Opportunity Costs And Trade

Production Possibilities Curve (PPC)

An economic model used to illustrate the opportunity cost of producing more of one product and to explain specialization in production and trade.

Purpose of the PPC

To show the combinations of products that can be produced with limited resources and technology and to illustrate the opportunity cost of producing more of one product.

PPC and Scarcity

The PPC illustrates that because resources are scarce, the products produced from those resources are also scarce.

Production Possibility

A specific combination of two products that can be produced with available resources and technology.

Points on the PPC

Each point on the PPC represents a different production possibility: a specific combination of two products that can be produced.

All Production Possibilities

The collection of all points on the PPC illustrates the different production possibilities available to an economy.

Movement Along the PPC

Moving from one point on the PPC to another represents changing the quantities of the two products produced.

Opportunity Cost on the PPC

Producing more of one product requires producing less of another product because resources are scarce.

Opportunity Cost

The quantity of another product that could have been produced but is given up when resources are used to produce more of the chosen product.

How Opportunity Cost Is Measured

Opportunity cost is measured by the quantity of another product that could have been produced, NOT in monetary units.

Opportunity Cost and the PPC

The opportunity cost of producing more of one product is determined by moving from one point on the PPC to another point.

Opportunity Cost Formula

Opportunity cost = quantity of product given up ÷ quantity of product gained.

Opportunity Cost of Product X

OC of X = amount of Product Y not produced ÷ additional amount of Product X produced.

Opportunity Cost of Product Y

OC of Y = amount of Product X not produced ÷ additional amount of Product Y produced.

Opportunity Costs Are Reciprocals

The opportunity cost of producing more of one product is the reciprocal of the opportunity cost of producing more of the other product.

Reciprocal

To find the reciprocal of a fraction, switch the numerator and denominator.

PPC Slope

The slope of the PPC represents the opportunity cost of producing more of the product measured on the horizontal axis in terms of the product measured on the vertical axis.

Slope Formula

Slope = rise ÷ run.

Opportunity Cost and Slope

The opportunity cost of producing more of one product is represented by the slope of the PPC between the relevant points.

Opportunity Cost of the Other Product

The opportunity cost of producing more of the other product is the reciprocal of the PPC's slope.

Graphical Meaning of Moving Up the PPC

Moving up the PPC means producing more of the product represented on the vertical axis and less of the product represented on the horizontal axis.

Graphical Meaning of Moving Down the PPC

Moving down the PPC means producing more of the product represented on the horizontal axis and less of the product represented on the vertical axis.

Increase in Production on a PPC

An increase in production of one product requires a decrease in production of the other product when moving along the PPC.

Decrease in Production on a PPC

A decrease in production of one product allows an increase in production of the other product when moving along the PPC.

Increasing Opportunity Cost

The opportunity cost of producing more and more of a product increases as more of that product is produced.

Cause of Increasing Opportunity Cost

Increasing opportunity cost exists because of the concave shape of the Production Possibilities Curve.

Shape of a PPC With Increasing Opportunity Cost

A concave PPC represents increasing opportunity cost.

First Increase vs. Later Increase

When opportunity costs are increasing, producing additional units of a product becomes increasingly costly in terms of the other product that must be given up.

How to Identify Increasing Opportunity Cost

If each additional increase in production requires giving up increasingly more of the other product, opportunity cost is increasing.

Comparative Advantage

An economic concept based on having a lower opportunity cost of producing a product compared with another producer.

Low Opportunity Cost Producer

The producer that gives up less of another product to produce an additional unit of a product.

High Opportunity Cost Producer

The producer that gives up more of another product to produce an additional unit of a product.

Law of Comparative Advantage

The producer with the lower opportunity cost should specialize in producing that product.

Specialization

The process of producing more of the product for which a producer has a lower opportunity cost and less of the product for which it has a higher opportunity cost.

Proper Specialization

Each producer specializes in producing more of the product for which it is the low opportunity cost producer and less of the product for which it is the high opportunity cost producer.

Improper Specialization

Each producer specializes in producing more of the product for which it is the high opportunity cost producer and less of the product for which it is the low opportunity cost producer.

How to Determine Comparative Advantage

Calculate the opportunity cost of producing each product for each producer, then compare the opportunity costs.

Who Should Specialize?

A producer should specialize in the product for which it has the lower opportunity cost.

Who Should Produce a Product?

The producer with the lower opportunity cost should produce more of that product.

Comparative Advantage vs. Absolute Production

Comparative advantage is determined by opportunity cost, not simply by who can produce the greater quantity. [Simplified]

Specialization and Opportunity Cost

Specialization should be based on comparative advantage, meaning the lower opportunity cost.

Trade

An exchange of products between producers or economies.

Why Specialization Leads to Trade

When producers specialize according to comparative advantage, they produce more of the products they have lower opportunity costs for, creating opportunities for trade.

Gains from Proper Specialization

Proper specialization can result in more of both products being produced using the same quantity of resources.

Why Proper Specialization Creates Gains

Each producer concentrates resources on the product it can produce at a lower opportunity cost, allowing total production of both products to increase.

Effect of Proper Specialization on Total Production

Proper specialization increases the total amount of products that can be produced from the same quantity of resources.

Effect of Improper Specialization on Total Production

Improper specialization causes less of both products to be produced from the same quantity of resources.

Loss from Improper Specialization

Improper specialization results in a decrease in production of both products when the same quantity of resources is used.

Proper vs. Improper Specialization

Proper specialization produces more of both products; improper specialization produces less of both products.

Resources and Specialization

Specialization changes how existing resources are allocated between products; it does not require an increase in the total quantity of resources.

Specialization and the PPC

When a producer specializes in the product for which it has the lower opportunity cost, it moves along its PPC toward producing more of that product.

Trade and Gains

If producers specialize according to comparative advantage and trade, both can potentially consume more than they could without specialization and trade. [Simplified]

Why Trade Can Benefit Both Producers

Each producer specializes in what it produces at a lower opportunity cost and can trade for the other product.

Rational Specialization and Trade

Rational producers specialize according to comparative advantage and trade with other producers to increase the products available for consumption.

Comparative Advantage and Trade Logic

Lower opportunity cost → specialization → increased production → trade → potential gains for both producers.

Opportunity Cost Calculation Process

1. Identify the change in production of the product being increased. 2. Identify the amount of the other product given up. 3. Divide the amount given up by the amount gained.

Finding the Opportunity Cost of Product X

Divide the amount of Product Y given up by the additional amount of Product X produced.

Finding the Opportunity Cost of Product Y

Divide the amount of Product X given up by the additional amount of Product Y produced.

Checking Opportunity Cost Calculations

The two opportunity costs for two products should be reciprocals when calculated from the same portion of the PPC.

Using the PPC to Find Opportunity Cost

Select the relevant points on the PPC, determine how much production of each product changes, and calculate the ratio of the product given up to the product gained.

Using the PPC to Find Comparative Advantage

Calculate each producer's opportunity cost for each product and identify which producer has the lower opportunity cost for each product.

Using Comparative Advantage to Determine Specialization

The producer with the lower opportunity cost specializes in that product.

PPC and Comparative Advantage

The PPC provides the production information needed to calculate opportunity costs and determine comparative advantage.

PPC and Specialization

The PPC shows how production changes when a producer specializes in one product.

PPC and Trade

The PPC can be used to determine opportunity costs, which can then be used to determine comparative advantage, specialization, and the potential gains from trade.

Main Logic of the Chapter

Scarcity creates opportunity costs; opportunity costs determine comparative advantage; comparative advantage determines specialization; specialization can create gains from trade.