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The Production Possibility Model,
                               Trade, and Globalization            2
                                      CHAPTER 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
The Production Possibility Model,
                                       Trade, and Globalization            2

                   Chapter Goals
• Demonstrate opportunity cost with a production
  possibility curve
• Discuss the increasing marginal opportunity cost
• Relate the concept of comparative advantage to the
  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


                                                                           2-2
The Production Possibility Model,
                                     Trade, and Globalization            2

    The Production Possibilities Model
• The production possibilities model can be presented
  in both a table and in a graph
• A production possibility table lists a choice’s
  opportunity cost by summarizing what alternative
  outputs you can achieve with your inputs
     • An output is a result of an activity
     • An input is what you put in production process
       to achieve an output




                                                                         2-3
The Production Possibility Model,
                                                  Trade, and Globalization            2

Application: A Production Possibilities Table
         History                 Economics
Hrs of Study       Grade   Hrs of Study   Grade
    20             98%          0         40%
                                                          What is the
    18             94%          2         46%
    16             90%          4         52%              output?
    14             86%          6         58%
    12             82%          8         64%             What is the
    10             78%         10         70%
                                                           input?
     8             74%         12         76%
     6             70%         14         82%
     4             66%         16         88%
     2             62%         18         94%
     0             58%         20         100%


                                                                                      2-4
The Production Possibility Model,
                                        Trade, and Globalization            2

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




                                                                            2-5
The Production Possibility Model,
                                                    Trade, and Globalization            2

 Application: A Production Possibilities Curve

Econ Grade
100                                          A PPC demonstrates:
             16 hrs for Econ and 4
                hrs for History           • There is a limit to what you
88
                                            can achieve, given existing
                      10 hrs for each       institutions, resources, and
70                   History and Econ       technology
                                          • Every choice you make has
                                 PPC        an opportunity cost


40
 58   66        78              100 History grade



                                                                                        2-6
The Production Possibility Model,
                                           Trade, and Globalization            2

         Increasing Marginal Opportunity Cost
                    The principle of increasing marginal
Butter
                opportunity cost states that opportunity costs
              increase the more you concentrate on the activity
         A
                      • Slope is flat at A
                      • This means there is a low opportunity
                        cost to produce more guns

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


                                                                               2-7
The Production Possibility Model,
                                       Trade, and Globalization            2

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

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




                                                                           2-8
The Production Possibility Model,
                                        Trade, and Globalization            2

                      Efficiency
                      Productive efficiency is achieving as
Butter
                      much output as possible from a given
                         amount of inputs or resources

         •   A
                              • Point of efficiency
                 •D           • Unattainable with given
                                amounts of inputs
                 •C           • Point of inefficiency

         •B
                  Guns


                                                                            2-9
The Production Possibility Model,
                                          Trade, and Globalization             2

      Efficiency and Technological Change
Neutral technological increase              Biased
 or an increase in resources         technological increase
A                                A




                         B                                           B
                                                                              2-10
The Production Possibility Model,
                                        Trade, and Globalization             2

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




                                                                            2-11
The Production Possibility Model,
                                       Trade, and Globalization             2

     Trade and Comparative Advantage
•                                               The PPC
                                                is bowed
                                                because
                                                individuals
• For a society to produce on its PPC, individuals must
                                                specialize
  produce those goods for which they have a comparative
                                                in the
  advantage and trade for other goods
                                                production
                                                of goods
• According to Adam Smith, humankind’s proclivity to
  trade leads to individuals using their comparativewhich
                                                for
  advantage                                     they have
                                                a
                                                comparati
                                                ve
                                                advantage                  2-12
The Production Possibility Model,
                                      Trade, and Globalization             2

         Markets, Specialization, and Growth
• Growth in per capita income during the past 2000 years
         $6,000

Income   $5,000

         $4,000

         $3,000

         $2,000

         $1,000

                                                          Year
                  0   500   1000     1500          2010


• What caused this growth?

                                                                          2-13
The Production Possibility Model,
                                                 Trade, and Globalization             2

                  The Benefits from Trade
•                                                         When
                                                          people
Textiles (yds)
                                                          freely enter
                                                          into trade,
5,000                                        Without trade, each
                                                          both
                                          country can only consume
4,000                                                     parties can
                                            those combinations of
                                                          be
                 Pakistan                  goods along their PPCs
3,000                                                     expected
                                                          to benefit
2,000                       Belgium                       from trade
1,000


          1       2     3     4       5      Chocolate (tons)

                                                                                     2-14
The Production Possibility Model,
                                              Trade, and Globalization             2

                  The Benefits from Trade

Textiles (yds)

5,000

4,000
                                            Why should Pakistan
3,000            Pakistan                   specialize in textiles
                                            and Belgium specialize
2,000                       Belgium         in chocolates?

