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of Microeconomics 3 . The Production Possibilities Frontier and Gains From Trade*

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*

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  1. 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

  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 • 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

  5. http://live.wsj.com/video/could-ralph-lauren-make-olympic-uniforms-in-us/F99C8D13-4329-4BAC-93E6-8B766B427C76.html#!F99C8D13-4329-4BAC-93E6-8B766B427C76http://live.wsj.com/video/could-ralph-lauren-make-olympic-uniforms-in-us/F99C8D13-4329-4BAC-93E6-8B766B427C76.html#!F99C8D13-4329-4BAC-93E6-8B766B427C76

  6. 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

  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. 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

  9. Graphically… E D C B A

  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?

  11. 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.

  12. 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.

  13. 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

  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

  15. 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.

  16. STUDENTS’ TURN:PPF and opportunity cost In which country is the opportunity cost of cloth lower? FRANCE ENGLAND 16

  17. Answer England, because its PPF is not as steep as France’s. FRANCE ENGLAND 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

  19. 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

  20. 2. Gains from Trade

  21. 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

  22. 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

  23. 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

  24. 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.

  25. 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

  26. 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!

  27. 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!

  28. 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)

  29. 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

  30. 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

  31. 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.

  32. 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.

  33. 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.

  34. 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

  35. 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

  36. 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

  37. 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

  38. 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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