CHAPTER 3 Production Possibilities and the Gains from

CHAPTER 3 Production Possibilities and the Gains from Trade Microeonomics PRINCIPLES OF N. Gregory Mankiw Premium Power. Point Slides by Ron Cronovich © 2009 South-Western, a part of Cengage Learning, all rights reserved

In this chapter, look for the answers to these questions: § Why do people – and nations – choose to be economically interdependent? § How can trade make everyone better off? § What is absolute advantage? What is comparative advantage? How are these concepts similar? How are they different? 1

Models simplify ”Imagine an economy that produces only two things: hot dogs and buns. Consumers in this economy insist that every hot dog come with a bun, and vice versa. And labor is the only input to production. OK, timeout. Before we go any further, I need to ask what you think of an essay that begins this way. Does it sound silly to you? Were you about to turn the virtual page, figuring that this couldn't be about anything important? INTERDEPENDENCE AND THE GAINS FROM TRADE 2

Models simplify One of the points of this column is to illustrate a paradox: You can't do serious economics unless you are willing to be playful. Economic theory is not a collection of dictums laid down by pompous authority figures. Mainly, it is a menagerie of thought experiments--parables, if you like--that are intended to capture the logic of economic processes in a simplified way. ” (Paul Krugman: The Accidental Theorist. Slate, Jan. 24, 1997) INTERDEPENDENCE AND THE GAINS FROM TRADE 3

Our Second Model: The Production Possibilities Frontier § The Production Possibilities Frontier (PPF): a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology § Example: § Two goods: computers and wheat § One resource: labor (measured in hours) § Economy has 50, 000 labor hours per month available for production. 4 INTERDEPENDENCE AND THE GAINS FROM TRADE 4

PPF Example § Producing one computer requires 100 hours labor. § Producing one ton of wheat requires 10 hours labor. Employment of labor hours Production Computers Wheat A 50, 000 0 500 0 B 40, 000 10, 000 400 1, 000 C 25, 000 250 2, 500 D 10, 000 40, 000 100 4, 000 E 0 50, 000 0 5, 000 INTERDEPENDENCE AND THE GAINS FROM TRADE 5

PPF Example Production Point on Comgraph puters Wheat A 500 0 B 400 1, 000 C 250 2, 500 D 100 4, 000 E 0 5, 000 6 E D INTERDEPENDENCE AND THE GAINS FROM TRADE C B A 6

ACTIVE LEARNING 1 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? INTERDEPENDENCE AND THE GAINS FROM TRADE 7

ACTIVE LEARNING 1 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 INTERDEPENDENCE AND THE GAINS FROM TRADE 8

ACTIVE LEARNING 1 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. INTERDEPENDENCE AND THE GAINS FROM TRADE G 9

The PPF: What We Know So Far 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 10 INTERDEPENDENCE AND THE GAINS FROM TRADE 10

The PPF and Opportunity Cost § Recall: The opportunity cost of an item is what must be given up to obtain that item. § 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. 11 INTERDEPENDENCE AND THE GAINS FROM TRADE 11

The PPF and Opportunity Cost slope = – 1000 = – 10 100 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. Here, the opportunity cost of a computer is 10 tons of wheat. 12 INTERDEPENDENCE AND THE GAINS FROM TRADE 12

The Shape of the PPF § The PPF could 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 opp. cost remains constant, PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat. ) § If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped. 13 INTERDEPENDENCE AND THE GAINS FROM TRADE 13

Why the PPF Might Be Bow-Shaped § So, PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other. § The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs (E. g. , different types of land suited for different uses). 14 INTERDEPENDENCE AND THE GAINS FROM TRADE 14

As the economy shifts resources from beer to mountain bikes: Beer Why the PPF Might Be Bow-Shaped § PPF becomes steeper § opp. cost of mountain bikes increases Mountain Bikes 15 INTERDEPENDENCE AND THE GAINS FROM TRADE 15

At point A, most workers are producing beer, even those that are better suited to building bikes. Beer Why the PPF Might Be Bow-Shaped A At A, opp. cost of mtn bikes is low. So, do not have to give up much beer to get more bikes. 16 INTERDEPENDENCE AND THE GAINS FROM TRADE Mountain Bikes 16

