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Chapter 2
TRADE, TRADE-OFFS,
AND GOVERNMENT POLICY
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
2-2
Today’s lecture will:
• Demonstrate opportunity costs with
•
•
a production possibilities curve.
Relate the concept of comparative
advantage to the production
possibilities curve.
Discuss the principle of increasing
marginal opportunity cost.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
2-3
Today’s lecture will:
• Show how comparative advantage and
•
•
•
trade can allow countries to consume
beyond their production possibilities.
Discuss the six roles of government.
Explain how outsourcing is part of a
global process guided by the law of one
price.
Compare the regulation of international
markets to the regulation of domestic
markets.
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2-4
The Production
Possibilities Model
• A production possibilities curve
•
illustrates opportunity cost by
showing trade-offs among choices
we make.
It measures the maximum number of
outputs that can be achieved from a
given number of inputs.
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2-5
A Production Possibilities
Curve for an Individual
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History grade
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2-6
The Production Possibility
Curve for an Individual
• The production possibilities curve
demonstrates that:
 There is a limit to what you can achieve,
given the existing institutions,
resources, and technology
 Every choice made has an opportunity
cost – you can get more of something
only by giving up something else.
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2-7
Production Possibility
Curve for a Society
• The production possibility curve (PPC)
•
is bowed outward showing that
opportunity costs increase as more of
one good is produced.
Opportunity costs increase because of
comparative advantage – some
resources are better suited for the
production of some goods than others.
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2-8
A Production Possibilities
Table for Society
% of resources
% of resources
devoted to
devoted to
production
production Pounds
Number
of guns
of butter
of butter Row
of guns
0
20
40
60
80
100
McGraw-Hill/Irwin
0
4
7
9
11
12
100
80
60
40
20
0
15
14
12
9
5
0
A
B
C
D
E
F
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
2-9
PPC for Society
Butter
1 pound 15 A
of butter
14
2 pounds
of butter 12
B
C
D
9
5
E
5 pounds
of butter
0
4
4 guns
McGraw-Hill/Irwin
7
3 guns
9
F
11 12 Guns
1 gun
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2-10
Increasing Marginal
Opportunity Cost
A
Slope is flat at A. Low
opportunity cost of guns.
The principle of increasing marginal
opportunity cost states that opportunity costs
increase as you produce more of one product.
Slope is steep at B. High
opportunity cost of guns.
B
Guns
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2-11
Efficiency and Inefficiency
• Productive efficiency – achieving as
•
•
much output as possible from a given
amount of resources – occurs at any
point on the PPC.
Any point within the PPC represents
inefficiency.
Any point outside the PPC is
unattainable, given present resources
and technology.
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2-12
Efficiency and Inefficiency
Unattainable point,
given available technology,
resources and labor force
10
Guns
8
6
0
Inefficient
point
2
4
D
B
4
2
McGraw-Hill/Irwin
C
Efficient
points
A
6
Butter
8
10
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2-13
Shifts in the PPC
• Society can produce more output if:
 Technology is improved,
 More resources are discovered.
 Economic institutions get better at
fulfilling our wants.
• More output is represented by an
outward shift in the PPC.
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2-14
Shifts in the PPC
Neutral Technological Change
Biased Technological Change
Butter
C
C
B
A
0
Guns
McGraw-Hill/Irwin
B
D
0
Guns
A
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2-15
Distribution and Production
Efficiency
• The PPC focuses on productive
•
efficiency and ignores distribution.
In our society, more is generally
preferred to less and many policies
have relatively small distributional
effects.
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2-16
Trade and Comparative Advantage
• The PPC is bowed because individuals
•
•
specialize in the production of goods for which
they have a comparative advantage and trade
with others.
For a society to produce on its PPC, individuals
must produce those goods for which they have
a comparative advantage.
According to Adam Smith, humankind’s
proclivity to trade leads to individuals using
their comparative advantage.
