the production possibility model, trade, and globalization

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THE PRODUCTION POSSIBILITY MODEL, TRADE, AND GLOBALIZATION

Chapter 2

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-2

Todays lecture will:

Demonstrate opportunity costs with a production possibilities curve. Discuss the principle of increasing marginal opportunity cost. Relate the concept of comparative advantage to the production possibilities curve.

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-3

Todays lecture will:

Show how comparative advantage and trade can allow countries to consume beyond their production possibilities. Explain how globalization and outsourcing are part of a global process guided by the law of one price.

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-4

A production possibilities curve

The Production Possibilities Model

illustrates opportunity cost by showing trade-offs among choices we make. It measures the maximum number of outputs that can be achieved from a given number of inputs.Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill/Irwin

2-5

A Production Possibilities Curve for an IndividualHours of study Grade in in history history Hours of study Grade in in economics economics

20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0

98 96 94 92 90 88 86 84 82 80 78 76 74 72 70 68 66 64 62 60 58

Economics grade

0 1 2 3 4 5 6 7 9 8 10 11 12 13 14 15 16 17 18 19 20

40 43 46 49 52 55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 100

A: 20 hours of economics, 0 hours of history 100 A 88 B

70

C

E: 20 hours of history, 0 hours of economics D

46 40 58 66

E 78 94 98 History grade

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-6

Increasing Marginal Opportunity CostAButter

Slope is flat at A. Low opportunity cost of guns. The principle of increasing marginal opportunity cost states that opportunity costs increase as you produce more of one product. Slope is steep at B. High opportunity cost of guns. B Guns

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-7

A Production Possibilities Table for Society% of resources % of resources devoted to devoted to production production Pounds Number of guns of butter of butter Row of guns 0 20 40 60 80 100McGraw-Hill/Irwin

0 4 7 9 11 12

100 80 60 40 20 0

15 14 12 9 5 0

A B C D E F

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-8

PPC for Society1 pound 15 A of butter 14 2 pounds of butter 12 Butter 9 5 B C D E F 11 12 Guns 1 gun

5 pounds of butter

0 4 gunsMcGraw-Hill/Irwin

4 3 guns

7

9

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2-9

Efficiency and Inefficiency10 8 Guns 6 4 2 0 Inefficient point 2 4 Efficient points C A D B Unattainable point

6 Butter

8

10

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-10

Shifts in the PPCNeutral Technological Change Biased Technological Change

Butter

C

Butter

C B

A

0 GunsMcGraw-Hill/Irwin

B

D

0 Guns A

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-11

Distribution and Production Efficiency

The PPC focuses on productive

efficiency and ignores distribution. In our society, more is generally preferred to less and many policies have relatively small distributional effects.

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-12

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, humankinds proclivity to trade leads to individuals using their comparative advantage.Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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2-13

Growth in the Past Two MillenniaPer capita income (in 1990 international dollars)

$6,000 $5,000 $4,000 $3,000 $2,000 $1,000 0 500 1000 1500 2010

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-14

Gains from TradeTextiles (in thousands of yards) 5 4 D 3 2 1 A BE

Pakistan

Without trade they can only consume only those combinations of goods along their PPCs, such as point A (Pakistan) and point B (Belgium).Belgium4

1 2 3 Chocolate (in tons)McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-15

Gains from TradeTextiles (in thousands of yards) If they specialize and trade, they can consume outside of their individual PPCs. Each country can consume 2,000 tons of fabric and 2 tons of chocolate (point C).

5 4 D 3 2 1 A

PakistanC

BelgiumBE

1 2 3 Chocolate (in tons)McGraw-Hill/Irwin

4

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-16

Summary of TradeTextiles (in thousands of yards)For Pakistan the opportunity cost of one ton of chocolate is 4000 yards of textiles.

5 4 D 3 2 1

For Belgium the opportunity cost of one ton of chocolate is 250 yards of textiles. Belgium has the comparative advantage in chocolate and specializes producing 4 tons (point E). Pakistan Pakistan has the comparative advantage in textiles and specializes producing 4000 yards (point D). A C If both countries divide what is jointly produced evenly, they will both be Belgium consuming at point C, beyond both countries PPC. B

E

1 2 3 Chocolate (in tons)McGraw-Hill/Irwin

4

Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-17

Comparative Advantage and the Combined PPC5 F Textiles (in thousands of yards) 4 3 2 1 The combined PPC is the curve connecting points F, H, and G. H

Pakistan Belgium

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

G 1 2 3 4 Chocolate (in tons) 5

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-18

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.Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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2-19

Outsourcing and Globalization

Outsourcing is the relocation of

production once done in the U.S. to foreign countries. Outsourcing occurs because many other countries have a comparative advantage in labor costs. The U.S. has a comparative advantage in technology, institutional structure, and specialized knowledge.Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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2-20

Globalization

Globalization is the increasing

integration of economies, cultures, and institutions across the world. The positive effect of globalization is that it provides larger markets than the domestic economy. Increased competition can be a negative effect of globalization.

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Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2-21

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.Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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2-22

Law of One Price The law of one price 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.

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2-23

Summary The production possibilities curve (PPC) measures the maximum combination of outputs that can be obtained from a given number of inputs. According to the principle of increasing marginal opportunity cost, as production of one good increases, we must give up ever-increasing quantities of something else. Points inside the PPC are inefficient, points along the PPC are efficient, and points outside the PPC are unattainable.Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

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2-24

The rise of markets, specialization, trade, and

Summary

competition have contributed to significant increases in output. By specializing in producin

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