Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 1 Micro Production Possibility Frontier

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 2 Micro The Production Possibilities Frontier u Let’s introduce the Production Possibilities Frontier –better known as the PPF. u The PPF is a basic workhorse in economics. u Important for understanding some basic issues in economics.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 3 Micro The PPF u Great application is with international trade theory. u Helps one understand and distinguish between comparative advantage and absolute advantage. u An important historical figure in all this is David Ricardo.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 4 Micro David Ricardo u Famous 19th century British economist. u Some consider him the grandfather of international trade theory. u Very influential in pioneering the theory of comparative advantage, inter alia. u Very interesting, very bright guy. u Had a lot of say about the “corn laws” in England.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 5 Micro The Production Possibility Frontier - What Is It? u The description of the best possible combinations of two goods to produce using all of the available resources. u Shows the trade-off between more of one good in terms of the other. u Assumes: input endowments given, technology given, time given and efficient production.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 6 Micro Opportunity Cost u The opportunity cost of an activity is the value of the resources used in that activity when they are measured by what they would have produced when used in their next best alternative. u The slope of the Production Possibility Frontier measures the marginal opportunity cost of producing one good in terms of the amount of the other good foregone.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 7 Micro A Typical PPF Picture Guns Butter unattainable inefficient just attainable The marginal opportunity cost of guns in terms of butter is increasing as we move down the PPF! The PPF is typically bowed- out or linear. It is not bowed-in

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 8 Micro Comparative Advantage u The person with the lower marginal opportunity cost of an activity has the comparative advantage at that activity. u This means that the person with the comparative advantage can produce the activity by giving up the smallest amount of the alternative activity.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 9 Micro The Idea of Comparative Advantage and Trade u Specialization and free trade will benefit all trading parties, even when some are “absolutely” more efficient producers than others. u Need to understand absolute vs. comparative advantage.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 10 Micro Absolute vs. Comparative Advantage Applied to Trade u Absolute advantage: if your country uses fewer resources to produce a given unit of output than the other country. u Comparative advantage: if your country can produce the output at a lower marginal cost in terms of other goods foregone than the other country. u Every country (or person, or economy) has a comparative advantage at some activity. u Absolute advantage is not important and may not always happen. Sometimes people or countries have the absolute advantage in nothing! Yet trade possibilities still exist. u It’s all about comparative advantage.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 11 Micro PPFs and Comparative Advantage u In this example, there are two goods being produced: Corn meal and RAM. u Juanita has an absolute advantage at both: she can produce more of each than Julio. u Juanita has a comparative advantage at producing RAM compared to Julio: she gives up 3.00 kg/day of corn meal to make an additional 1k of chips. u Julio has a comparative advantage at producing corn meal compared to Juanita: he gives up 0.25 k chips to make an additional kg of corn meal.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 12 Micro Production Possibilities u When we draw the production possibilities for Juanita and Julio, there is a kink at 8 kg/day corn meal and 4.00 k chips/day RAM. u The chart shows who specializes in corn meal and RAM at each production level.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 13 Micro Adding a Third Producer u Sergio has no absolute advantage; however, he has a comparative advantage over both Juanita and Julio in the production of RAM. u He sacrifices 2.00 kg of corn meal to make an additional 1k of chips.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 14 Micro Adding a Fourth Producer u Question: What is Maria’s comparative advantage with respect to each of the other three producers?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 15 Micro Comparative Advantage and Specialization u As more and more producers enter the economy, the production possibility curve gets more and more bowed out (concave). u Along any segment, most of the producers are fully specialized. u Only one producer is producing both goods along any segment.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 16 Micro The Supply Curve from the PPF u At each relative price of RAM in terms of foregone corn meal, we can determine the market supply u The table shows how much is supplied and who is producing.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 17 Micro The Supply Curve for RAM u The graph shows the supply curve for RAM based on the data in the previous table. Each additional supplier is shown above the segment where that supplier determines the relative price. u The supply curve of RAM is rising, reflecting the increasing opportunity cost (also called marginal cost) of RAM in terms of foregone corn meal.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 18 Micro Supply Curve for Corn Meal u Do the exact same thing... u But in reverse!