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2-17
Markets, Specialization,
and Growth
• The growth in per capita income in the
•
•
past 200 years is due mainly to markets
and democracy.
Markets allow specialization, leading to
trade and growth.
As people compete and specialize, they
get better at what they do, develop new
technologies, and the market grows
larger.
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2-18
Per capita income
(in 1990 international dollars)
Growth in the Past Two Millennia
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
0
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500
1000
1500
2010
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2-19
Gains from Trade
• Suppose Pakistan has a comparative
•
•
advantage in producing fabric and Belgium
has a comparative advantage in producing
chocolate.
Pakistan can produce either 4,000 yards of
fabric, 1 ton of chocolate, or any proportional
combination of the two.
Belgium can produce either 1,000 yards of
fabric, 4 tons of chocolate or any proportional
combination of the two.
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2-20
Textiles
(in thousands of yards)
Gains from Trade
If they don’t trade they can only have
a combination of goods along their
PPCs. For example, Pakistan could
produce and consume 2000 yards of
fabric and 0.5 tons of chocolate (point
A) and Belgium could produce and
consume 500 yards of fabric and 2
tons of chocolate (point B).
5
4 D
Pakistan
3
2
A
1
Belgium
B
E
1
2
3
Chocolate (in tons)
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2-21
Textiles
(in thousands of yards)
Gains from Trade
If instead, Pakistan specializes in what it
does best (produce fabric) and Belgium
specializes in what it does best (produce
chocolate) and trade with each other, each
country can consume more of each good.
They can consume 2,000 tons of fabric and
2 tons of chocolate (point C).
5
4 D
Pakistan
3
2
A
1
C
Belgium
B
E
1
2
3
Chocolate (in tons)
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2-22
Textiles
(in thousands of yards)
Summary of Trade
For Pakistan the opportunity cost of one ton of chocolate
is 4000 yards of textiles.
5
4 D
3
2
A
1
For Belgium the opportunity cost of one ton of chocolate
is 250 yards of textiles.
Belgium has the comparative advantage in chocolate
and specializes producing 4 tons (point E). Pakistan
Pakistan
has the comparative advantage in textiles and
specializes producing 4000 yards (point D).
C
Belgium
B
If both countries divide production evenly,
they will both be consuming at point C,
beyond both countries’ PPC.
E
1
2
3
Chocolate (in tons)
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2-23
Comparative Advantage
and the PPC
•
•
Another way to show trade is to combine both
PPCs into one curve.
1. If both countries produce only fabric, they can
produce 5,000 yards.
2. If both countries produce only chocolate, they can
produce 5 tons.
3. If each country specialized, they can produce 4,000
yards of fabric and 4 tons of chocolate.
Connecting these three points will show the
combined PPC.
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2-24
Comparative Advantage and
the Combined PPC
Textiles
(in thousands of yards)
5 F
The combined PPC is the curve
connecting points F, H, and G.
4
H
3
The slope of the combined
PPC is determined by the
country with the lowest
opportunity cost.
Pakistan
The combined PPC has the
same slope as Belgium’s
PPC from F to H and the
same slope as Pakistan’s
from H to G.
2
Belgium
1
G
1
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2
3
4
Chocolate (in tons)
5
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2-25
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, such
as Bangladesh, have the comparative
advantage in textiles.
The gains from trade are higher wages for
workers in Bangladesh and lower-priced
cloth for U.S. consumers.
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2-26
Outsourcing: Will the U.S. Be
Left Producing Anything?
• Outsourcing is the relocation of
•
•
production once done in the U.S. to
foreign countries.
Outsourcing occurs because many other
countries have a comparative advantage
in labor costs.
The U.S. has a comparative advantage in
technology, institutional structure, and
specialized knowledge.
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2-27
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.
In order to regain our comparative
advantage, the U.S. exchange rate will
decline and foreign wages will increase to
make U.S. exports cheaper and imports to
the U.S. more expensive.
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2-28
Law of One Price
• The law of one price – the wages of equal
•
workers in one country will not differ
significantly from the wages of workers in
another institutionally similar country.
