the production possibility model, trade, and globalization 2 the production possibility model,...

The Production Possibility Model, Trade, and Globalization

2

The Production Possibility Model,Trade, and Globalization

No one ever saw a dog make a fair and deliberate exchange of one bone for another with another dog .

— Adam Smith

CHAPTER

2

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


2

Chapter Goals

• Discuss the increasing marginal opportunity cost

• Relate the concept of comparative advantage to the production possibility curve

• Demonstrate opportunity cost with a 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

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The Production Possibilities Model

• An output is a result of an activity• An input is what you put in production process

to achieve an output

• A production possibility table lists a choice’s opportunity cost by summarizing what alternative outputs you can achieve with your inputs

• The production possibilities model can be presented in both a table and in a graph

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Application: A Production Possibilities Table

History Economics

Hrs of Study Grade Hrs of Study Grade

20 98% 0 40%

18 94% 2 46%

16 90% 4 52%

14 86% 6 58%

12 82% 8 64%

10 78% 10 70%

8 74% 12 76%

6 70% 14 82%

4 66% 16 88%

2 62% 18 94%

0 58% 20 100%

What is the

output?

What is the

input?

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The Production Possibilities Model

• 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

• A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs

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Application: A Production Possibilities Curve

History grade100

10 hrs for each History and Econ

Econ Grade

7840

58

100

88

66

70

16 hrs for Econ and 4 hrs for History

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 costPPC

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Increasing Marginal Opportunity Cost

Guns

Butter

• Slope is flat at A• This means there is a low opportunity

cost to produce more guns

A

The principle of increasing marginal opportunity cost states that opportunity costs

increase the more you concentrate on the activity

B

• Slope is steep at B•This means there is a high opportunity cost to produce more guns

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Comparative Advantage

• A resource has comparative advantage if it has the ability to be better suited to the production of one good than another

• The reason the opportunity cost of guns increases as we produce more guns is that some resources have comparative advantage over other resources

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Efficiency

Guns

Butter

• Point of efficiency• A

• B

• Point of inefficiency

Productive efficiency is achieving as much output as possible from a given

amount of inputs or resources

• Unattainable with given amounts of inputs

• C

• D

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Efficiency and Technological Change

Neutral technological increase or an increase in resources

Biased technological increase

A

B

A

B2-10


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Distribution and Productive Efficiency

• In our society, most people prefer more to less, and many policies have relatively small distribution effects

• 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

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Trade and Comparative Advantage

• According to Adam Smith, humankind’s proclivity to trade leads to individuals using their 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

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Markets, Specialization, and Growth

• Growth in per capita income during the past 2000 years

• What caused this growth?

$6,000

$5,000

$4,000

$3,000

$2,000

$1,000

500 1000 1500 20100

Income

Year

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The Benefits from Trade

Chocolate (tons)

Textiles (yds)

Without trade, each country can only consume

those combinations of goods along their PPCs

• When people freely enter into trade, both parties can be expected to benefit from trade

5,000

4,000

3,000

2,000

1,000

2 3 4 51

Belgium

Pakistan

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The Benefits from Trade

Chocolate (tons)

Textiles (yds)

5,000

4,000

3,000

2,000

1,000

2 3 4 51

Belgium

PakistanWhy should Pakistan specialize in textiles and Belgium specialize in chocolates?

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Comparative Advantage and the Combined PPC

Chocolate (tons)

Textiles (yds)

5,000

4,000

3,000

2,000

1,000

2 3 4 51

Belgium

Pakistan

Combined PPC with trade

The slope of the combined PPC is determined by the country with the lowest

opportunity cost

Pakistan + Belgium

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Application: U.S. Textile Production and Trade

• The gains from trade are higher wages for workers in Bangladesh and lower-priced cloth for U.S. consumers

• 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

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Outsourcing, Trade and Comparative Advantage

• The U.S. has comparative advantage in technology, institutional structure, and specialized knowledge

• 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

Outsourcing

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• The global economy increases the number of competitors and this increased competition can be a negative effect of 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

Globalization

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• 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

• The U.S. comparative advantage in innovation results in higher wages in the U.S.

• As industries mature, they move to lower wage countries

Exchange Rates and Comparative Advantage

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• 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 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

The Law of One Price

The reality is that the citizens in the U.S. has been living better than it could have otherwise

because of trade and outsourcing

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Chapter Summary

• The production possibility curve embodies the opportunity cost concept

• Through specialization and trade, countries can increase consumption

• 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

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Chapter Summary

• Because many goods are cheaper to produce in foreign countries, production of goods formerly in the U.S. is being outsourced

• Globalization is the increasing integration of economies, cultures, and institutions across the world

• Outsourcing is the product of the law of one price

• The typical outward bow of the PPC is the result of comparative advantage and trade

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Preview of Chapter 3: Economic Institutions

• Define market economy

• Summarize briefly the advantages and disadvantages of various types of businesses

• Describe how businesses, households, and government interact in a market economy

• Compare and contrast capitalism with socialism

• Explain why, even though households have the ultimate power, much of the economic decision making is done by business and government

• Explain why global policy issues differ from national policy issues

• State six roles of government

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