Lesson Overview Chapter 2 Trade Production Possibility Frontier

Lesson Overview Chapter 2 Trade Production Possibility Frontier Opportunity Cost Specialization and Trade Comparative vs. Absolute Advantage International Trade Efficient Markets Controversy: Sweatshop Labor Summary Review Questions BA 210 Lesson I. 3 Trade 1

Production Possibility Frontier One important economic model is the production possibility frontier. It illustrates: Opportunity cost, showing how much less of one good can be produced if more of the other good is produced. Efficiency, with an economy efficient in production if it produces on the production possibility frontier, and efficient in allocation if it produces the mix of goods and services that people want to consume. BA 210 Lesson I. 3 Trade 2

Production Possibility Frontier • The production possibility frontier illustrates the trade-offs facing an economy that produces only two goods. It shows the maximum quantity of one good that can be produced for any given production of the other. BA 210 Lesson I. 3 Trade 3

Production Possibility Frontier One important conclusion is comparative advantage, which explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something -- some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with absolute advantage, an ability to produce a particular good or service better than anyone else. This confusion leads some to erroneously conclude there are no gains from trade between people or countries unless each country has some absolute advantage. BA 210 Lesson I. 3 Trade 4

Production Possibility Frontier Quantity of coconuts D 30 Not feasible Feasible and efficient in production A 15 B 9 Feasible but not efficient 0 BA 210 Lesson I. 3 Trade C Production possibility frontier 20 28 40 Quantity of fish 5

Opportunity Cost Increasing Opportunity Costs Quantity of coconuts 35 …requires giving up 5 coconuts Producing the first 20 fish. . . But producing 20 more fish. . . 30 A 25 20 …requires giving up 25 more coconuts… 15 10 5 PPF 0 10 20 30 40 50 Quantity of fish BA 210 Lesson I. 3 Trade 6

Specialization and Trade Question: Consider the individual consumption and individual production possibilities for Tom and Hank on these two slides. Determine trade to make production efficient, and make Tom and Hank better off. 30 Quantity of coconuts (a) Tom’s Production Possibilities Tom’s consumption without trade 9 Tom’s PPF 0 BA 210 Lesson I. 3 Trade 28 40 Quantity of fish 7

Specialization and Trade (b) Hank’s Production Possibilities Quantity of coconuts 20 Hank’s consumption without trade 8 Hank’s PPF 0 6 10 BA 210 Lesson I. 3 Trade Quantity of fish 8

Specialization and Trade Answer: Opportunity Costs determine efficient trade and mutually-beneficial trade. BA 210 Lesson I. 3 Trade 9

Specialization and Trade • Production becomes efficient and both castaways are better off when they each specialize in what they are good at and trade. • It’s efficient for Tom to catch the fish for both of them, because his opportunity cost of a fish in terms of coconuts not gathered is only 3/4 of a coconut, versus 2 coconuts for Hank. If Tom specializes, he can catch 40 fish total. • It’s efficient for Hank to gather coconuts for the both of them. If Hank specializes, he can gather 20 coconuts total. • Without trade, total production is 28+6=34 fish and 9+8=17 coconuts. So, specialization increases production by 6 fish and 3 coconuts. • If the gains from increased production are split 50 -50, both Tom and Hank can have 3 more fish and 1. 5 more coconuts. BA 210 Lesson I. 3 Trade 10

Comparative vs. Absolute Advantage • An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people. • An individual has an absolute advantage in an activity if he or she can do it better than other people. Having an absolute advantage is not the same thing as having a comparative advantage. BA 210 Lesson I. 3 Trade 11

Comparative vs. Absolute Advantage Tom vs. Hank – Absolute vs. Comparative • Tom has an absolute advantage in both activities: he can produce more output with a given amount of input (in this case, his time) than Hank. • But we’ve just seen that Tom can indeed benefit from a deal with Hank because comparative, not absolute, advantage is the basis for mutual gain. • So Hank, despite his absolute disadvantage, even in coconuts, has a comparative advantage in coconut gathering. • Meanwhile Tom, who can use his time better by catching fish, has a comparative disadvantage in coconut-gathering. BA 210 Lesson I. 3 Trade 12

