Of microeconomics 3 the production possibilities frontier and gains from trade
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of Microeconomics 3 . The Production Possibilities Frontier and Gains From Trade*. Akos Lada July 22 nd 2014. * Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint. How economists think….

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Of microeconomics 3 the production possibilities frontier and gains from trade

of Microeconomics3. The Production Possibilities Frontierand Gains From Trade*

AkosLada

July 22nd 2014

* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint


How economists think

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

Today’s Objectives

  • Production Possibilities Frontier

    • 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?


1 the ppf

1. The PPF


Of microeconomics 3 the production possibilities frontier and gains from trade

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The production possibilities frontier

The Production Possibilities Frontier

0

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


A slightly more realistic example

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


  • 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

    How many computers and how much wheat can society produce?

    0


    Graphically

    Graphically…

    E

    D

    C

    B

    A


    Students turn points off the ppf

    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

    F

    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.


    Answers1

    G

    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.


    The ppf in summary

    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

    E

    D

    G

    C

    F

    B

    A


    The ppf and opportunity cost

    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 cost1

    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.

    slope =

    The PPF and Opportunity Cost

    –1000

    = –10

    100

    Here, the opportunity cost of 1 computer is 10 tons of wheat.


    Of microeconomics 3 the production possibilities frontier and gains from trade

    STUDENTS’ TURN:PPF and opportunity cost

    In which country is the opportunity cost of cloth lower?

    FRANCE

    ENGLAND

    16


    Answer

    Answer

    England, because its PPF is not as steep as France’s.

    FRANCE

    ENGLAND

    17


    Note 1 changes shifts in the ppf

    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


    Note 2 the shape of the ppf

    Note 2: The Shape of the PPF

    Beer

    Mountain Bikes

    • 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


    2 gains from trade

    2. Gains from Trade


    How can two individuals firms countries gain from trade

    How can two individuals / firms / countries gain from trade?

    0

    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

    Step 1: Determine the production opportunities of each producer

    0

    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


    Step 2 determine which producer has absolute advantage in which good s

    Step 2: Determine which producer has Absolute Advantage in which good(s)

    0

    • 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


    Step 3 draw the ppf for each producer u s

    Wheat (tons)

    The U.S. has enough labor to produce 500 computers,

    4,000

    5,000

    2,000

    1,000

    3,000

    Computers

    0

    300

    200

    500

    100

    400

    Step 3: Draw the PPF for each producer - U.S.

    0

    or 5000 tons of wheat,

    or any combination along the PPF.


    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

    Computers

    0

    100

    200

    300

    Step 3: Draw the PPF for each producer - Japan

    0


    Step 4 pick a point of production without trade autarky u s

    Wheat (tons)

    4,000

    5,000

    2,000

    1,000

    3,000

    Computers

    0

    100

    500

    400

    300

    200

    Step 4: Pick a point of production without trade (autarky) – U.S.

    0

    • 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!


    Step 4 pick a point of production without trade autarky japan

    Wheat (tons)

    2,000

    1,000

    Computers

    0

    100

    200

    300

    Step 4: Pick a point of production without trade (autarky) – Japan

    0

    • 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!


    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

    Step 5: Determine which producer has Comparative Advantage for which good

    0

    The US has comparative advantage in wheat (1/10<1/5)

    Japan has comparative advantage in computers (5<10)


    Step 5 determine which producer has comparative advantage for which good1

    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!

    Step 5: Determine which producer has Comparative Advantage for which good

    0

    • 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

    Step 6: Production with trade

    0


    Students turn production under trade

    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)

    4,000

    5,000

    2,000

    1,000

    3,000

    Computers

    0

    100

    500

    400

    300

    200

    U.S. Production With Trade

    0

    Producing 3400 tons of wheat requires 34,000 labor hours.

    The remaining 16,000 labor hours are used to produce 160 computers.


    Japan s production with trade

    Wheat (tons)

    2,000

    1,000

    Computers

    0

    100

    200

    300

    Japan’s Production With Trade

    0

    Producing 240 computers requires all of Japan’s 30,000 labor hours.

    So, Japan would produce 0 tons of wheat.


    Step 7 determine gains from trade and their allocation

    Step 7: Determine gains from trade and their allocation

    0

    Excess / Deficit Production

    Consumption in Autarky

    Production

    + 900

    tns. of wheat

    3,400

    tns. of wheat

    2500

    tns. of wheat

    - 90

    computers

    160

    computers

    250

    computers

    300 more!

    0

    tns. of wheat

    - 600

    tns. of wheat

    600

    tns. of wheat

    30 more!

    240

    computers

    + 120

    computers

    120

    computers

    • 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


    Step 8 determine consumption with trade u s

    Wheat (tons)

    computers

    wheat

    produced

    160

    3400

    + imported

    110

    0

    – exported

    0

    700

    = amount consumed

    270

    2700

    4,000

    3,000

    1,000

    2,000

    5,000

    Computers

    0

    400

    300

    200

    500

    100

    Step 8: Determine Consumption With Trade – U.S.

    0


    Japan s consumption with trade

    computers

    wheat

    Wheat (tons)

    produced

    240

    0

    + imported

    0

    700

    – exported

    110

    0

    2,000

    = amount consumed

    130

    700

    1,000

    Computers

    0

    100

    200

    300

    Japan’s Consumption With Trade

    0


    Trade makes both countries better off

    Trade Makes Both Countries Better Off!

    computers

    250

    270

    20

    wheat

    2,500

    2,700

    200

    Japan

    consumption without trade

    consumption with trade

    gains from trade

    computers

    120

    130

    10

    wheat

    600

    700

    100

    0

    U.S.

    consumption without trade

    consumption with trade

    gains from trade


    In sum comparative advantage and trade

    In Sum: Comparative Advantage and Trade

    0

    • 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.


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