If the U.S. loses its comparative advantage
based on technology and institutional
structure, U.S. wages will decrease
relative to wages in many other countries.
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2-29
Six Roles of Government
in a Market
1. Provide a stable institutional framework.
Government can create a stable environment and
enforce contracts through its legal system.
2. Promote effective and workable competition.
Government can prevent excess monopoly power
– the ability of individuals or firms currently in
business to prevent others from entering the same
kind of business.
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2-30
Six Roles of Government
in a Market
3. Correct for externalities – the effect of a
decision on a third party not taken into
account by the decision maker.



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A positive externality, such as education,
benefits society more than the two parties.
A negative externality, such as pollution,
benefits society less than the two parties.
When there are externalities, there is a
potential role for government to adjust the
market result.
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2-31
Six Roles of Government
in a Market
4. Ensure economic stability and
growth.

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The government can correct
macroeconomic externalities –
externalities that affect the levels of
unemployment, inflation, or growth in
the economy as a whole.
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2-32
Six Roles of Government
in a Market
5. Provide for public goods – a good that if
supplied to one person must be supplied
to all and whose consumption by one
individual does not prevent its
consumption by another individual.


Government provides public goods and
requires that everyone pays for them, thereby
reducing the free rider problem.
A free rider is someone who participates in
something without having to pay for it.
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2-33
Six Roles of Government
in a Market
6. Adjust for undesirable market results.



Market results may not be fair or good for
individuals.
In deciding what is fair, the government must
determine whether taxes should be
 progressive – rates increase with income
 proportional – rates are constant
 regressive – rates decrease as income increases
In deciding what is best for people, the
government may
 discourage demerit goods or activities – those that
are harmful.
 encourage merit goods or activities- those that are
beneficial.
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2-34
Market Failures and
Government Failures
• Market failures are situations in which the
•
•
market does not lead to a desired result.
Government failures are situations where
government intervention makes things
worse.
Policy makers must decide which is the
least bad – market failure or government
failure.
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2-35
Summary
• The production possibilities curve (PPC)
•
•
measures the maximum combination of
outputs that can be obtained from a given
number of inputs.
According to the principle of increasing
marginal opportunity cost, as production
of one good increases, we must give up
ever-increasing quantities of something
else.
Points inside the PPC are inefficient,
points along the PPC are efficient, and
points outside the PPC are unattainable.
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2-36
•
•
•
•
Summary
The rise of markets, specialization, trade, and
competition have contributed to significant increases
in output.
By specializing in producing those goods for which
one has a comparative advantage (lowest opportunity
cost) one can produce the greatest amount of goods
with which to trade.
Specialization and trade shift the PPC out.
Outsourcing of U.S. jobs occurs because many other
countries have a comparative advantage in labor
costs, while the U.S. has a comparative advantage in
technology, institutional structure, and specialized
knowledge.
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2-37
Summary
• Six roles of government are to
 provide a stable set of institutions and
rules
 promote effective and workable
competition
 correct for externalities
 ensure economic stability and growth
 provide public goods
 adjust for undesirable market results
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2-38
Review Question 2-1
Given the following PPC
Computers
Books
A
B
C
D
E
0
1
2
3
4
100 90 70 40
0
What is the marginal opportunity cost of the third
computer?
To produce the third computer, production moves from
alternative C to D. The marginal opportunity cost of the
third computer is 70 – 40 = 30 books.
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2-39
Review Question 2-2
Suppose that the U.S. can produce 80 computer chips
or 80 video games in one hour. Japan can produce 40
computer chips or 80 video games in one hour. What
is the opportunity cost of computer chips in each
country? In which product should each country
specialize?
In the U.S. the cost of 1 computer chip is 80/80 =
1 video game.
In Japan the cost of 1 computer chip is 80/40 =
2 video games.
The U.S. should specialize in computer chips and
Japan should specialize in video games.
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