International Trade Question: Consider the individual consumption and individual production possibilities for the U. S. and Canada on these two slides. Determine trade to make production efficient, and make both countries better off. (a) The U. S. Production Possibilities Frontier (b) Canadian Production Possibilities Frontier 3, 000 Quantity of aircraft Canadian production with trade Quantity of aircraft U. S. consumption without trade Canadian consumption without trade 2, 000 1, 500 U. S. production with trade 1, 000 U. S. PPF 0 1 2 3 Quantity of pork (millions of tons) BA 210 Lesson I. 3 Trade Canadian PPF 0 0. 5 1 1. 5 Quantity of pork (millions of tons) 13

International Trade Answer: Opportunity Costs determine efficient trade and mutually-beneficial trade. BA 210 Lesson I. 3 Trade 14

International Trade • Production becomes efficient and both countries are better off when they each specialize in what they are good at and trade. • It’s efficient for U. S. to produce pork for both of them, because U. S. opportunity cost of pork in terms of aircraft is only 500 aircraft, versus 2000 aircraft for Canada. If U. S. specializes, it can produce 3 pork total. • It’s efficient for Canada to produce aircraft for the both of them. If Canada specializes, it can produce 3000 aircraft total. • Without trade, total production is 1+. 5=1. 5 pork and 1000+2000=3000 aircraft. So, specialization increases production by 1. 5 pork, without any reduction in aircraft. • If the gains from increased production are split 50 -50, both U. S. and Canada can have 0. 75 more pork. BA 210 Lesson I. 3 Trade 15

Efficient Markets Comment: The previous examples of efficient and mutuallybeneficial trade guided by comparative advantage evenly split the gains from increased production among two individual people or countries. Now consider richer examples of efficient trade: § There are three individuals. § With efficient trade, one of the individuals does not specialize his production. § The trade of production among the three individuals is guided by prices in the marketplace. BA 210 Lesson I. 3 Trade 16

Efficient Markets Question: Consider the following linear production possibilities from Tom, Jeffery, and Hank. To be useful, an ad must be both composed and televised. BA 210 Lesson I. 3 Trade 17

Efficient Markets For example, Tom can compose 2 ads if he specializes in composing; or televise 2 previously composed ads if he specializes in televising; or complete an ad (compose and televise) if he spends half his time composing and half his time televising. BA 210 Lesson I. 3 Trade 18

Efficient Markets Part a. How many ads can be completed if Tom, Jeffery, and Hank work separately? That is, each composes and televises his own ads. (As usual, fractions are allowed. ) BA 210 Lesson I. 3 Trade 19

Efficient Markets Answer to Part a: First consider Tom. On one hand, if he spent all day composing, he would compose 2 ads and televise 0 ads and, thereby, complete 0 ads. On the other hand, if he spent all day trying to televise, he would compose 0 ads and try to televise 2 ads and, thereby, complete 0 ads. Obviously, to complete the maximum number of ads he would split his day evenly: spending half his day composing and the other half his day televising, he would compose 1 ad and televise 1 ad and, thereby, complete 1 ad. BA 210 Lesson I. 3 Trade 20

Efficient Markets Next consider Jeffery. Like Tom, to complete the maximum number of ads he splits his day between composing and televising. Let’s find that split with algebra. Let c be the fraction of his day spent composing; that leaves the fraction 1−c for televising. Spending c of his day composing and 1−c of his day televising, he would compose c letters and televise 2(1−c) letters. If c < 2(1−c), then some televising exceeds composing, which is wasted effort. Likewise, c > 2(1−c) has some composing exceeding televising, which is also wasted effort. Therefore, to complete the maximum number of ads he would set c = 2(1 − c), which implies 3 c = 2 and c = 2/3. That is, Jeffery spends 2/3 of his day composing and 1/3 of his day televising and, thereby, composes, televises, and completes 2/3 ads, which is approximately. 66 ads. BA 210 Lesson I. 3 Trade 21

