PPF Review Slide #1 What do points A-C have in common? Efficient What do points D & E have in common? Attainable & Inefficient What do points F & G have in common? Unattainable What is the Oppcost moving from C to B 14 Wheat B to C 1 Soybeans D to A 6 Wheat A to E 4 Soybeans PPF Review Slide #2 PPF Review Slide #2 Draw a PPF that shows constant opportunity cost Draw a PPF that shows increasingopportunity cost What causes the difference between the 2 types of PPF? Specialization of inputs 1
Specialization Improves productivity Encourages Trade Lowers cost of goods More variety Trade creates interdependence Ch. 2 Learning Targets (Part 2) I can: explain and distinguish between absolute advantage and comparative advantage for production and exchange; identify countries or individuals which possess comparative advantages and the respective gains from trade (given production possibilities information); Ch. 2 Parts 3-6 Comparative Advantage & Gains from Trade Interdependence occurs because people are better off when they specialize and trade with others. Patterns of production and trade are based upon differences in opportunity costs. 2
Comparative vs. Absolute Advantage comparative advantage: if opportunity cost of producing the good is lower for that individual than for other people. An individual has an absolute advantage in an activity if he or she can do it better than other people. Having an absolute advantage is not the same thing as having a comparative advantage. Absolute advantage: When a person can produce more of a good with the same resources as another person If Kris can produce 15 Christmas cards in the same amount of time that takes Kringleto produce 1, we say that Kris has an absolute advantage in the production of Christmas cards Two Types of Comparative Advantage Situations Time as the variable How long it takes to produce an item Mike can produce 1 widgets in 15 minutes Fred can produce 1 widgets in 2 minutes Hint: TOT: Time on Top Units as the variable How many can be produced Mike can produce 25 gadgets a day Fred can produce 5 gadgets a day Hint UU = Units Under 3
Example Labor Hours needed to produce a unit of: Country Wheat Cloth Portugal 1 2 England 2 6 Who has absolute advantage in Wheat? In Cloth? Who has the absolute advantage in wheat? 2 hours Portugal 2 hours England Wheat 1 hours Wheat Cloth? 2 hours 6 hours Cloth 6 hours Cloth Should Portugal engage in trade with England? Yes Trade can be win-win because voluntary trade is based on comparative advantage. 4
Given any two products, a person has a comparative advantage in the product with the lower opportunity cost. Two Types of Comparative Advantage Situations Time as the variable How long it takes to produce an item Mike can produce 1 widgets in 15 minutes Fred can produce 1 widgets in 2 minutes Hint: TOT: Time on Top Units as the variable How many can be produced Mike can produce 25 gadgets a day Fred can produce 5 gadgets a day Hint UU = Units Under How many UNITS can be produced in an hour Fish Tom 15 5 Hank 1 2 Coconuts Hint UU = Units Under Tom: For every fish he catches he must give up 5/15= (1/3 )coconuts Hank: For every fish he catches he must give up 2/1= (2) coconuts Therefore Tom should catch fish because he has the lowest O.C. Tom: For every coconut he gets he give up 15/5= (3) fish Hank: For every coconut he get he gives up 1/2= (1/2) fish Therefore Hank should collect coconuts since he has the lowest O.C. 5
Production Possibilities for Two Castaways Quantity of coconuts (a) Tom s Production Possibilities 3 Tom s consumption without trade 9 Tom s PPF 28 4 Quantity of fish Production Possibilities for Two Castaways Quantity of coconuts (a) Hank s Production Possibilities 2 Hank s consumption without trade 8 Hank s PPF 6 1 Quantity of fish Tom and Hank s Opportunity Costs Tom s Opportunity Cost Hank s Opportunity Cost One fish 3/4 coconut 2 coconuts One coconut 4/3 fish 1/2 fish 6
Specialize and Trade Both castaways are better off when they each specialize in what they are good at and trade. It s a good idea for Tom to catch the fish for both of them, because his opportunity cost of a fish in terms of coconuts not gathered is only 3/4 of a coconut, versus 2 coconuts for Hank. Correspondingly, it s a good idea for Hank to gather coconuts for the both of them. Comparative Advantage and Gains from Trade (a) Tom s Production and Consumption (b) Hank s Production and Consumption Quantity of coconuts Quantity of coconuts 3 Tom s consumption without trade Tom s consumption 2 Hank s production Hank s consumption 1 9 Tom s production Tom's PPF 1 8 283 4 Quantity of fish 6 1 Hank s consumption without trade Hank's PPF Quantity of fish Tom vs. Hank Absolute vs. Comparative Tom has an absolute advantage in both activities: he can produce more output with a given amount of input (in this case, his time) than Hank. But we ve just seen that Tom can indeed benefit from a deal with Hank because comparative, not absolute, advantage is the basis for mutual gain. So Hank, despite his absolute disadvantage, even in coconuts, has a comparative advantage in coconut gathering. Meanwhile Tom, who can use his time better by catching fish, has a comparative disadvantage in coconut-gathering. 7