1,000


          1       2     3     4       5   Chocolate (tons)



                                                                                  2-15
The Production Possibility Model,
                                                   Trade, and Globalization             2

   Comparative Advantage and the Combined PPC

                                Combined PPC with trade
Textiles (yds)
                      Pakistan + Belgium
5,000
                                               The slope of the combined
4,000                                           PPC is determined by the
                                                 country with the lowest
           Pakistan                                 opportunity cost
3,000


2,000
                  Belgium

1,000


          1       2         3     4        5   Chocolate (tons)



                                                                                       2-16
The Production Possibility Model,
                                     Trade, and Globalization             2

Application: 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




                                                                         2-17
The Production Possibility Model,
                                     Trade, and Globalization             2

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




                                                                         2-18
The Production Possibility Model,
                                          Trade, and Globalization            2

    Outsourcing, Trade and Comparative Advantage
                        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
•                                                                               T
                                                                                h
                                                                                e

                                                                                 g
                                                                                 l
                                                                                 o
                                                                              2-19
The Production Possibility Model,
                                      Trade, and Globalization             2

Outsourcing, Trade and Comparative Advantage
    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



                                                                          2-20
The Production Possibility Model,
                                         Trade, and Globalization             2

 Outsourcing, Trade and Comparative Advantage
                  The Law of One Price
• 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
• 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 reality is that the citizens in the U.S. has
    been living better than it could have otherwise
          because of trade and outsourcing
                                                                             2-21
The Production Possibility Model,
                                        Trade, and Globalization             2

                 Chapter Summary
• The production possibility curve embodies the
  opportunity cost concept
• 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
• Through specialization and trade, countries can increase
  consumption


                                                                            2-22
The Production Possibility Model,
                                            Trade, and Globalization             2

                  Chapter Summary
• The typical outward bow of the PPC is the result
  of comparative advantage and trade
• Because many goods are cheaper to produce in foreign
  countries, production of goods formerly in the U.S. is being
  outsourced

• Outsourcing is the product of the law of one price
• Globalization is the increasing integration of economies,
  cultures, and institutions across the world




                                                                                2-23
The Production Possibility Model,
                                          Trade, and Globalization             2

              Preview of Chapter 3:
                Economic Institutions
• Define market economy
• Compare and contrast capitalism with socialism
• Describe how businesses, households, and government interact
  in a market economy
• Summarize briefly the advantages and disadvantages of various
  types of businesses
• Explain why, even though households have the ultimate power,
  much of the economic decision making is done by business and
  government
• State six roles of government
• Explain why global policy issues differ from national policy
  issues
                                                                              2-24