Efficient Markets Finally consider Hank. Let c be the fraction of his day spent composing; that leaves the fraction 1−c for televising. Spending c of his day composing and 1−c of his day televising, he would compose 6 c letters and televise 3(1−c) letters. To complete the maximum number of ads he would set 6 c = 3(1 − c), which implies 9 c = 3 and c = 1/3. That is, Jeffery spends 1/3 of his day composing and 2/3 of his day televising and, thereby, composes, televises, and completes 2 ads. Altogether, the three complete 3. 66 ads when working separately. BA 210 Lesson I. 3 Trade 22

Efficient Markets Part b. Who has the absolute advantage in televising ads? who is next? On the basis of absolute advantage in televising ads, how would production be organized? What is the total output of ads per day? BA 210 Lesson I. 3 Trade 23

Efficient Markets Answer to Part b: Hank has the absolute advantage in televising, so consider this trial solution: Hank spends all day televising and, thereby, televises 3 ads. Both Tom and Jeffery spend all day composing and, thereby, compose 3 ads. Since the number televised equals the number composed, that is the absoluteadvantage solution. In particular, total output is 3 completed ads per day. Comment: That output is less than when they worked separately. BA 210 Lesson I. 3 Trade 24

Efficient Markets Part c. How should production be organized? What is the total output of ads per day? BA 210 Lesson I. 3 Trade 25

Efficient Markets Answer to Part c: To find efficient production, compute the opportunity cost of televising ads. For Larry, each ad televised takes 1/2 of a day (since in one day he can televise 2 letters), and in that 1/2 of a day he could have composed 1 letter (since in one day he can compose 2 ads). Hence, Tom’s opportunity cost of televising a letter is 1 composed letter. BA 210 Lesson I. 3 Trade 26

Efficient Markets For Jeffery, each ad televised takes 1/2 of a day, and in that 1/2 of a day he could have composed 1/2 letter. Hence, Jeffery’s opportunity cost of televising a letter is 1/2 composed letter. Likewise, Hence, Hank’s opportunity cost of televising a letter is 6/3 composed letter (the ratio of maximum composing output to maximum televising output). BA 210 Lesson I. 3 Trade 27

Efficient Markets Jeffery has the comparative advantage in televising (he gives up the fewest composed letters), so consider this trial solution: Jeffery spends all day televising and, thereby, televises 2 ads. Both Tom and Hank spend all day composing and, thereby, compose 8 letters. Since the number televised is less than the number composed, we need another televiser and, so, must consider another trial solution: BA 210 Lesson I. 3 Trade 28

Efficient Markets After Jeffery, Tom has the comparative advantage in televising, so consider this trial solution: Jeffery and Tom spend all day televising and, thereby, televise 4 ads. Hank spends all day composing and, thereby, composes 6 ads. Since the number televised is less than the number composed, we need another televiser (at least part time) and must consider another trial solution: BA 210 Lesson I. 3 Trade 29

Efficient Markets Clearly, if Hank joins Jeffery and Tom to spend all day televising, then the number televised is greater than the number composed. Hence, Hank splits his time between composing and televising, spending the fraction c composing and the fraction 1−c televising and, thereby, composing 6 c and televising 3(1−c). As before, Jeffery and Tom spend all day televising and, thereby, televise 4 ads total. All together, the three compose 6 c and televise 4+3(1−c). To complete the maximum number of ads, set 6 c = 4 + 3(1 − c), which implies 9 c = 7 and c = 7/9. That is, Hank spends 7/9 of his day composing and 2/9 of his day televising and, thereby, the three compose, televise, and complete 6(7/9) = 4 + 3(2/9) = 14/3 ads, which is approximately 4. 66 ads. That is the maximum number of ads that can be completed per day. BA 210 Lesson I. 3 Trade 30

