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ECO1000EconomicsSemester One, 2004
Lecture Two
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Outline or Plan of Today’s Lecture Material Covered: Module
One, Part Two Reading: Chapter 3 of the
Text and Chapter 3 of the Study Guide (Hakes and Parry)
Topics Considered: Interdependence and Gains From Trade
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Objectives of Today’s Lecture You will learn about:
The benefits of trade Absolute and comparative advantage How comparative advantage explains the
benefits of trade How comparative advantage and trade applies to
your daily lives and your nation’s policies
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Relevant Economic Principles The cost of something is what you give up
to get it Trade can make everyone better off
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How do we satisfy our wants and needs? We can be economically self-
sufficient; or We can specialise and trade with
others, leading to economic interdependence.
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The Production Possibilities Frontier
A Model of Production Capacity
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The Production Possibility Frontier A representation of two choices of
production based on full utilisation of known resources
All points within the PPF are also combinations of production of goods
Illustrates opportunity cost movement along the frontier means giving up
production of one to gain production in another
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Building the Model Start with individual behaviour & capacity
‘Robinson Crusoe’ economics
Add more people to the model Used to illustrate a general tendency, not
detailed reality Assume the principles are still valid in a
complex society
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Scenario One person (George) on an island Only producing two goods
Food & cloth
Limited by: Physical capacity Skill
Trade-off between the 2 goods
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George’s production possibilities in relation to food & cloth
Food (kgs/wk)
Cloth (m/wk)
10 & 0
or
8 & 3
or
6 & 6
or
4 & 9
or
2 & 12
or
0 & 15
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Graphing George’s PPF
Food(Kgs/wk)
Cloth (m/wk)
8
10
6
3 6 9 15
4
*
*
*
Point A
Point B
Point C
*
*
Point D
Point E
0
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Principles of a PPF
Food(Kgs/wk)
Cloth (m/wk)
8
10
6
3 6 9 15
4
**
Point A: possible but can produce more
Point B: At full capacity*Point C: Not possible under current conditions
02
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Shifting along the PPF
Food(Kgs/wk)
Cloth (m/wk)
8
10
6
3 6 9 15
4
Give up 2 kgs of food
Give up 2 kgs of food
Give up 2 kgs of food
Gain 3 m of cloth
Gain 3 m of cloth
Gain 3 m of cloth
**
*
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Calculating opportunity cost George gives up 2 kgs of food/wk to gain 3
m of cloth/wk Converting this to single units, each extra
metre of cloth ‘costs’ 2/3 (0.66) kgs of food Therefore, the opportunity cost of
increasing cloth production by 1 m/wk = 0.66 kgs/wk of food
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Points to note
George could gather 10 kgs/wk of food and make no cloth or make 15 m of cloth and gather no food
NB. There is always a time factor per/day, per/wk, per month etc
It is likely that opportunity cost will vary, usually increasing with any shift of resources
This is based on constant opportunity cost
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John’s PPF
Food 12 9 6 3 0 Cloth 0 3 6 9 12
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Comparing PPFsFood
(Kgs/wk)
Cloth (m/wk)
9
6
3 6 9 15
3
12
12
John
George
*
*
*
*
*
Gives up 3 kgs/wk
Gains 3 m/wk
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Comparing the Cost of Food: John’s Absolute Advantage
Absolute advantage is a term used when comparing productivity.
In our example, John has an absolute advantage in producing food because he requires less time than George to produce a unit of this good.
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Another Way of Comparing Costs: Opportunity Cost and Comparative Advantage John’s opportunity cost of producing cloth:
John gives up 3 kgs of food/wk to gain 3 m of cloth/wk
Opportunity cost for 1 m/wk of cloth = 1 kg of food/wk Compared with George’s opportunity cost of 0.66 kg
of food/wk George has a lower opportunity cost than John for
the production of cloth (he gives up less food) John has a lower opportunity cost than George for
the production of food (he gives up less cloth) WORK IT OUT!
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Comparative Advantage
The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.
George has a comparative advantage in cloth production and John has a comparative advantage in food production
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Comparative Advantage and Specialisation George could specialise in cloth production
(where he has a comparative advantage) and John could specialise in food production (where he has a comparative advantage)
The result of specialisation is a greater total production of both goods
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The logic of specialisationFood
(Kgs/wk)
Cloth (m/wk)
9
6
3 6 9 15
3
12
12
Maximum combined production
john
george
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George & John Trade… George specialises in cloth production and
produces 15 m/wk John specialises in food production and
produces 12 kgs/wk John eats 6 kgs of food and trades the
other 6 kgs for 8 m of cloth He ends up with 6 kgs of food and 8 m of cloth
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John’s Consumption PossibilitiesFood
(Kgs/wk)
Cloth (m/wk)
9
6
3 6 9 15
3
12
12
* *
The PPF (does not change)
Consumption with trade
8
Consumption without trade
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George’s Situation With Trade George uses 7 m of cloth and trades the
other 8 m for 6 kgs of food. George ends up with 7 m of cloth and 6 kgs
of food.
