Chapter 2 - Specialization and exchange. In this chapter you will learn: How to construct a production possibilities frontier, describe what causes shifts in production possibilities curves, define absolute and comparative advantage, define specialization and explain why people specialize, explain how the gains from trade follow from comparative advantage.
Chapter2 SpecializationandExchange â2014byMcGrawHillEducation Whatwillyoulearninthischapter? ã Howtoconstructaproductionpossibilities frontier ã Describewhatcausesshiftsinproduction possibilitiescurves ã Defineabsoluteandcomparativeadvantage ã Definespecializationandexplainwhypeople specialize ã Explainhowthegainsfromtradefollowfrom comparativeadvantage â2014byMcGrawHillEducation Who produces which goods and why? • People around the globe coordinate production activities to sell to consumers what they want • The global production is a natural outcome of people everywhere acting in their own self‐ interest toimprovetheirownlives ã Economistscallthiscoordinationmechanism theinvisiblehand â2014byMcGrawHillEducation Productionpossibility ã Onewaytounderstandtheinvisiblehandis the production possibility model – Two groups: producers and consumers – Two goods being produced – Each producer has their own production technology • Technologycanbeproprietary ã Modelanalyzeswhoproduceswhichgoods â2014byMcGrawHillEducation Theproductionpossibilityfrontier Acountrysproductioncapabilitiescanbe modeledusingtheproductionpossibilities frontier (PPF) Millions of bushels of wheat The U.S can make million bushels of wheat A B C The U.S can also produce these combinations of wheat and shirts OR million shirts D E Shirts (millions) Production Possibilities Bushels of Wheat (millions) A B 0.5 C 1.0 D 1.5 E Millions of shirts © 2014 by McGraw‐Hill Education Production possibility frontier The production possibilities frontier is the line or curve that shows all possible combinations of two outputs that can be produced using all available resources Millions of bushels of wheat R U S The trade‐off between producing more of one good and less of another is the opportunity cost Unattainable points can’t be reached because there aren’t enough workers • Equal to the slope of PPF, ‐2 The opportunity cost of Production possibilities frontier (PPF) 1 shirt is 2 bushels of wheat Attainable points require million or fewer workers T Millions of shirts © 2014 by McGraw‐Hill Education Active Learning: Calculating opportunity cost Use the following PPF to calculate the opportunity cost of wheat Millions of bushels of wheat 1 Millions of shirts â2014byMcGrawHillEducation ConcavePPFs ã ThepreviousPPFsassumedthatallinputsare able to be transferred between production processes at a constant rate • It is likely that some inputs are better suited for making shirts, while others inputs are better suited for farming • What happens to the shape of the PPF transferring inputs between production processes is costly? © 2014 by McGraw‐Hill Education Concave PPFs The opportunity cost of producing an additional unit of a good typically increases as more resources are allocated to its production Millions of bushels of wheat 1. Giving up 1 million bushels of wheat gains 1 million shirts Slope = ‐1 C1 C2 2.Givingup1million bushelsofwheatgains onlyẵmillionshirts Slope=2 3.Givingup1million bushelsofwheatgains onlyẳmillionshirts Slope=4 C3 PPF C4 © 2014 by McGraw‐Hill Education Millions of T-shirts Cocave PPFs At each point of the curved production possibilities frontier, the slope represents the opportunity cost of producing more t‐shirts Millions of bushels of wheat The opportunity cost represents the suitability of the next input that is transferred from one production process to the another C1 C2 C3 PPF C4 Millions of T-shirts © 2014 by McGraw‐Hill Education 10 PPFs and opportunity cost If the country is producing inside the PPF, producing more of one good does NOT require giving up some of the other good Millions of bushels of wheat Producing at B1 requires only 1.5 million workers B3 …so the U.S can produce more wheat without giving up any shirts by moving toward the frontier B2 B1 PPF Millions of T-shirts © 2014 by McGraw‐Hill Education 11 PPFs and opportunity cost If the country is producing on the PPF, producing more of one good requires giving up some of the other good Millions of bushels of wheat Producing more shirts F1 means producing less wheat F2 PPF © 2014 by McGraw‐Hill Education Millions of T-shirts 12 Shifting the PPF The PPF shifts when resources are adjusted. Millions of bushels