 computers, 3400 tons of wheat). We will assume that this is the combination the U.S. produces in the scenario in which the U.S. trades. 32

33. Japan’s Production With Trade
Computers
Wheat (tons)
2,000
1,000
200
100
300
Producing 240 computers requires all of Japan’s 30,000 labor hours.
So, Japan would produce 0 tons of wheat.
The red dot represents the combination (240 computers, 0 tons wheat). We will assume this is the combination that Japan produces.
Point out that, just because Japan is not producing any wheat does not mean that Japan’s consumers must all go on the Atkins diet (which shuns bread and other foods made from wheat). When trade is allowed, Japan can trade some of its computers for wheat produced in another country. 33

34. Step 7: Determine gains from trade and their allocation
Excess / Deficit Production
Consumption in Autarky
Production
160
computers
3,400
tns. of wheat
250
computers
2500
tns. of wheat
- 90
computers
+ 900
tns. of wheat
300 more!
30 more!
240
computers
tns. of wheat
120
computers
600
tns. of wheat
+ 120
computers
- 600
tns. of wheat
The red dot represents the combination (240 computers, 0 tons wheat). We will assume this is the combination that Japan produces.
Point out that, just because Japan is not producing any wheat does not mean that Japan’s consumers must all go on the Atkins diet (which shuns bread and other foods made from wheat). When trade is allowed, Japan can trade some of its computers for wheat produced in another country.
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.
The additional production can be traded at a price between the two opportunity costs 34

35. Step 8: Determine Consumption With Trade – U.S.
Computers
Wheat (tons)
wheat
computers
4,000
100
5,000
2,000
1,000
3,000
500
200
300
400
3400
160
produced
110
+ imported
700
– exported
2700
270
= amount consumed
The red point again represents production.
Trade un-tethers consumption from production. The light blue point represents consumption. Notice that the consumption point is above the PPF. Without trade, it would not be possible to consume this combination of the two goods!
In a sense, international trade is like technological progress: it allows society to produce quantities of goods that would otherwise not be possible. 35

36. Japan’s Consumption With Trade
Computers
Wheat (tons)
2,000
1,000
200
100
300
wheat
computers
240
produced
700
+ imported
110
– exported
700
130
= amount consumed
Again, the light blue point representing consumption is above the PPF. Without trade, it would not be possible to consume this combination of the goods. 36

37. Trade Makes Both Countries Better Off!
U.S.
consumption without trade
consumption with trade
gains from trade 20
270
250
computers
200
2,700
2,500
wheat
gains from trade
consumption with trade
consumption without trade
Japan
These tables summarize the gains from trade for both countries. 10
130
120
computers
100
700
600
wheat 37

38. 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. 38