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 19 Micro Supply Curve for Corn Meal: Graph u The supply curve for corn meal is shown above. u The new producer along each segment is indicated above.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 20 Micro International Trade u All the facts are the same as in the previous example except that now we are talking about countries that can trade at an international price. u The international price is between the relative prices that prevail in each country when no trade is permitted. u There are many countries in the market in addition to the two shown so that a country can buy or sell as much as it wants or produces at the international price.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 21 Micro Country U’s Production and Gains from Trade u Country U has a comparative advantage in RAM production. u The blue line shows its production possibilities without trade. Slope = –0.33. u The red line shows the possibilities at the international price of 0.29 k chips per kg corn (or 3.50 kg corn/ k chips RAM). Slope = –0.29. u The gain to trade is the distance between the two production possibility curves.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 22 Micro Country M’s Production and Gains from Trade u Country M has a comparative advantage in corn meal production. u The blue line shows its production possibilities without trade. Slope = –0.25. u The red line shows the possibilities at the international price of 0.29 k chips/ kg corn (or 3.50 kg corn/ k chips RAM). Slope = –0.29. u The gain to trade is the distance between the two production possibility curves.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 23 Micro Question u If country U chooses to consume 7 kg/day of corn meal, what is the gain to trade from specializing in RAM production, measured in k chips/day of RAM?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 24 Micro Answer u The vertical distance between the blue and red PPFs at a corn meal consumption of 7 kg/day measures country U’s gain to trade in k chips RAM/day. u The point on the blue PPF is the best country U can do without trade. u With trade country U can consume more RAM per day, up to the point on the red PPF.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 25 Micro Question u What is country M’s gain if it chooses to consume 1.5 k chips per day, measured in kg/day of corn meal?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 26 Micro Answer u The horizontal distance between the red and blue PPFs measures country M’s gain to trade at a RAM consumption of 1.5 k chips/day. u The blue PPF is the best that country M can do without trade. u Trade allows country M to specialize in the production of corn meal and still benefit from a higher consumption of RAM.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 27 Micro The International Supply Curve for RAM u The international supply curve for RAM is a rising function of the opportunity cost of RAM in terms of foregone corn meal. u Which countries actually produce RAM for the international market will depend upon where the demand curve crosses this supply curve. RAM (K chips/day) Relative Price (kg corn meal/k chips) Most Efficient Producers Least Efficient Producers Demand

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 28 Micro The Sources of Comparative Advantage u The Heckscher-Ohlin Theorem is a theory that explains the existence of a country’s comparative advantage by its factor endowments. –Factor endowments: the quantity and quality of labor, land, and natural resources of a country. –From Sweden in the early 1900s u According to the H-O theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 29 Micro The Sources of Comparative Advantage u Edward Leamer of UCLA’s five biggies: –Natural resources –Knowledge capital –Physical capital –Land –Skilled and unskilled labor

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 30 Micro Other Explanations for Observed Trade Flows u Product differentiation and competitive markets u Acquired comparative advantage u Natural comparative advantages u Economies of scale u Trading Environments u Openness of Economy

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 31 Micro Note of Caution u Information on comparative advantage is often given in many other forms - pay careful attention to the information you are given. u Two more ways to present the same kind of information:

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 32 Micro Absolute Advantage and Comparative Advantage u Portugal has the A.A. in both wine and cloth. u England has the C.A. in cloth. u Portugal has the C.A. in wine. u Can you figure out the marginal opportunity cost for each output in each country?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 33 Micro From Opportunity Cost to Marginal Cost u The concept of marginal cost is the most important concept in the theory of producer supply behavior. u Marginal cost is the additional cost associated with increasing production by one unit. u In our production possibility examples, marginal cost is the value of the activity that is reduced when the other activity is increased by one unit. u Marginal cost is, therefore, the same thing as marginal opportunity cost.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 34 Micro PPF Gymnastics Guns Butter PPF old PPF new u The PPF is also useful for many other types of questions. u Questions about efficiency. u Questions about equity. u Questions about tax and transfer policy. u Questions about composition of output. u Questions about growth and productivity.