Production Possibility Frontier

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Production Possibility Frontier
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The Production Possibilities Frontier

• Lets introduce the Production Possibilities
  Frontier
• better known as the PPF.
• The PPF is a basic workhorse in economics.
• Important for understanding some basic issues in
  economics.

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The PPF

• Great application is with international trade
  theory.
• Helps one understand and distinguish between
  comparative advantage and absolute advantage.
• An important historical figure in all this is
  David Ricardo.

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David Ricardo

• Famous 19th century British economist.
• Some consider him the grandfather of
  international trade theory.
• Very influential in pioneering the theory of
  comparative advantage, inter alia.
• Very interesting, very bright guy.
• Had a lot of say about the corn laws in England.

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The Production Possibility Frontier - What Is It?

• The description of the best possible combinations
  of two goods to produce using all of the
  available resources.
• Shows the trade-off between more of one good in
  terms of the other.
• Assumes input endowments given, technology
  given, time given and efficient production.

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Opportunity Cost

• The opportunity cost of an activity is the value
  of the resources used in that activity when they
  are measured by what they would have produced
  when used in their next best alternative.
• The slope of the Production Possibility Frontier
  measures the marginal opportunity cost of
  producing one good in terms of the amount of the
  other good foregone.

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A Typical PPF Picture
The marginal opportunity cost of guns in terms
of butter is increasing as we move down the
PPF! The PPF is typically bowed-out or linear. It
is not bowed-in
Butter
unattainable
just attainable
inefficient
just attainable
Guns
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Comparative Advantage

• The person with the lower marginal opportunity
  cost of an activity has the comparative advantage
  at that activity.
• This means that the person with the comparative
  advantage can produce the activity by giving up
  the smallest amount of the alternative activity.

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The Idea of Comparative Advantage and Trade

• Specialization and free trade will benefit all
  trading parties, even when some are absolutely
  more efficient producers than others.
• Need to understand absolute vs. comparative
  advantage.

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Absolute vs. Comparative Advantage Applied to
Trade

• Absolute advantage if your country uses fewer
  resources to produce a given unit of output than
  the other country.
• Comparative advantage if your country can
  produce the output at a lower marginal cost in
  terms of other goods foregone than the other
  country.
• Every country (or person, or economy) has a
  comparative advantage at some activity.
• Absolute advantage is not important and may not
  always happen. Sometimes people or countries
  have the absolute advantage in nothing! Yet
  trade possibilities still exist.
• Its all about comparative advantage.

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PPFs and Comparative Advantage

• In this example, there are two goods being
  produced Corn meal and RAM.
• Juanita has an absolute advantage at both she
  can produce more of each than Julio.
• Juanita has a comparative advantage at producing
  RAM compared to Julio she gives up 3.00 kg/day
  of corn meal to make an additional 1k of chips.
• Julio has a comparative advantage at producing
  corn meal compared to Juanita he gives up 0.25 k
  chips to make an additional kg of corn meal.

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Production Possibilities

• When we draw the production possibilities for
  Juanita and Julio, there is a kink at 8 kg/day
  corn meal and 4.00 k chips/day RAM.
• The chart shows who specializes in corn meal and
  RAM at each production level.

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Adding a Third Producer

• Sergio has no absolute advantage however, he has
  a comparative advantage over both Juanita and
  Julio in the production of RAM.
• He sacrifices 2.00 kg of corn meal to make an
  additional 1k of chips.

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Adding a Fourth Producer

• Question What is Marias comparative advantage
  with respect to each of the other three producers?

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Comparative Advantage and Specialization

• As more and more producers enter the economy, the
  production possibility curve gets more and more
  bowed out (concave).
• Along any segment, most of the producers are
  fully specialized.
• Only one producer is producing both goods along
  any segment.

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The Supply Curve from the PPF

• At each relative price of RAM in terms of
  foregone corn meal, we can determine the market
  supply
• The table shows how much is supplied and who is
  producing.

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The Supply Curve for RAM
Maria
Julio
Juanita
Sergio

• The graph shows the supply curve for RAM based on
  the data in the previous table. Each additional
  supplier is shown above the segment where that
  supplier determines the relative price.

• The supply curve of RAM is rising, reflecting the
  increasing opportunity cost (also called marginal
  cost) of RAM in terms of foregone corn meal.

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Supply Curve for Corn Meal

• Do the exact same thing...
• But in reverse!

