Chapter 2: The Production Possibility Model, Trade, and Globalization

Learning Objectives

• Demonstrate trade-offs with a production possibility curve.
• Relate the concepts of comparative advantage and efficiency to the production possibility curve.
• State how, through comparative advantage and trade, countries can consume beyond their individual production possibilities.
• Explain how globalization is guided by the law of one price.

The Production Possibility Model

• A production possibility model conveys the trade-offs society faces.
• The model can be presented both in a table and in a graph.
• Through specialization and trade, individuals, firms, and countries can achieve greater levels of output than they could otherwise achieve.

The Production Possibility Curve (PPC)

• 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 gives you a visual picture of the trade-off embodied in a decision.
• A PPC is created from a production possibility table by mapping the table in a two-dimensional graph.

Applications: Production Possibility Table for Grades in Economics and History

• Application title: Production Possibility Table for Grades in Economics and History.
• Structure: History vs Economics, with Hours of Study and Grades.
• Sample mappings from the slide:
  • History hrs = 20, History grade = 98; Economics hrs = 0, Economics grade = 40
  • History hrs = 18, History grade = 94; Economics hrs = 2, Economics grade = 46
  • History hrs = 10, History grade = 78; Economics hrs = 10, Economics grade = 70
  • History hrs = 4, History grade = 66; Economics hrs = 16, Economics grade = 88
  • History hrs = 0, History grade = 58; Economics hrs = 20, Economics grade = 100
• These pairs illustrate how more time in one subject affects the grade in the other, reflecting the trade-off concept in the PPC framework.

Applications: A Production Possibility Curve

• 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.
• Example reference (from the slide): an illustrative pairing of outputs with resource allocations mentioned as part of the curve construction, showing feasible points on the curve.
• The slide presents a simple data point: e.g., a point labeled on the curve where one good is increased at the expense of the other.

Increasing Opportunity Costs of the Tradeoff

• The principle of increasing marginal opportunity cost tells us that opportunity costs increase the more you concentrate on the activity.
• In the Guns and Butter illustration:
  • The slope is flat at point A, meaning there is a low opportunity cost to produce more guns.
  • The slope is steep at point B, meaning there is a high opportunity cost to produce more guns.
• This showcases the bow-shaped PPC: as you move along the curve, the forgone amount of the other good increases.

Application: A Production Possibility Table for Guns and Butter

• The table shows the trade-off between production of guns and butter.
• Key layout (interpreted from the slide):
  • Columns indicate the % of resources devoted to Guns and the resulting Pounds of Butter.
  • Rows map the corresponding gun output with the accompanying butter output.
  • Example interpretation of the rows:
  • 0% Resources to Guns → 0 Guns produced; 100% Butter → 15 pounds of Butter (Row A).
  • 20% Resources to Guns → 4 Guns produced; 80% Butter → 14 pounds of Butter (Row B).
  • 40% Resources to Guns → 7 Guns produced; 60% Butter → 12 pounds of Butter (Row C).
  • 60% Resources to Guns → 9 Guns produced; 40% Butter → 9 pounds of Butter (Row D).
  • 80% Resources to Guns → 11 Guns produced; 20% Butter → 5 pounds of Butter (Row E).
  • 100% Resources to Guns → 12 Guns produced; 0% Butter → 0 pounds of Butter (Row F).
• Key takeaway: The trade-off surfaces as the percentage of resources devoted to Guns increases, and butter output falls, illustrating the PPC’s trade-off shape.

Application: A Production Possibility Curve for Guns and Butter

• Opportunity cost of choosing guns over butter increases as guns production increases.
• The curve is typically bowed outward because some resources are better suited for producing one good than another.
• This leads to increasing marginal opportunity costs as you move along the curve.

Comparative Advantage

• The reason we must give up more and more butter as we produce more guns is that some resources are relatively better suited to producing guns, while others are relatively better suited to producing butter.
• A resource has a comparative advantage if it is better suited to the production of one good than to the production of another good.
• In a society, individuals or factors with comparative advantage should specialize in producing the good for which they have the lower opportunity cost and then trade for the other good.

Efficiency

• Productive efficiency is achieving as much output as possible from a given amount of inputs or resources.
• Inefficiency is getting less output from inputs that, if devoted to some other activity, would produce more output.
• Points A and C are points of efficiency on the PPC; Point D is unattainable with given inputs; Point B is a point of inefficiency.
• Diagrammatic gun-butter representation:
  • Guns Butter
  • • B • C • D A
• Efficient production lies on the PPC; any point inside the curve is inefficient; any point outside is unattainable with current resources.

Efficiency and Technological Change

• Neutral technological increase or an increase in resources shifts the PPC outward, expanding the production frontier.
• Biased technological change can shift the PPC differently for the two goods (A B A B are labels used in the slide to illustrate shifts).

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 society, most people prefer more to less, so distribution effects matter in policy decisions.

Trade and Comparative Advantage

• The PPC is bowed outward because individuals specialize in producing 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.
• Adam Smith’s notion: humankind’s proclivity to trade leads to individuals using their comparative advantage.

Markets, Specialization, and Growth

• Growth in per capita income over long horizons (illustrated as a historical trend): a stylized graph showing income per capita rising over time with globalization and specializations contributing to growth.

The Benefits from Trade (1 of 2)

• When people freely enter into trade, both parties can be expected to benefit from trade.
• Without trade, each country can only consume those combinations of goods along their PPCs.
• Example setup (Chocolate vs Textiles):
  • Chocolate (tons) and Textiles (yards) for two countries (Belgium and Pakistan) are shown to illustrate the no-trade PPC boundary.
  • The table indicates that without trade, consumption is limited to each country’s PPC.

The Benefits from Trade (2 of 2)

• Why should Pakistan specialize in textiles and Belgium specialize in chocolates?
• If each country specializes according to comparative advantage and trades, they can consume beyond their “no-trade” PPCs.
• Visual: Chocolate (tons) and Textiles (yards) plots for Belgium and Pakistan show consumption with trade lying beyond the no-trade PPCs, indicating gains from trade.

Application: U.S. Textile Production and Trade

• Historical shift: Two hundred years ago, the United States had a comparative advantage in textile production.
• Global shift: Countries with cheaper labor, such as Bangladesh, now have the comparative advantage in textiles.
• Gains from trade include higher wages for Bangladesh workers and lower-priced cloth for U.S. consumers.

Globalization

• Globalization is the increasing integration of economies, cultures, and institutions across the world.
• Effects on firms:
  • Positive effect: Globalization provides larger markets than the domestic economy.
  • Negative effect: The global economy increases the number of competitors for the firm.

Exchange Rates and Comparative Advantage

• The U.S. comparative advantage in innovation results in higher wages in the United States.
• As industries mature, they move to low-wage areas.
• To regain comparative advantage, the U.S. wage premium will have to decline.
• Consequences: The U.S. exchange rate will likely decline or there will be large increases in foreign wages — or both.
• Resulting effects: Exports become cheaper for foreigners and imports become more expensive.

The Law of One Price

• The law of one price states that wages of workers in one country will not differ significantly from the wages of (equal) 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.
• Reality: The U.S. has been living better than it could have otherwise precisely because of trade.