The Production Possibility Model, Trade, and Globalization

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

McGraw-Hill/Irwin

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

The Production Possibility Model, Trade, and Globalization

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 choices 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

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The Production Possibility Model, Trade, and Globalization

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

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The Production Possibility Model, Trade, and Globalization

Application: A Production Possibilities Curve

Econ Grade
100 88

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 cost

70

10 hrs for each History and Econ

PPC
40 58

66

78

100 History grade

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The Production Possibility Model, Trade, and Globalization

Increasing Marginal Opportunity Cost

Butter

The principle of increasing marginal 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 cost to produce more guns
Guns
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The Production Possibility Model, Trade, and Globalization

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

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The Production Possibility Model, Trade, and Globalization

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

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The Production Possibility Model, Trade, and Globalization

The Benefits from Trade

Textiles (yds)
5,000 4,000 3,000 2,000 1,000 1 2 3 4 5

If each country specializes according to comparative advantage and trades, they can consume beyond their PPCs Why should Pakistan specialize in textiles and Belgium specialize in chocolates?

Pakistan Belgium

Chocolate (tons)

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The Production Possibility Model, Trade, and Globalization

Comparative Advantage and the Combined PPC

Combined PPC with trade
Textiles (yds)
Pakistan + Belgium 5,000 4,000 3,000 2,000 1,000 1 2 3 4 5 Pakistan

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

Belgium

Chocolate (tons)

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The Production Possibility Model, Trade, and Globalization

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

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The Production Possibility Model, Trade, and Globalization

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

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The Production Possibility Model, Trade, and Globalization

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

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The Production Possibility Model, Trade, and Globalization

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

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The Production Possibility Model, Trade, and Globalization

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
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