of Microeconomics

3. The Production Possibilities Frontier

and Gains From Trade*

Akos LadaJuly 22nd 2014

* Slide content principally sourced from N. Gregory Mankiw “Principles of Economics” Premium PowePoint

How economists think…

• Economics as the study of how society manages scarce resources

• The principles of how people make decisions• People face trade-offs• The cost of something is what you give up to get it

(opportunity cost)• Rational people think at the margin• People respond to incentives

• Economics as a science

• The use of assumptions and models

Today’s Objectives

1. Production Possibilities Frontier A building block to the study of trade

2. Gains from Trade Why does it make sense to buy, sell, and

trade? Why don’t we all make our own clothes? Can we all gain from trade?

1. The PPF

http://live.wsj.com/video/could-ralph-lauren-make-olympic-uniforms-in-us/F99C8D13-4329-4BAC-93E6-8B766B427C76.html#!F99C8D13-4329-4BAC-93E6-8B766B427C76

The Production Possibilities Frontier

The Production Possibilities Frontier (PPF) is a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology

Econ

Quant

A very simple example:

Resource: 48 hours of weekend timeAll used for producing one of two goods:

Studying EconStudying Quant

48

48

A (slightly) more realistic example…

Let’s assume that:

1. We live in a world where only two goods can be produced Computers and wheat

2. The goods are made using only one factor of production (input) Labor (people’s work) Limited amount of labor available, 50,000 labor hours per

month

3. The technology is given by: Producing 1 computer requires 100 hours labor Producing 1 ton of wheat requires 10 hours labor

How many computers and how much wheat can society produce?

5,0000

4,000100

2,500250

1,000400

50,0000

40,00010,000

25,00025,000

10,00040,000

0500050,000

E

D

C

B

A

WheatComputersWheatComputers

ProductionEmployment of

labor hours

Point on

graph

Production

Com-puters

Wheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,000 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

A

B

C

D

E

Graphically…

STUDENTS’ TURN:STUDENTS’ TURN:

Points off the PPFPoints off the PPF

A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods?Why or why not?

B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods?

Point F:100 computers, 3000 tons wheat Point F requires 40,000 hours of labor. Possible but not efficient: could get more of either good w/o sacrificing any of the other.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

F

AnswersAnswers

AnswersAnswers

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

Point G:300 computers, 3500 tons wheat Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours.

G

The PPF, in Summary….

Points on the PPF (like A – E)

• possible

• efficient: all resources are fully utilized

Points under the PPF (like F)

• possible

• not efficient: some resources underutilized (e.g., workers unemployed, factories idle)

Points above the PPF (like G)

• not possible 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

A

B

C

D

E

F

G

The PPF and Opportunity Cost

• Recall: The opportunity cost of an item is what must be given up to obtain it

Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other

Society faces a tradeoff: Getting more of one good requires sacrificing some of the other

The slope of the PPF tells you the opportunity cost of one good in terms of the other

The PPF and Opportunity Cost

The slope of a line equals the “rise over the run,” the amount the line rises when you move to the right by one unit.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

–1000100

slope =

= –10

Here, the opportunity cost of 1 computer is 10 tons of wheat.

16

In which country is the opportunity cost of cloth lower?

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

STUDENTS’ TURN:STUDENTS’ TURN:

PPF and opportunity costPPF and opportunity cost

AnswerAnswer

17

0

100

200

300

400

500

600

0 100 200 300 400Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400Cloth

WineFRANCE ENGLAND

England, because its PPF is not as steep as France’s.

Note 1: Changes / Shifts in the PPF

• The whole PPF can shift over time as a result of growth in a factor of production or change in technology

• If labor increases (but also capital, land etc)

• If technology changes to allow greater incremental production of both goods

• That is the process of economic growth!

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

• The PPF can also pivot• E.g as a result of a change in technology that affects the rate at which one of the goods can be produced but does not affect the other

Note 2: The Shape of the PPF

Mountain Bikes

Beer•The PPF can be a straight line,

or bow-shaped

•Depends on what happens to opportunity cost as economy shifts resources from one industry to the other.

• If opportunity cost remains constant, PPF is a straight line.

• If opportunity cost of a good rises as the economy produces more of the good, PPF is bow-shaped.

•For now, we will assume straight line

2. Gains from Trade

How can two individuals / firms / countries gain from trade?

We can answer this with an example of two countries.

Let us assume…

•Two countries: the U.S. and Japan

•Two goods: Computers and Wheat

•One factor of production: Labor• The U.S. has 50,000 hours of labor for production per month.

• Japan has 30,000 hours of labor for production per month.

