1 Production Possibility Frontier

 The production possibility set is a set that shows all possible

combinations of output that the economy can possibly produce.

These are also known as feasible allocations. Allocations are
infeasible if they are not within the production possibility set.
 The allocations are ecient if you cannot increase the production of one item without reducing the production of other items.
Allocations are inecient if you can.
 The production possibility frontier shows all ecient allocations in the production possibility set.
 The economic growth means that the production possibility
frontier shifts allowing everybody to consume more.

2 Opportunity Cost
 Opportunity cost is how much you give up in terms of other
goods in order to get one good. For example, the opportunity
cost of going to the University of Illinois is the tuition that you
pay (4$20; 000 = $80; 000?) plus your foregone earnings (how
much money you could have been making by working full-time)
(4  $30; 000 = $120; 000?).
 Question: Why are you throwing away $200,000?

3 The Farmer and The Rancher

 Suppose there are only two people in the world: the farmer and

the rancher.
 Suppose they can only produce and consume two goods: meat
and potatoes.
 Suppose that their production technologies are as follows (and
they can produce both goods at a constant rate):

Table 1: How many hours of the farmer and the rancher need to produce one pound of meat
or potatoes.

Meat Potatoes
Farmer 20
10
Rancher 1
8

 Suppose that both work 40 hours in a week:

Table 2: How many pounds of meat and potatoes the farmer and the rancher can produce
in an 40 hours.

Meat Potatoes
Farmer 2
4
Rancher 40
5

 Notice that the rancher has an absolute advantage in producing

both meat and potatoes: she is more ecient in producing both

goods.

 Suppose that given their production technologies, and assuming

that they have no contact with each other, the farmer would like
to consume 2 pounds of potatoes and 1 pound of meat in a week.
The rancher would like to consume 2.5 pounds of potatoes and
20 pounds of meat in a week.
 Question: Is it possible to make either one of them better o?

 Answer: Yes, let them trade as follows.

Table 3: The gains from trade.
Production
0 pounds meat
4 pounds potatoes
Rancher 24 pounds meat
2 pounds potatoes

Farmer

Trade
Consumption
Gains from Trade
Gets 3 pounds meat 3 pounds meat
2 pounds meat
for 1 pound potatoes 3 pounds potatoes 1 pound potatoes
Gives 3 pounds meat 21 pounds meat
1 pound meat
for 1 pound potatoes 3 pounds potatoes 0.5 pound potatoes

 Notice that trade makes both of them better o.

 Question: How can it be the case that trade is benecial for
the rancher even though she is more ecient in producing both
goods?

 Answer: Remember opportunity cost|how much you give up

in terms of other goods in order to get one good|even though

the rancher is more ecient than the farmer in producing both
goods, she is more ecient in producing meat than in producing
potatoes.
 To see this, let's calculate the opportunity costs for both guys.
Table 4: Opportunity costs of producing one pound of one good in terms giving up another
good.

Meat Potatoes
Farmer 2
0.5
Rancher 0.125
8

 Notice that the opportunity cost of producing potatoes is lower

for the farmer and the opportunity cost of producing meat is

lower for the rancher. The economists say the farmer has comparative advantage in producing potatoes and the rancher has
comparative advantage in producig meat.
 In addition, trade is posssible because the opportunity cost of
producing potatoes (8 pounds of meat) is higher for the rancher
than the cost of buying them (3 pounds of meat).

 Question 1: Why doesn't the rancher produce 40 pounds of

meat?
 Question 2: What would happen if the rancher and the farmer
were identical?
 Question 3: What would happen if both of them had exactly the
same opportunity costs?
 Question 4: Okay, now I am confused. How robust is this result,
anyway?
 Question 5: So, is this empirically valid? Do countries trade
because of dierent opportunity costs?

 Answer 1: The farmer could not buy all that meat.

 Answer 2: There would be no incentive to trade.
 Answer 3: There would be no incentive to specialize/trade.
 Answer 4: Remember the rst lesson of economics: Prices are
good. To understand what's going on we have to calculate prices.
Consider the following example:

 If there is no trade, the price of potatoes (in meat) is 1 for the

rancher. Therefore, as long as the price is no more than 1, the

rancher would like to buy potatoes from the farmer. The price
of potatoes (in meat) is 0.5 for the farmer. Therefore, as long as
the price is no less than 0.5, the farmer would like to sell potatoes
to the rancher.
 As long as the producers don't have exactly the same opportunity costs, there are gains from trade.

Table 5: How many hours of the farmer and the rancher need to produce one pound of meat
or potatoes.

Meat Potatoes
Farmer 20
10
Rancher 10
10
Table 6: How many pounds of meat and potatoes the farmer and the rancher can produce
in an 40 hours.

Meat Potatoes
Farmer 2
4
Rancher 4
4
Table 7: Opportunity costs for the farmer and the rancher.

Meat Potatoes
Farmer 2
0.5
Rancher 1
1
Table 8: Prices in meat in for the farmer and the rancher (without trade).

Meat Potatoes
Farmer 1
0.5
Rancher 1
1

 Answer 5: Well, good question. The trade theorists were puzzled

in the early 1970's when they noticed that most trading takes
place between neighboring countries that seem to have very similar strengths and weaknesses (opportunity costs). Why are these
countries trading?
 The answer was provided by so-called \The New Trade Theory."
[The old one was created in the early 19th century by David Ricardo.] Probably the most famous name in this school was Paul
Krugman (currently at Princeton and in the New York Times).
The New Trade Theory took seriously the idea of division of
labor by Adam Smith. According to the New Trade Theory,
countries face increasing returns to scale. It takes time and
other resources to learn to do something, but once you do you
get better and better at it. It then will make sense to specialize.

4 Applications
 Suppose that Michael Jordan can mow his lawn in 2 hours. On

the other hand, in that same hours, he could do make a television

commercial and get paid $10,000. By contrast, her neighbor's
daughter, Jennifer, can mow the lawn in 4 hours or work in
McDonald's for $20. Question: Should Michael Jordan mow his
own lawn?
 Suppose that Juha can wash the dishes in 4 hours or spend that
time by writing a newspaper article for $100. By contrast, her
neighbor's daughter, Jennifer, can wash the dishes in 2 hours or
work in McDonald's for $10. Hence, Juha hires Jennifer for $20
and watches Michael Jordan in TV. Question: Is this allocation
ecient? [HINT: Juha's wife doesn't think so.]