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Micro ch2

  • 1. The Production Possibility Model, Trade, and Globalization 2 CHAPTER 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
  • 2. The Production Possibility Model, Trade, and Globalization 2 Chapter Goals • Demonstrate opportunity cost with a production possibility curve • Discuss the increasing marginal opportunity cost • Relate the concept of comparative advantage to the 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 2-2
  • 3. The Production Possibility Model, Trade, and Globalization 2 The Production Possibilities Model • The production possibilities model can be presented in both a table and in a graph • A production possibility table lists a choice’s opportunity cost by summarizing what alternative outputs you can achieve with your inputs • An output is a result of an activity • An input is what you put in production process to achieve an output 2-3
  • 4. The Production Possibility Model, Trade, and Globalization 2 Application: A Production Possibilities Table History Economics Hrs of Study Grade Hrs of Study Grade 20 98% 0 40% What is the 18 94% 2 46% 16 90% 4 52% output? 14 86% 6 58% 12 82% 8 64% What is the 10 78% 10 70% input? 8 74% 12 76% 6 70% 14 82% 4 66% 16 88% 2 62% 18 94% 0 58% 20 100% 2-4
  • 5. The Production Possibility Model, Trade, and Globalization 2 The Production Possibilities Model • A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs • 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 2-5
  • 6. The Production Possibility Model, Trade, and Globalization 2 Application: A Production Possibilities Curve Econ Grade 100 A PPC demonstrates: 16 hrs for Econ and 4 hrs for History • There is a limit to what you 88 can achieve, given existing 10 hrs for each institutions, resources, and 70 History and Econ technology • Every choice you make has PPC an opportunity cost 40 58 66 78 100 History grade 2-6
  • 7. The Production Possibility Model, Trade, and Globalization 2 Increasing Marginal Opportunity Cost The principle of increasing marginal Butter opportunity cost states that opportunity costs increase the more you concentrate on the activity A • Slope is flat at A • This means there is a low opportunity cost to produce more guns • Slope is steep at B •This means there is a high opportunity B cost to produce more guns Guns 2-7
  • 8. The Production Possibility Model, Trade, and Globalization 2 Comparative Advantage • The reason the opportunity cost of guns increases as we produce more guns is that some resources have comparative advantage over other resources • A resource has comparative advantage if it has the ability to be better suited to the production of one good than another 2-8
  • 9. The Production Possibility Model, Trade, and Globalization 2 Efficiency Productive efficiency is achieving as Butter much output as possible from a given amount of inputs or resources • A • Point of efficiency •D • Unattainable with given amounts of inputs •C • Point of inefficiency •B Guns 2-9
  • 10. The Production Possibility Model, Trade, and Globalization 2 Efficiency and Technological Change Neutral technological increase Biased or an increase in resources technological increase A A B B 2-10
  • 11. The Production Possibility Model, Trade, and Globalization 2 Distribution and Productive Efficiency • 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 • In our society, most people prefer more to less, and many policies have relatively small distribution effects 2-11
  • 12. The Production Possibility Model, Trade, and Globalization 2 Trade and Comparative Advantage • The PPC is bowed because individuals • For a society to produce on its PPC, individuals must specialize produce those goods for which they have a comparative in the advantage and trade for other goods production of goods • According to Adam Smith, humankind’s proclivity to trade leads to individuals using their comparativewhich for advantage they have a comparati ve advantage 2-12
  • 13. The Production Possibility Model, Trade, and Globalization 2 Markets, Specialization, and Growth • Growth in per capita income during the past 2000 years $6,000 Income $5,000 $4,000 $3,000 $2,000 $1,000 Year 0 500 1000 1500 2010 • What caused this growth? 2-13
  • 14. The Production Possibility Model, Trade, and Globalization 2 The Benefits from Trade • When people Textiles (yds) freely enter into trade, 5,000 Without trade, each both country can only consume 4,000 parties can those combinations of be Pakistan goods along their PPCs 3,000 expected to benefit 2,000 Belgium from trade 1,000 1 2 3 4 5 Chocolate (tons) 2-14
  • 15. The Production Possibility Model, Trade, and Globalization 2 The Benefits from Trade Textiles (yds) 5,000 4,000 Why should Pakistan 3,000 Pakistan specialize in textiles and Belgium specialize 2,000 Belgium in chocolates? 1,000 1 2 3 4 5 Chocolate (tons) 2-15
  • 16. The Production Possibility Model, Trade, and Globalization 2 Comparative Advantage and the Combined PPC Combined PPC with trade Textiles (yds) Pakistan + Belgium 5,000 The slope of the combined 4,000 PPC is determined by the country with the lowest Pakistan opportunity cost 3,000 2,000 Belgium 1,000 1 2 3 4 5 Chocolate (tons) 2-16
  • 17. The Production Possibility Model, Trade, and Globalization 2 Application: 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 2-17
  • 18. The Production Possibility Model, Trade, and Globalization 2 Outsourcing, Trade and Comparative Advantage Outsourcing • 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 • The U.S. has comparative advantage in technology, institutional structure, and specialized knowledge 2-18
  • 19. The Production Possibility Model, Trade, and Globalization 2 Outsourcing, Trade and Comparative Advantage 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 • T h e g l o 2-19
  • 20. The Production Possibility Model, Trade, and Globalization 2 Outsourcing, Trade and Comparative Advantage 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 2-20
  • 21. The Production Possibility Model, Trade, and Globalization 2 Outsourcing, Trade and Comparative Advantage The Law of One Price • 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 • 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 reality is that the citizens in the U.S. has been living better than it could have otherwise because of trade and outsourcing 2-21
  • 22. The Production Possibility Model, Trade, and Globalization 2 Chapter Summary • The production possibility curve embodies the opportunity cost concept • 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 • Through specialization and trade, countries can increase consumption 2-22
  • 23. The Production Possibility Model, Trade, and Globalization 2 Chapter Summary • The typical outward bow of the PPC is the result of comparative advantage and trade • Because many goods are cheaper to produce in foreign countries, production of goods formerly in the U.S. is being outsourced • Outsourcing is the product of the law of one price • Globalization is the increasing integration of economies, cultures, and institutions across the world 2-23
  • 24. The Production Possibility Model, Trade, and Globalization 2 Preview of Chapter 3: Economic Institutions • Define market economy • Compare and contrast capitalism with socialism • Describe how businesses, households, and government interact in a market economy • Summarize briefly the advantages and disadvantages of various types of businesses • Explain why, even though households have the ultimate power, much of the economic decision making is done by business and government • State six roles of government • Explain why global policy issues differ from national policy issues 2-24