Comparative Advantage and International Trade (a) The U.S. Production Possibilities Frontier Quantity of aircraft (b) Canadian Production Possibilities Frontier Quantity of aircraft 1,5 1, U.S. consumption without trade U.S. consumption U.S. production U.S. PPF 1 2 3 Quantity of pork (millions of tons) 3, 2, 1,5 Canadian production Canadian consumption without trade Canadian consumption Canadian PPF.5 1 1.5 Quantity of pork (millions of tons) Two Types of Comparative Advantage Situations Time as the variable How long it takes to produce an item Mike can produce 1 widgets in 15 minutes Fred can produce 1 widgets in 2 minutes Hint: TOT: Time on Top Units as the variable How many can be produced Mike can produce 25 gadgets a day Fred can produce 5 gadgets a day Hint UU = Units Under How many hours (TIME) it takes to produce a unit of Country Wheat Cloth Portugal 1 2 England 2 6 Hint: TOT Time on Top Portugal O.C. Wheat? 1/2 Cloth (1/2) O.C. Cloth? 2 Wheat (2/1) England O.C. Wheat? 1/3 Cloth (2/6) O.C. Cloth? 3 Wheat (6/2) Portugal has the lower o.c. in cloth production (2 units of wheat), and England has the lower o.c. in wheat (1/3 unit of cloth) If each country produced only the good in which it held a comparative advantage and traded for the other product, then both countries could consume more of both goods. 8
Misunderstanding Comparative Advantage A common mistake is to confuse comparative advantage with absolute advantage. Ex.: U.S. vs. Japan in 198s: Commentators: U.S. might soon have no comparative advantage in anything Wrong! They meant absolute advantage Practice? From AP Exam A farmer in Country A can harvest 2 bushels of wheat or 1 bushels of corn in a day, while a farmer in Country B can harvest 8 bushels of wheat or 8 bushels of corn in a day. If Country A and Country B specialize and trade, Country A will: A. export wheat and import corn B. export corn and import wheat C. export both wheat and corn D. import both wheat and corn E. benefit more from trade than will Country B Wheat: OppCost for A=1/2 Corn Opp Cost B= 1 corn Corn: Opp Cost for A= 2 Wheat OppCost B= 1 Wheat Ch. 2 Parts 3-6 3) Comparative Advantage & Gains from Trade 4) Circular Flow Diagram 9
Transactions: The Circular-Flow Diagram Trade takes the form of barter when people directly exchange goods or services they have for goods or services they want. The circular-flow diagram is a model that represents the transactions in an economy by flows around a circle. Circular-Flow of Economic Activities A household is a person or a group of people that share their income. A firm is an organization that produces goods and services for sale. Firms sell goods and services that they produce to households in markets for goods and services. Firms buy the resources they need to produce factors of production in factor markets. Circular Flow of a Market Economy Factor Market Households sell. Firms buy. Land, Labor, & Capital Finished Products Product Market Firms sell. Households buy. 1
Ch. 2 Parts 3-6 3) Comparative Advantage & Gains from Trade 4) Circular Flow Diagram 5) Positive v. Normative Economics 6)Why Economists Disagree POSITIVE VERSUS NORMATIVE ANALYSIS Positive statementsare statements that attempt to describe the world as it is. Fact Normative statementsare statements about how the world should be. Opinion A forecast is a simple prediction of the future. POSITIVE VERSUS NORMATIVE ANALYSIS Positive or Normative Statements? An increase in the minimum wage will cause a decrease in employment among the least-skilled. POSITIVE?? State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. NORMATIVE? 11
POSITIVE VERSUS NORMATIVE ANALYSIS Positive or Normative Statements? The income gains from a higher minimum wage are worth more than any slight reductions in employment. NORMATIVE?? Single mothers are more than twice as likely as married mothers to be in poverty. POSITIVE? Using Models Economists can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments. The exceptions are when policies designed to achieve a certain prescription can be clearly ranked in terms of efficiency. It is important to understand that economists don t use complex models to show how clever they are, but rather because they are not clever enough to analyze the real world as it is. When and Why Economists Disagree There are two main reasons economists disagree: Which simplifications to make in a model Values 12
Ch. 2 Learning Targets (Part 2) I can: explain and distinguish between absolute advantage and comparative advantage for production and exchange; identify countries or individuals which possess comparative advantages and the respective gains from trade (given production possibilities information); 13