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Chapter Goals Demonstrate opportunity cost with a production possibility curve Discuss the increasing marginal opportunity cost Relate the concept of comparative advantage to the production possibility curve Show how through comparative advantage and trade, a country can consume beyond their production possibility Explain how globalization and outsourcing are part of a global process guided by the law of one price 2-2

The Production Possibilities Model The production possibilities model can be presented in both a table and in a graph A production possibility table lists a choice’s opportunity cost by summarizing what alternative outputs you can achieve with your inputs An output is a result of an activity An input is what you put in production process to achieve an output 2-3

Application: A Production Possibilities Table History Economics Hrs of Study Grade 20 98% 40% 18 94% 2 46% 16 90% 4 52% 14 86% 6 58% 12 82% 8 64% 10 78% 70% 74% 76% 66% 88% 62% 100% What is the output? input? 2-4

The Production Possibilities Model A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs It is a graphical representation of the opportunity cost concept A PPC is created from a production possibility table by mapping the table in a two-dimensional graph 2-5

Application: A Production Possibilities Curve Econ Grade A PPC demonstrates: There is a limit to what you can achieve, given existing institutions, resources, and technology Every choice you make has an opportunity cost 100 16 hrs for Econ and 4 hrs for History 88 10 hrs for each History and Econ 70 PPC 40 58 66 78 100 History grade 2-6

Increasing Marginal Opportunity Cost The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on the activity Butter A Slope is flat at A This means there is a low opportunity cost to produce more guns Slope is steep at B This means there is a high opportunity cost to produce more guns B Guns 2-7

Comparative Advantage The reason the opportunity cost of guns increases as we produce more guns is that some resources have comparative advantage over other resources A resource has comparative advantage if it has the ability to be better suited to the production of one good than another 2-8

Efficiency Productive efficiency is achieving as much output as possible from a given amount of inputs or resources Butter A Point of efficiency D Unattainable with given amounts of inputs C Point of inefficiency B Guns 2-9

Efficiency and Technological Change Neutral technological increase or an increase in resources Biased technological increase A A B B 2-10

Distribution and Productive Efficiency The productive possibility curve focuses on efficiency and ignores distribution If a method of production will change income distribution we cannot determine if that method is efficient or not Efficiency has meaning when analyzing a particular goal In our society, most people prefer more to less, and many policies have relatively small distribution effects 2-11

Trade and Comparative Advantage The PPC is bowed because individuals specialize in the production of goods for which they have a comparative advantage For a society to produce on its PPC, individuals must produce those goods for which they have a comparative advantage and trade for other goods According to Adam Smith, humankind’s proclivity to trade leads to individuals using their comparative advantage 2-12

Markets, Specialization, and Growth Growth in per capita income during the past 2000 years $6,000 $5,000 Income $4,000 $3,000 $2,000 $1,000 Year 500 1000 1500 2010 What caused this growth? 2-13

The Benefits from Trade When people freely enter into trade, both parties can be expected to benefit from trade Textiles (yds) Without trade, each country can only consume those combinations of goods along their PPCs 5,000 4,000 Pakistan 3,000 2,000 Belgium 1,000 Chocolate (tons) 1 2 3 4 5 2-14

The Benefits from Trade If each country specializes according to comparative advantage and trades, they can consume beyond their PPCs Textiles (yds) 5,000 4,000 Why should Pakistan specialize in textiles and Belgium specialize in chocolates? Pakistan 3,000 2,000 Belgium 1,000 Chocolate (tons) 1 2 3 4 5 2-15

Comparative Advantage and the Combined PPC Combined PPC with trade Textiles (yds) Pakistan + Belgium 5,000 The slope of the combined PPC is determined by the country with the lowest opportunity cost 4,000 Pakistan 3,000 2,000 Belgium 1,000 Chocolate (tons) 1 2 3 4 5 2-16

Application: U.S. Textile Production and Trade Two hundred years ago, the U.S. had a comparative advantage in textile production Now, countries with cheaper labor (such as Bangladesh) have the comparative advantage in textiles The gains from trade are higher wages for workers in Bangladesh and lower-priced cloth for U.S. consumers 2-17

Outsourcing, Trade and Comparative Advantage Outsourcing is the relocation of production once done in the United States to foreign countries Outsourcing occurs because many other countries have a comparative advantage in labor costs The U.S. has comparative advantage in technology, institutional structure, and specialized knowledge 2-18

Outsourcing, Trade and Comparative Advantage Globalization Globalization is the increasing integration of economies, cultures, and institutions across the world A positive effect of globalization is that it provides larger markets than the domestic economy The global economy increases the number of competitors and this increased competition can be a negative effect of globalization 2-19

Outsourcing, Trade and Comparative Advantage Exchange Rates and Comparative Advantage The U.S. comparative advantage in innovation results in higher wages in the U.S. As industries mature, they move to lower wage countries In order to regain our comparative advantage, the U.S. exchange rate will decline and foreign wages will increase to make U.S. exports cheaper and imports to the U.S. more expensive 2-20

Outsourcing, Trade and Comparative Advantage The Law of One Price The law of one price is the wages of equal workers in one country will not differ significantly from the wages of workers in another institutionally similar country If the U.S. loses its comparative advantage based on technology and institutional structure, U.S. wages will decrease relative to wages in many other countries The reality is that the citizens in the U.S. has been living better than it could have otherwise because of trade and outsourcing 2-21

Chapter Summary The production possibility curve embodies the opportunity cost concept Increasing marginal opportunity cost exists Trade allows people to use their comparative advantage and shifts out society’s combined production possibility curve Efficient, inefficient and unattainable points on the PPC Through specialization and trade, countries can increase consumption 2-22

Chapter Summary The typical outward bow of the PPC is the result of comparative advantage and trade Because many goods are cheaper to produce in foreign countries, production of goods formerly in the U.S. is being outsourced Outsourcing is the product of the law of one price Globalization is the increasing integration of economies, cultures, and institutions across the world 2-23

Preview of Chapter 3: Economic Institutions Define market economy Compare and contrast capitalism with socialism Describe how businesses, households, and government interact in a market economy Summarize briefly the advantages and disadvantages of various types of businesses Explain why, even though households have the ultimate power, much of the economic decision making is done by business and government State six roles of government Explain why global policy issues differ from national policy issues 2-24