At B, most workers are producing bikes. The few left in beer are the best brewers. Beer Why the PPF Might Be Bow-Shaped Producing more bikes would require shifting some of the best brewers away from beer production, would cause a big drop in beer output. 17 INTERDEPENDENCE AND THE GAINS FROM TRADE At B, opp. cost of mtn bikes is high. B Mountain Bikes 17

The PPF: A Summary § The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology. § The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth. § A bow-shaped PPF illustrates the concept of increasing opportunity cost. 18 INTERDEPENDENCE AND THE GAINS FROM TRADE 18

Interdependence Every day hair gel from Cleveland, OH you rely on many people cell phone from around from Taiwan the world, most of whom dress shirt you’ve never met, from China to provide you with the goods coffee from and services Kenya you enjoy.

Interdependence § One of the Ten Principles from Chapter 1: Trade can make everyone better off. § We now learn why people – and nations – choose to be interdependent, and how they can gain from trade. INTERDEPENDENCE AND THE GAINS FROM TRADE 20

Our Example § Two countries: the U. S. and Japan § Two goods: computers and wheat § One resource: labor, measured in hours § We will look at how much of both goods each country produces and consumes § if the country chooses to be self-sufficient § if it trades with the other country INTERDEPENDENCE AND THE GAINS FROM TRADE 21

Production Possibilities in the U. S. § The U. S. has 50, 000 hours of labor available for production, per month. § Producing one computer requires 100 hours of labor. § Producing one ton of wheat requires 10 hours of labor. INTERDEPENDENCE AND THE GAINS FROM TRADE 22

The U. S. PPF Wheat (tons) The U. S. has enough labor to produce 500 computers, or 5000 tons of wheat, or any combination along the PPF. 5, 000 4, 000 3, 000 2, 000 1, 000 0 Computers 100 200 300 400 500 INTERDEPENDENCE AND THE GAINS FROM TRADE 23

Wheat (tons) The U. S. Without Trade 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. 5, 000 4, 000 3, 000 2, 000 1, 000 0 Computers 100 200 300 400 500 INTERDEPENDENCE AND THE GAINS FROM TRADE 24

ACTIVE LEARNING 1 Derive Japan’s PPF Use the following information to draw Japan’s PPF. § Japan has 30, 000 hours of labor available for production, per month. § Producing one computer requires 125 hours of labor. § Producing one ton of wheat requires 25 hours of labor. Your graph should measure computers on the horizontal axis. 25

Japan’s PPF Wheat (tons) Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF. 2, 000 1, 000 0 Computers 100 200 300 INTERDEPENDENCE AND THE GAINS FROM TRADE 26

Japan Without Trade Wheat (tons) 2, 000 Suppose Japan uses half its labor to produce each good. Then it will produce and consume 120 computers and 600 tons of wheat. 1, 000 0 Computers 100 200 300 INTERDEPENDENCE AND THE GAINS FROM TRADE 27

Consumption With and Without Trade § Without trade, § U. S. consumers get 250 computers and 2500 tons wheat. § Japanese consumers get 120 computers and 600 tons wheat. § We will compare consumption without trade to consumption with trade. § First, we need to see how much of each good is produced and traded by the two countries. INTERDEPENDENCE AND THE GAINS FROM TRADE 28

ACTIVE LEARNING 2 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. 29

U. S. Production With Trade Wheat (tons) Producing 3400 tons of wheat requires 34, 000 labor hours. 5, 000 4, 000 The remaining 16, 000 labor hours are used to produce 160 computers. 3, 000 2, 000 1, 000 0 Computers 100 200 300 400 500 INTERDEPENDENCE AND THE GAINS FROM TRADE 30

Japan’s Production With Trade Wheat (tons) Producing 240 computers requires all of Japan’s 30, 000 labor hours. 2, 000 So, Japan would produce 0 tons of wheat. 1, 000 0 Computers 100 200 300 INTERDEPENDENCE AND THE GAINS FROM TRADE 31

Basic international trade terms § Exports: goods produced domestically and sold abroad To export means to sell domestically produced goods abroad. § Imports: goods produced abroad and sold domestically To import means to purchase goods produced in other countries. INTERDEPENDENCE AND THE GAINS FROM TRADE 32