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George’s Consumption PossibilitiesFood
(Kgs/wk)
Cloth (m/wk)
9
6
3 6 9 15
3
12
12
Consumption with trade
* *
PPF (does not change)
7
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Points to Note
Interdependence and trade can allow people to enjoy a greater quantity and variety of goods and services.
The person who can produce a good with a smaller quantity of inputs has an absolute advantage.
The person with a smaller opportunity cost has a comparative advantage.
The gains from trade are based on comparative advantage, not absolute advantage.
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National Production Possibilities
Applying the Same Principles to National Economies
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A National PPF
Information gigabytes/yr
Textilescu m/yr
750,000
1 m
500,000
8 m4 m 16 m
*Assume full use of resources
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Points to note Country produces either textiles or
information At 750,000 gb/yr & 4 m cu metres/yr, an
increase of 4 m cu metres will mean giving up 250,000 gb/yr Opp cost of 4 m cu m. = 250,000 gb of info. Opp cost of 1 cu m = 0.0625 gb of info
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A Positive Change in the PPF
Information gigabytes/yr
Textilescu m/yr
* NB: It is a change in potential production
Increase in population, discovery of new resources, invention of new technology, higher education
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A Negative Change in the PPF
Information gigabytes/yr
Textilescu m/yr
* NB: It is a change in potential production
Decrease in population, depletion of resources, environmental degradation, natural disaster, human disaster
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A Positive Change in Textile TechnologyInformation gigabytes/yr
Textilescu m/yr
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Changes within the PPF
Information gigabytes/yr
Textilescu m/yr
*
*
There has been no change in population, resources or technology, but there has been a change in policy or work practices
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The Impact of Policy
Information gigabytes/yr
Textilescu m/yr
750,000
1 m
500,000
5m 6.5 m16 m
*
*
1. Government cuts assistance to industry
2. Resources shift to another industry and production moves closer to PPF. (Greater efficiency)
*This is a more realistic situation.There is not full use of all resources.
Initial production
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Towards PPF & Away from PPF More efficient use of
resources Low unemployment Change in government
policy
Less efficient use of resources
High unemployment Change in government
policy Political favours for
some inefficient sectors of groups
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An Example of Production Without Trade
12
11
10
9
8
7
6
5
4
3
2
1
0
Televisionsmillion/yr
0 2 4 6 8 10 12 13 14 16 18 20 22Wheat million tonnes/yr
Japan
Australia
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Opportunity Costs Japan can either produce 1 tonne of wheat
or 1 TV. Opp Cost of 1 t. of wheat = 1 TV Australia can produce 1 TV or 3 tonnes of
wheat. Opp cost of 1 TV = 3 tonnes of wheat
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Japan Australia
1 TV 1 tonne of Wheat
1 tonne of Wheat
1 TV
1 tonne of wheat
1 TV 0.33 TVs 3 tonnes of wheat
Opportunity Costs Compared
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The Development of Trade Japan wants to get wheat cheaper than
at a cost of 1 TV/tonne if possible Australia wants to get TVs cheaper than
at a cost of 3 tonnes of wheat/TV if possible
Suppose they agree to specialise and trade
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New Consumption Possibility with trade
12
11
10
9
8
7
6
5
4
3
2
1
0
Televisionsmillion/yr
0 2 4 6 8 10 12 13 14 16 18 20 22Wheat million tonnes/yr
Australia’s PPF**
Australia produces 16 million tonnes of wheat, keeps 7 million tonnes and trades 9 million tonnes for 5 million televisions.
Australia’s consumption with trade
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New Consumption Possibility with trade
12
11
10
9
8
7
6
5
4
3
2
1
0
Televisionsmillion/yr
0 2 4 6 8 10 12 13 14 16 18 20 22Wheat million tonnes/yr
Japan produces 10 million TVs, keeps 5 million and trades the other 5 million for 9 million tonnes of wheat
* *
Japan’s PPF
Japan’s consumption with trade
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Points to note The PPF (production) cannot increase,
but consumption can It just shows the potential for an increase
in goods and services No country fully specialises However, this idea is the basis for free
trade arguments
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Conclusions
Lower opportunity cost creates the conditions for benefits from exchange
In the absence of other impediments & costs, countries will increase possible consumption through trade
This is true even where one country has an absolute advantage over another
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Next Week Next week’s lecture:
Material: Module Two, Part One Reading: Text Chapter Four plus Hakes and
Parry Chapter Four Topics: Supply and Demand
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THE END