Efficient Markets Part d. Show the market can organize production efficiently. Specifically, suppose the market price per unit for televising ads is $100. Find the price PC per unit for composing ads so that, when the output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income. BA 210 Lesson I. 3 Trade 31

Efficient Markets Answer to Part d: When the output of completed ads is maximized, Hank spends part of his day composing and part of his day televising, so his daily income must equal from the two jobs, 6 PC = 300, or PC = 50. And Tom and Jeffery each specialize in televising, so at PC = 50 their daily incomes from composing must lower than from televising, 100 < 200 and 50 < 200. So, at the price PC = 50 per unit for composing ads, when the output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income. BA 210 Lesson I. 3 Trade 32

Controversy: Sweatshop Labor BA 210 Lesson I. 3 Trade 33

Controversy: Sweatshop Labor A sweatshop is a working environment with unhealthy conditions that are considered by many people of industrialized nations to be difficult or dangerous, usually where the workers have few opportunities to address their situation. This can include exposure to harmful materials, hazardous situations, extreme temperatures, or abuse from employers. Sweatshop workers often work long hours for little pay, regardless of any laws mandating overtime pay or a minimum wage. Child labor laws may also be violated. BA 210 Lesson I. 3 Trade 34

Controversy: Sweatshop Labor Defenders of sweatshops, such as Paul Krugman, claim that people choose to work in sweatshops because the sweatshops offer them substantially higher wages and better working conditions compared to their previous jobs of manual farm labor, and that sweatshops are an early step in the process of technological and economic development whereby a poor country turns itself into a rich country. Economists are focused on “trade offs” and when it comes to sweatshops, they ask whether the alternative of unemployment or even worse employment is better. In addition, sometimes when anti-sweatshop activists were successful in getting sweatshops to close, some of the employees who had been working in the sweatshops ended up starving to death, while others ended up turning to prostitution. BA 210 Lesson I. 3 Trade 35

Controversy: Sweatshop Labor In 1996, the National Labor Committee, a human rights group, reported that sweatshop labor in Honduras was used to make clothes for the Kathie Lee line, sold at Wal-Mart. The biggest consumer import into Honduras are processed foods. Consider how Hondurans benefit by exporting clothes to the U. S. and importing cars. BA 210 Lesson I. 3 Trade 36

Controversy: Sweatshop Labor Question: Consider the following linear production possibilities from the U. S. and Honduras. Production number are average monthly production per worker. Describe trade that can make both countries better off if, currently, both countries do not trade, the U. S. makes 20 dresses and 20 cans of processed food, and Honduras makes 4 dresses and 2 cans. What would happen if the National Labor Committee shut down such trade? BA 210 Lesson I. 3 Trade 37

Controversy: Sweatshop Labor Answer: Compute and compare opportunity costs. U. S. has the absolute advantage in both goods, but Honduras has the comparative advantage in dresses. Hence trade that can make both countries better off is U. S. making more food and Honduras making more dresses. Specifically, suppose the U. S. makes one more can of processed food and Honduras makes one less can of processed food. The U. S. then has to sacrifice 1 dress but Honduras can make 2 more dresses. If the gain of 1 dress is split evenly each month, the U. S. can trade the extra can of food for 1. 5 dresses (thus gaining 0. 5 dresses), and Honduras can trade 1. 5 dresses for the 1 can of food (thus gaining 0. 5 dresses). If the National Labor Committee shut down such trade, then Honduras looses their gain from trade. BA 210 Lesson I. 3 Trade 38

Summary 1. Almost all economics is based on models and assumptions in those models. 2. One important economic model is the production possibility frontier. It illustrates opportunity cost, efficiency, and economic growth. There are two basic sources of growth: an increase in factors of production, resources such as land, labor, capital, and human capital, inputs that are not used up in production, and improved technology. 3. One important conclusion is comparative advantage explains the gains from trade between individuals and countries. Everyone has a comparative advantage in something. This is often confused with absolute advantage, an ability to produce a particular good better than anyone else. BA 210 Lesson I. 3 Trade 39