•Technology:• Producing one computer requires 100 hours of labor in the U.S.

and 125 hours of labor in Japan

• Producing one ton of wheat requires 10 hours of labor in the U.S. and 25 hours in Japan

Step 1: Determine the production opportunities of each producer

Shown below are the total amount of labor needed to produce each good in the U.S. and in Japan and the total amount of each good that can be produced given the endowment of labor

Labor needed to produce one:

Total amount that can be produced:

Computer Wheat (tons)

Computer Wheat (tons)

United States 100 hrs 10 hrs 500 5000

Japan 125 hrs 25 hrs 240 1200

Step 2: Determine which producer has Absolute Advantage in which good(s)

• From this Table we can see that in this example, the U.S. has absolute advantage in the production of both computers and wheat

• The U.S. is able to produce both computers and wheat using fewer inputs (labor hours) than Japan

• 100 hrs versus 125 hrs for computers

• 10 hrs versus 25 hrs for wheatLabor needed to

produce one:Total amount that can

be produced:Computer Wheat

(tons)Computer Wheat

(tons)

United States 100 hrs 10 hrs 500 5000

Japan 125 hrs 25 hrs 240 1200

4,000

100

5,000

2,0001,000

3,000

500

200

300

400

0 Computers

Wheat (tons)

Step 3: Draw the PPF for each producer - U.S.

The U.S. has enough labor to produce 500 computers,or 5000 tons of wheat,or any combination along the PPF.

Computers

Wheat (tons)2,00

0

1,000

2000

100 300

Step 3: Draw the PPF for each producer - Japan

Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF.

4,000

100

5,000

2,0001,000

3,000

500

200

300

400

0 Computers

Wheat (tons)

Step 4: Pick a point of production without trade

(autarky) – U.S.The point where a country produces

in autarky depends on its preferences

• Suppose the U.S. uses half its labor to produce each of the two goods

• Then it will produce and consume 250 computers and 2500 tons of wheat

Key lesson: In autarky, production = consumption!

Step 4: Pick a point of production without trade

(autarky) – Japan

Computers

Wheat (tons)2,00

0

1,000

2000

100 300

• Suppose Japan uses half its labor to produce each good.

• Then it will produce and consume 120 computers and 600 tons of wheat.

Key lesson: In autarky, production = consumption!

Step 5: Determine which producer has Comparative Advantage for

which good• Remember: The slope of the PPF tells you the opportunity

cost of one good in terms of the other

• Comparative advantage is the ability to produce a good at a lower opportunity cost than another producer

Opportunity Cost of:

Computer Wheat (ton)

United States 10 1/10

Japan 5 1/5

Step 5: Determine which producer has Comparative Advantage for which good• The U.S. has comparative advantage in wheat and Japan has

comparative advantage in computers• This is true although the U.S. has absolute advantage in both wheat

AND computers!

Key Lesson: Absolute advantage is not necessary for comparative advantage!

• The direction of trade will be determined by comparative advantage• The country that has comparative advantage in a good will

specialize in that good and export it

• It will import the good in which it does not have comparative advantage

Step 6: Production with trade

• With trade, each country doesn’t need to produce everything it consumes

• It can instead allocate more of its factors of production (in our example, labor) to the product in which they have comparative advantage

1. Suppose the U.S. produces 3400 tons of wheat. How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF.

2. Suppose Japan produces 240 computers. How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japan’s PPF.

STUDENTS’ TURN:STUDENTS’ TURN:

Production under tradeProduction under trade

4,000

100

5,000

2,0001,000

3,000

500

200

300

400

0Computers

Wheat (tons)

U.S. Production With Trade

Producing 3400 tons of wheat requires 34,000 labor hours.

The remaining 16,000 labor hours are used to produce 160 computers.

Japan’s Production With Trade

Producing 240 computers requires all of Japan’s 30,000 labor hours.

Computers

Wheat (tons)2,00

0

1,000

2000

100 300

So, Japan would produce 0 tons of wheat.

Step 7: Determine gains from trade and their allocation

ProductionConsumption

in Autarky

240 computer

s

0tns. of wheat

160 computer

s

3,400tns. of wheat

250computer

s

2500tns. of wheat

120 computer

s

600tns. of wheat

Excess / Deficit

Production

- 90computer

s

+ 900tns. of wheat

+ 120 computer

s

- 600tns. of wheat

300 more!

30 more!

The additional production can be traded at a price between the two opportunity costs

• For this example lets assume that, in addition to fulfilling autarky consumption levels, the US exchanges 100 tons of wheat for 20 Japanese computers. • In total the US exports 700 tons of wheat to Japan and imports 110 computers from them.

4,000

100

5,000

2,0001,000

3,000

500

200

300

400

0 Computers

Wheat (tons)

Step 8: Determine Consumption With Trade – U.S.

2700270

= amount consumed

0110+ imported

7000– exported

3400160produced

wheatcompute

rs

Japan’s Consumption With Trade

Computers

Wheat (tons)2,00

0

1,000

2000

100 300

700130= amount consumed

7000+ imported

0110– exported

0240produced

wheatcomputer

s

Trade Makes Both Countries Better Off!

2002,7002,500wheat

20270250computer

s

gains from trade

consumption with trade

consumption without

trade

U.S.

100700600wheat

10130120computer

s

gains from trade

consumption with trade

consumption without

trade

Japan

In Sum: Comparative Advantage and Trade

• Gains from trade arise from comparative advantage (differences in opportunity costs).

• When each country specializes in the good(s) in which it has a comparative advantage,

total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.

• The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other.