Introduction:

Thinking Like an Economist 1

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
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Chapter Goals

 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
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Economic Systems
The U.S. economy is a market economy, which is an
economic system based on private property and the markets
in which, in principle, individuals decide how, what, and for
whom to produce
• Markets work through a system of rewards and payments
• Individuals are free to do whatever they want as long as
it is legal
• Fluctuations in prices play a central role in coordinating
individuals’ wants in a market economy
Most economists believe the market
is a good way to coordinate economic activity
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Capitalism and Socialism

 Capitalism is an economic system based on the
market in which the ownership of the means of
production resides with a small group of individuals
(called capitalists)

 Socialism is an economic system based on

individuals’ goodwill towards others, not on their
own self-interest, and in which, in principle, society
decides what, how, and for whom to produce
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Capitalism and Socialism

Socialism
 Is where all people contribute what they can and get
what they need
 Is based on government ownership of the means of
production with economic activity governed by central
planning
 China and Venezuela are often identified as socialistic
in the news

People today talk little about differences in economic systems;

instead they talk about differences in institutions
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Economic Institutions in a Market Economy

GOODS
MARKET

INTERNATIONAL INTERNATIONAL
CONNECTION CONNECTION

GOVERNMENT BUSINESS
HOUSEHOLDS
(Consumption) (Production)

FACTOR
MARKET
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The Production Possibilities Model

 The production possibilities model can be presented
both in a table and in a graph

 A production possibility table is a table that lists the

trade-offs between two choices

• An output is a result of an activity

• An input is what you put in a production
process to achieve an output
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Application: A Production Possibilities Table

History Economics
Hrs of Study Grade Hrs of Study Grade
20 98% 0 40%
18 94% 2 46%
10 78% 10 70% What is the
4 66% 16 88% output?
0 58% 20 100%

What is the
input?
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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 gives you a visual picture of the tradeoff
embodied in a decision
• A PPC is created from a production possibility
table by mapping the table in a two-dimensional
graph
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Application: A Production Possibilities Curve

Econ Grade
100 A PPC demonstrates:
16 hrs for Econ and
4 hrs for History • There is a limit to what you
88
can achieve, given existing
10 hrs for each institutions, resources, and
70 History and Econ technology
• Every choice you make has
PPC an opportunity cost

40
58 66 78 100 History grade
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Increasing Opportunity Costs of the Trade-off

The principle of increasing marginal opportunity
Butter
cost tells us 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
B
opportunity cost to produce more guns
Guns
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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
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Efficiency
Productive efficiency is achieving as
Butter
much output as possible from a given
amount of inputs or resources
A
• • Points of efficiency
•D • Unattainable with given
amounts of inputs
•C • Point of inefficiency

•B
Guns
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Efficiency and Technological Change

Neutral technological increase Biased
or an increase in resources technological increase
A A

B B
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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 our society, most people prefer more to less, and

many policies have relatively small distribution effects
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Trade and Comparative Advantage

 The PPC is bowed outward 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, humankind’s proclivity to

trade leads to individuals using their comparative
advantage
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Markets, Specialization, and Growth

• Growth in per capita income during the past 2000 years
$6,000

Income $5,000

$4,000

$3,000

$2,000

$1,000

Year
0 500 1000 1500 2020

• What caused this growth?

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The Benefits from Trade

• When people freely enter into trade, both parties can be
expected to benefit from trade
Textiles (yds)

5,000 Without trade, each

country can only consume
4,000 those combinations of
Pakistan goods along their PPCs
3,000

2,000 Belgium
1,000

1 2 3 4 5 Chocolate (tons)
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The Benefits from Trade

Textiles (yds) If each country specializes according to

comparative advantage and trades,
5,000 they can consume beyond
their “no-trade” PPCs
4,000

3,000 Pakistan Consumption Why should Pakistan

with trade
specialize in textiles
2,000 • Belgium and Belgium specialize
in chocolates?
1,000

1 2 3 4 5 Chocolate (tons)
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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 or cotton production

expertise (such as Pakistan, Bangladesh, etc.) have the
comparative advantage in textiles

 The gains from trade are higher wages for workers in

Pakistan, Bangladesh, etc. and lower-priced cloth for
U.S. consumers
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Globalization and the Law of One Price

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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Globalization and the Law of One Price

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

 Exchange rates and costs of production as automatic

stabilizers.
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Globalization and the Law of One Price

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
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Chapter Summary
 The production possibility curve illustrates maximum
outputs from a given number of inputs
 To get increasing amounts of something, we must give
up ever-increasing quantities of something else
 Trade allows people to use their comparative
advantage and shift out society’s PPC
 Efficient, inefficient, and unattainable points on the PPC
 Through specialization and trade, countries can increase
consumption
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Chapter Summary
 Globalization is the increasing integration of economies,
cultures, and institutions across the world
 High Income countries can maintain their strong
comparative advantage using new technologies and
innovation, replacing low paying jobs with other high-
paying jobs
 Production shifts to countries where it is cheapest to
produce is guided by the law of one price