1. The PPF & Trade
Dr. Jennifer P. Wissink ©2011 John M. Abowd and Jennifer P. Wissink, all rights reserved.

2. PPF, MOC & Trade Very nice application of PPF.
Nice way to introduce the ideas of absolute advantage and comparative advantage.
David Ricardo, again.
Famous 19th century British economist.
Some consider him the grandfather of international trade theory.
Very influential in pioneering the theory of comparative advantage, inter alia.
Very interesting, very bright guy.
Had a lot of say about the “corn laws” in England. 2

3. The Idea of Comparative Advantage & Trade
Specialization and free trade will benefit all trading parties, even when some are “absolutely” more efficient producers than others.
Need to understand absolute vs. comparative advantage.
Paul Samuelson on Comparative Advantage:
“…the best example he knows of an economic principle that is undeniably true yet not obvious to intelligent people.”
Paul A. Samuelson, Economist, Dies at 94 (NYTimes obit) 3

4. Absolute vs. Comparative Advantage
Absolute advantage: if your country uses fewer resources to produce a given unit of output than the other country.
Comparative advantage: if your country can produce an output at a lower marginal cost in terms of other goods foregone than the other country.
Every country (or person, or economy) has a comparative advantage at some activity.
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.
It’s all about comparative advantage. 4

5. PPFs & Comparative Advantage
Suppose that Juanita and Julio each have 10 hours a day they can spend making corn meal and/or RAM chips.
Suppose Juanita and Julio can make any linear combination between these endpoints.
Note: Given each has 10 hours,
Juanita can do 1.2kg of corn meal an hour and she can do 0.4k of RAM an hour
Julio can do 0.8kg of corn meal and hour and he can do 0.2k of RAM an hour
Consider their marginal opportunity costs
It costs Juanita 3kg of corn meal for each k of RAM she makes (which is the same as saying it costs Juanita .33k of RAM for each kg of corn meal she makes).
It costs Julio 4kg of corn meal for each k of RAM he makes (which is the same as saying it costs Julio .25k of RAM for each kg of corn meal he makes).

6. PPFs & Comparative Advantage
Juanita has an absolute advantage at both: she can produce more of each than Julio.
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 RAM, and Julio would have to give up 4.00 kg/day.
Julio has a comparative advantage at producing corn meal compared to Juanita: he gives up 0.25 k RAM to make an additional kg of corn meal, whereas Juanita gives up 0.33 k RAM.

7. Production Possibilities
When we draw the EFFICIENT JOINT production possibilities frontier for Juanita and Julio, there is a kink at 8 kg/day corn meal and 4.00 k chips/day RAM.
The chart shows who specializes in corn meal and RAM at each production level.

8. Adding A Third Producer
Suppose Sergio has the same amount of time as Juanita and Julio.
Sergio has no absolute advantage; however, he has a comparative advantage over both Juanita and Julio in the production of RAM.
He sacrifices only 2.00 kg of corn meal to make an additional 1k of RAM.

9. Adding A Fourth Producer
Question: What is Maria’s comparative advantage with respect to each of the other three producers?

10. Adding A Fifth Producer

11. Comparative Advantage & Specialization
As more and more producers enter the economy, the production possibility curve moves further out and gets more and more bowed out (concave).
Along any segment, most of the producers are fully specialized.
Only one producer is producing both goods along any segment.

12. Getting The Supply Curve Of RAM From The PPF
At each relative price of RAM in terms of foregone corn meal, we can determine the market supply
The table shows how much is supplied and who is producing.

13. The Supply Curve Of RAM add Maria add Julio add Juanita Sergio
The graph shows the supply curve of RAM based on the data in the previous table. Each additional supplier is shown above the segment where that supplier determines the relative price.
The supply curve of RAM is rising, reflecting the increasing opportunity cost (also called marginal cost) of RAM in terms of foregone corn meal.

14. Supply Curve Of Corn Meal
Do the exact same thing...
But in reverse!

15. Supply Curve Of Corn Meal: Graph
add Sergio
add Juanita
add Julio
Maria
The supply curve of corn meal is shown above.
The new producer along each segment is indicated above.

16. International Trade
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.
The international price is between the relative prices that prevail in each country when no trade is permitted.
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.

17. Country M’s Production & Gains From Trade
Country M has a comparative advantage in corn meal production.
The blue line shows its production possibilities without trade. Slope = –0.25.
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.
The gain to trade is the distance between the two production possibility curves.

18. Question
What is country M’s gain if it chooses to consume 1.5 k chips per day, measured in kg/day of corn meal?

19. Answer
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.
The blue PPF is the best that country M can do without trade.
Trade allows country M to specialize in the production of corn meal and still benefit from a higher consumption of RAM.

20. The International Supply Curve Of RAM
The international supply curve of RAM is a rising function of the opportunity cost of RAM in terms of foregone corn meal.
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

21. Sources Of Comparative Advantage
Natural resources
Human resources
Capital resources
Acquired comparative advantage
Note: many interesting applications in the fields of international trade and the economics of developing countries

22. From Opportunity Cost To Marginal Cost
The concept of marginal cost is the most important concept in the theory of producer supply behavior.
Marginal cost is the additional cost associated with increasing production by one unit.
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.
Marginal cost is, therefore, the same thing as marginal opportunity cost.

23. Note Of Caution
Information on comparative advantage is often given in many other forms - pay careful attention to the information you are given.
Three ways to present the same kind of information.
Suppose England and Portugal each have the same amount of labor to use to produce cloth or wine or both.