ACTIVE LEARNING 3 Consumption under trade Suppose the U. S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan. (So, Japan imports 700 tons wheat and exports 110 computers. ) § How much of each good is consumed in the U. S. ? Plot this combination on the U. S. PPF. § How much of each good is consumed in Japan? Plot this combination on Japan’s PPF. 33

U. S. Consumption With Trade Wheat (tons) 5, 000 computers produced 160 + imported 110 wheat 3400 0 4, 000 – exported 0 700 3, 000 = amount consumed 2700 2, 000 1, 000 0 Computers 100 200 300 400 500 INTERDEPENDENCE AND THE GAINS FROM TRADE 34

Japan’s Consumption With Trade Wheat (tons) produced + imported – exported = amount consumed 2, 000 computers 240 0 110 wheat 0 700 0 130 700 1, 000 0 Computers 100 200 300 INTERDEPENDENCE AND THE GAINS FROM TRADE 35

Trade Makes Both Countries Better Off U. S. consumption gains from without trade with trade computers 250 270 20 wheat 2, 500 2, 700 200 Japan consumption gains from without trade with trade computers 120 130 10 wheat 600 700 100 INTERDEPENDENCE AND THE GAINS FROM TRADE 36

Where Do These Gains Come From? § Absolute advantage: the ability to produce a good using fewer inputs than another producer § The U. S. has an absolute advantage in wheat: producing a ton of wheat uses 10 labor hours in the U. S. vs. 25 in Japan. § If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade. INTERDEPENDENCE AND THE GAINS FROM TRADE 37

Where Do These Gains Come From? § Which country has an absolute advantage in computers? § Producing one computer requires 125 labor hours in Japan, but only 100 in the U. S. § The U. S. has an absolute advantage in both goods! So why does Japan specialize in computers? Why do both countries gain from trade? INTERDEPENDENCE AND THE GAINS FROM TRADE 38

Two Measures of the Cost of a Good § Two countries can gain from trade when each specializes in the good it produces at lowest cost. § Absolute advantage measures the cost of a good in terms of the inputs required to produce it. § Recall: Another measure of cost is opportunity cost. § In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer. INTERDEPENDENCE AND THE GAINS FROM TRADE 39

Opportunity Cost and Comparative Advantage § Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer § Which country has the comparative advantage in computers? § To answer this, must determine the opp. cost of a computer in each country. INTERDEPENDENCE AND THE GAINS FROM TRADE 40

Opportunity Cost and Comparative Advantage § The opp. cost of a computer is § 10 tons of wheat in the U. S. , because producing one computer requires 100 labor hours, which instead could produce 10 tons of wheat. § 5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat. § So, Japan has a comparative advantage in computers. Lesson: Absolute advantage is not necessary for comparative advantage! INTERDEPENDENCE AND THE GAINS FROM TRADE 41

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. INTERDEPENDENCE AND THE GAINS FROM TRADE 42

Unanswered Questions…. § We made a lot of assumptions about the quantities of each good that each country produces, trades, and consumes, and the price at which the countries trade wheat for computers. § In the real world, these quantities and prices would be determined by the preferences of consumers and the technology and resources in both countries. § For now, though, our goal was merely to see how trade can make everyone better off. INTERDEPENDENCE AND THE GAINS FROM TRADE 43

CHAPTER SUMMARY § Interdependence and trade allow everyone to enjoy a greater quantity and variety of goods & services. § Comparative advantage means being able to produce a good at a lower opportunity cost. Absolute advantage means being able to produce a good with fewer inputs. § When people – or countries – specialize in the goods in which they have a comparative advantage, the economic “pie” grows and trade can make everyone better off. 44

Mankiw, p. 60, Problem 7 England Scotland both produce scones and sweaters. Suppose that an English worker can produce 50 scones per hour or 1 sweater per hour. Suppose that a Scottish worker can produce 40 scones per hour or 2 sweaters per hour. a) Which country has the absolute advantage in the production of each good? Which country has the comparative advantage? b) If England Scotland decide to trade, which commodity will Scotland trade to England? Explain. c) If a Scottish worker could produce only 1 sweater per hour, would Scotland still gain from trade? Would England still gain from trade? Explain. INTERDEPENDENCE AND THE GAINS FROM TRADE 45