Section 2

Production Possibility Frontier

& Trade

Chapter 2: pages 32-60

KEY DEFINITIONS

Production possibilities frontier is a curve showing the maximum attainable combinations of two products that may be produced with available resources.

Opportunity Cost The highest-valued alternative that must be given up in order to engage in an activity.

Practice Problem 2-1 (on your own). Highly Recommended!

Constant opportunity cost PPFs vs. Increasing opportunity cost PPFs

Increasing Marginal Opportunity Costs

500

Economic Growth

Economic Growth

Assumptions

Let’s assume there are two products (Apples and cherry).

There are two persons in our small society now: you and your neighbor.

To be or not to be...

To be self-sufficient and produce everything we need

OR To cooperate with others - TRADE

The benefit of trade is pretty obvious if you only have apple trees and your neighbor only has cherry.

Furthermore, the benefit of trade also seems obvious if you are much better in picking apples and your neighbor is better in picking cherry.

In this case you should SPRECIALIZE in apple production and your neighbor should SPECILIZE in cherry production.

And you should TRADE

But what happens if one of you is much better in picking both apples and cherry?

Your Production and Consumption Possibilities without TRADE

Your neighbor’s Production and Consumption possibilities

Without Trade

Opportunity cost of picking

1 pound of apples

Opportunity cost of picking 1

pound of cherries

You 1 pound of cherries

1 pound of apples

Your neighbor

2 pounds of cherries

.5 pound of apples

Absolute vs. Comparative Advantage

Absolute advantage The ability of an individual, firm, or country to produce more of a good or service than competitors using the same amount of resources.

Comparative advantage The ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than other producers.

TRADE

You should specialize in whatever you have comparative advantage in.

The Principle of Comparative Advantage

Comparative advantage and differences in opportunity costs are the basis for specialized production and trade.

Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

Practice

Solved Problem 2-2 on your own (Highly recommended!)

Should the United States trade with other countries?

As we all know Americans enjoy a lot of goods produced by other countries.

Imports: goods produced abroad and sold domestically.

Exports: goods produced domestically and sold abroad.

The Circular-Flow Diagram

Firms Households

Market for Factors

of Production

Market for Goods

and Services

SpendingRevenue

Wages, rent, and

profit

Income

Goods & Services

sold

Goods & Services bought

Labor, land, and capital

Inputs for production