of wheat Millions of bushels of wheat An increase in available resources the entire frontier outward An improvement in technology for one good the frontier outward PPF2 PPF 1 PPF PPF 4 Millions of shirts Millions of shirts © 2014 by McGraw‐Hill Education 13 Active Learning: Shifting the PPF Show that it is possible to increase both wheat and shirt production with an increase in technology to produce shirts Millions of bushels of wheat PPF2 PPF 1 Millions of shirts © 2014 by McGraw‐Hill Education 14 Absolute and comparative advantage • The PPF illustrates the key trade‐offs faced by one economy • If there is no trade between economies, then what a country produces is what it consumes • Using the understanding of PPFs, the analysis canbeextendedtounderstandhowcountries decidewhattoproduce â2014byMcGrawHillEducation 15 Absoluteandcomparativeadvantage ã SupposethatanAmericanworkercanproduce50shirts or200bushelsofwheatperday.AChineseworker can produce only 25 shirts or 50 bushels of wheat – The U.S. has an absolute advantage in shirt production since a U.S. worker can produce more shirts than a Chinese worker – The U.S. has an absolute advantage in wheat production since a U.S. worker can produce more wheat than a Chineseworker ã Absoluteadvantagedoesnotaidinunderstandinghow countriesdecidewhichgoodstoproduce Foreverytshirtproduced,thecountryusesresourcesthat couldotherwisebespentgrowingwheat Tradeisbasedonopportunitycost â2014byMcGrawHillEducation 16 Absolute and comparative advantage • To understand how each country decides which good to produce when they interact, the opportunity costs are calculated: – U.S.: 1 shirt costs 4 bushels of wheat – China: 1 shirt costs 2 bushels of wheat • Using the reciprocal of the above opportunity costs: – U.S.: 1 bushel of wheat costs 1/4 shirt of wheat – China: 1 bushel of wheat costs 1/2 shirt of wheat © 2014 by McGraw‐Hill Education 17 Absolute and comparative advantage • A country has a comparative advantage in a good if it can produce it at a lower opportunity cost than other countries – U.S. has a comparative advantage in wheat production over China – Chinahasacomparativeadvantageinshirt production overtheU.S ã Nocountryhasacomparativeadvantagein everything,andeachcountryhasa comparativeadvantageinproducing something â2014byMcGrawHillEducation 18 Why trade? Suppose the U.S. has 150 million workers and China has 800 million • In isolation, each country produces and consumes on its own – The U.S. produces 5 billion shirts and 10 billion bushels of wheat – China produces 10 billion shirts and 20 billion bushels of wheat • If each country specializes by producing the good for which it has a comparative advantage, total production increases Wheat (billions of bushels) Country Without specialization United States 10 China Total 20 10 15 30 United States 30 China Total With specialization T-shirts (billions) 20 20 30 © 2014 by McGraw‐Hill Education 19 Gains from trade The improvement in outcomes that occurs when specialized producers exchange goods and services is called the gains from trade Wheat (M of bu.) 40 United States’ gains from trade Wheat (M of bu.) 40 China’s gains from trade Without trade: Production & consumption 30 Without trade: Production & consumption With trade: Consumption possibilities increases 20 20 With trade: Consumption possibilities increase 10 PPF 7.5 Billions of T-shirts PPF 20 10 12.5 Billions of T-shirts 20 Withspecializedproduction,consumptionisoutside ofthePPF â2014byMcGrawHillEducation 20 Summary ã Specializationandtradecanmakeeveryone betteroff ã Aneconomyisdrivenbyindividualsseekingto makeaprofit;peoplespecializesoastoexploit theircomparativeadvantages ã Thisprincipleisastrueforcountries,likethe UnitedStatesandChina,asitisforindividuals pickingtheircareers â2014byMcGrawHillEducation 21 ... 7.5 Billions of T-shirts PPF 20 10 12.5 Billions of T-shirts 20 Withspecializedproduction,consumptionisoutside ofthePPF â2014byMcGrawHillEducation 20 Summary ã Specialization? ?and? ?trade can make everyone ... whatacountryproducesiswhatitconsumes ã UsingtheunderstandingofPPFs,theanalysis canbeextendedtounderstandhowcountries decidewhattoproduce â2014byMcGrawHillEducation 15 Absoluteandcomparativeadvantage ã Suppose that an American worker can produce 50 shirts ... SupposetheU.S.has150millionworkersandChinahas800million ã Inisolation,eachcountryproducesandconsumesonitsown TheU.S.produces5 billion shirts? ?and? ?10 billion bushels of wheat – China produces 10 billion shirts? ?and? ?20 billion bushels of wheat • If each country specializes