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Supply Curve for Corn Meal Graph
Sergio
Juanita
Julio
Maria

• The supply curve for corn meal is shown above.
• The new producer along each segment is indicated
  above.

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International Trade

• All the facts are the same as in the previous
  example except that now we are talking about
  countries that can trade at an international
  price.
• The international price is between the relative
  prices that prevail in each country when no trade
  is permitted.
• There are many countries in the market in
  addition to the two shown so that a country can
  buy or sell as much as it wants or produces at
  the international price.

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Country Us Production and Gains from Trade

• Country U has a comparative advantage in RAM
  production.
• The blue line shows its production possibilities
  without trade. Slope 0.33.
• The red line shows the possibilities at the
  international price of 0.29 k chips per kg corn
  (or 3.50 kg corn/ k chips RAM). Slope 0.29.
• The gain to trade is the distance between the two
  production possibility curves.

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Country Ms Production and Gains from Trade

• Country M has a comparative advantage in corn
  meal production.
• The blue line shows its production possibilities
  without trade. Slope 0.25.
• The red line shows the possibilities at the
  international price of 0.29 k chips/ kg corn (or
  3.50 kg corn/ k chips RAM). Slope 0.29.
• The gain to trade is the distance between the two
  production possibility curves.

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Question

• If country U chooses to consume 7 kg/day of corn
  meal, what is the gain to trade from specializing
  in RAM production, measured in k chips/day of
  RAM?

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Answer

• The vertical distance between the blue and red
  PPFs at a corn meal consumption of 7 kg/day
  measures country Us gain to trade in k chips
  RAM/day.
• The point on the blue PPF is the best country U
  can do without trade.
• With trade country U can consume more RAM per
  day, up to the point on the red PPF.

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Question

• What is country Ms gain if it chooses to consume
  1.5 k chips per day, measured in kg/day of corn
  meal?

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Answer

• The horizontal distance between the red and blue
  PPFs measures country Ms gain to trade at a RAM
  consumption of 1.5 k chips/day.
• The blue PPF is the best that country M can do
  without trade.
• Trade allows country M to specialize in the
  production of corn meal and still benefit from a
  higher consumption of RAM.

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The International Supply Curve for RAM

• The international supply curve for RAM is a
  rising function of the opportunity cost of RAM in
  terms of foregone corn meal.
• Which countries actually produce RAM for the
  international market will depend upon where the
  demand curve crosses this supply curve.

Demand
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The Sources ofComparative Advantage

• The Heckscher-Ohlin Theorem is a theory that
  explains the existence of a countrys comparative
  advantage by its factor endowments.
• Factor endowments the quantity and quality of
  labor, land, and natural resources of a country.
• From Sweden in the early 1900s
• According to the H-O theorem, a country has a
  comparative advantage in the production of a
  product if that country is relatively well
  endowed with inputs used intensively in the
  production of that product.

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The Sources ofComparative Advantage

• Edward Leamer of UCLAs five biggies
• Natural resources
• Knowledge capital
• Physical capital
• Land
• Skilled and unskilled labor

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Other Explanations forObserved Trade Flows

• Product differentiation and competitive markets
• Acquired comparative advantage
• Natural comparative advantages
• Economies of scale
• Trading Environments
• Openness of Economy

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Note of Caution

• Information on comparative advantage is often
  given in many other forms - pay careful attention
  to the information you are given.
• Two more ways to present the same kind of
  information

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Absolute Advantage and Comparative Advantage

• Portugal has the A.A. in both wine and cloth.
• England has the C.A. in cloth.
• Portugal has the C.A. in wine.
• Can you figure out the marginal opportunity cost
  for each output in each country?

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From Opportunity Cost to Marginal Cost

• The concept of marginal cost is the most
  important concept in the theory of producer
  supply behavior.
• Marginal cost is the additional cost associated
  with increasing production by one unit.
• In our production possibility examples, marginal
  cost is the value of the activity that is reduced
  when the other activity is increased by one unit.
• Marginal cost is, therefore, the same thing as
  marginal opportunity cost.

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PPF Gymnastics

• The PPF is also useful for many other types of
  questions.
• Questions about efficiency.
• Questions about equity.
• Questions about tax and transfer policy.
• Questions about composition of output.
• Questions about growth and productivity.

Butter
PPF new
PPF old
Guns