Summary 4. The efficient trade of production can be guided by either a comparison of opportunity costs, or by prices in the marketplace. BA 210 Lesson I. 3 Trade 40

Review Questions § You should try to answer some of the following questions before the next class. § You will not turn in your answers, but students may request to discuss their answers to begin the next class. § Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exams. BA 210 Lesson I. 3 Trade 41

Review Questions Question: Consider the following linear production possibilities of Army missions and computer programs from 1 high school dropout (D), 1 high school graduate with no college degree (H), and 1 college graduate (C). BA 210 Lesson I. 3 Trade 42

Review Questions Part a. If you need 2. 5 missions per month (for example, 5 every 2 months) and if the market price (or wage) for producing a computer program is 6 pesos each, then what should be the unit price paid per mission? BA 210 Lesson I. 3 Trade 43

Review Questions Answer to Part a: Step 1. Find whom to draft. That is, who has the comparative advantage. For D, each mission takes up 1/2 of his month, during which time he could complete ½ × 1 = ½ program. For H, each mission takes up ¼ of his month, during which time he could complete ¼ × 4 = 1 program. For C, each mission takes up 1/6 of his month, during which time he could complete 1/6 × 9 = 3/2 programs. Conclusion: Despite his absolute disadvantage, it’s comparatively cheaper for D to serve first. Then H, then C. So, for 2. 5 missions, start with D in the military full time, for 2 missions. That leaves. 5 missions, to be completed by H serving part time. BA 210 Lesson I. 3 Trade 44

Review Questions Step 2. Find the price PM per mission. Given that classes pay 6 pesos each, here is what that price PM must satisfy to get the solution above: For D to choose the military full-time, potential income from the military 2 PM must be no less than potential income from writing computer programs, 1 × 6 = 6. Conclusion: 2 PM > 6, or PM > 3. For type H to choose the military part-time, potential income from the military 4 PM must be the same as potential income from writing programs 4 × 6 = 24. Conclusion: 4 PM = 24, or PM = 6. BA 210 Lesson I. 3 Trade 45

Review Questions For C to choose programming full-time, potential income from the military 6 PM must be no greater than potential income from writing computer programs, 9 × 6 = 54. Conclusion: 6 PM < 54, or PM < 9. Putting it all together, the price should be PM = 6 pesos per mission. (See how the non-specialist determines price, and that the specialists inequalities are satisfied at that price. ) BA 210 Lesson I. 3 Trade 46

Review Questions Part b. Now suppose you need 7 missions per month. What should be the unit price paid per mission? BA 210 Lesson I. 3 Trade 47

Review Questions Answer to Part b: The production possibilities have not changed, so it is still comparatively cheaper for D to serve first; then H; then C. So, for 7 missions, start with D in the military full time, for 2 missions; then H, for 4 missions. That leaves 1 mission, to be completed by C serving part time. For type C to choose the military part-time, potential income from the military 6 PM must be the same as potential income from writing programs 9 × 6 = 54. Conclusion: 6 PM = 54, or PM = 9. (As always, the non-specialist determines price, and the specialists choose the right specialties at that price. ) BA 210 Lesson I. 3 Trade 48

Review Questions Follow the link http: //faculty. pepperdine. edu/jburke 2/ba 210/Power. P 1/Set 2 Answers. pdf for review questions for Lesson I. 3 that practices these skills: ü Draw a linear production possibilities frontier. ü Draw a bowed production possibilities frontier. ü Compute opportunity costs from a production possibilities frontier. ü Identify feasible and infeasible and efficient and inefficient points from a production possibilities frontier. ü Identify comparative and absolute advantage from a production possibilities frontier. ü Describe trade based on comparative advantage. ü Identify positive and normative statements. BA 210 Lesson I. 3 Trade 49

BA 210 Introduction to Microeconomics End of Lesson I. 3 BA 210 Lesson I. 3 Trade 50