TRADE, TRADE-OFFS, AND GOVERNMENT POLICY

1. TRADE, TRADE-OFFS,AND GOVERNMENT POLICY Chapter 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.

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.

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.

5. A Production Possibilities Curve for an Individual Hours of study Grade in Hours of study Grade in in history history in economics economics 20 hours of economics 0 hours of history 20 98 0 40 A 100 19 96 1 43 18 94 2 46 17 92 3 49 B 88 16 90 4 52 15 88 5 55 14 86 6 58 Economics grade 13 84 7 61 12 82 8 64 20 hours of history 0 hours of economics C 70 11 80 9 67 10 78 10 70 9 76 1 1 73 8 74 12 76 7 72 13 79 6 70 14 82 5 68 15 85 D 46 4 66 16 88 E 3 64 17 91 40 58 66 78 94 98 2 62 18 94 1 60 19 97 History grade 0 58 20 100

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.

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.

8. % of resources % of resources devoted to devoted to production production Pounds Number of guns of butter of butter Row of guns 0 0 100 15 A 20 4 80 14 B 40 7 60 12 C 60 9 40 9 D 80 1 1 20 5 E 100 12 0 0 F A Production Possibilities Table for Society

9. 1 pound of butter 2 pounds of butter 5 pounds of butter 4 guns 3 guns 1 gun PPC for Society A 15 B 14 C 12 D 9 Butter E 5 F 4 7 9 11 12 0 Guns

10. Increasing Marginal Opportunity Cost Slope is flat at A. Low opportunity cost of guns. A The principle of increasing marginal opportunity cost states that opportunity costs increase as you produce more of one product. Butter Slope is steep at B. High opportunity cost of guns. B Guns

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.

12. Unattainable point, given available technology, resources and labor force 10 8 C D Efficient points 6 Guns B 4 A Inefficient point 2 0 2 4 6 8 10 Butter Efficiency and Inefficiency

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.

14. Shifts in the PPC Neutral Technological Change Biased Technological Change Butter C Butter C B A 0 0 D B A Guns Guns

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.

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.

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.

18. $6,000 $5,000 $4,000 Per capita income (in 1990 international dollars) $3,000 $2,000 $1,000 0 500 1000 1500 2010 Growth in the Past Two Millennia

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.

20. A B 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 D 4 Pakistan Textiles (in thousands of yards) 3 2 1 Belgium E 1 2 3 4 Chocolate (in tons)

21. A B 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 D 4 Pakistan Textiles (in thousands of yards) 3 C 2 Belgium 1 E 1 2 3 4 Chocolate (in tons)

22. 5 D 4 Pakistan Textiles (in thousands of yards) 3 C A 2 Belgium B 1 E 1 2 3 4 Chocolate (in tons) Summary of Trade For Pakistan the opportunity cost of one ton of chocolate is 4000 yards of textiles. 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 has the comparative advantage in textiles and specializes producing 4000 yards (point D). If both countries divide production evenly, they will both be consuming at point C, beyond both countries’ PPC.

23. Comparative Advantage and the PPC • Another way to show trade is to combine both PPCs into one curve. • If both countries produce only fabric, they can produce 5,000 yards. • If both countries produce only chocolate, they can produce 5 tons. • 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.

24. Comparative Advantage and the Combined PPC F The combined PPC is the curve connecting points F, H, and G. 5 The slope of the combined PPC is determined by the country with the lowest opportunity cost. 4 H 3 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. Textiles (in thousands of yards) 2 Belgium 1 G 1 2 3 4 5 Chocolate (in tons)

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.

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.

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.

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.

29. Six Roles of Government in a Market • Provide a stable institutional framework. Government can create a stable environment and enforce contracts through its legal system. • 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.

30. Six Roles of Government in a Market • Correct for externalities – the effect of a decision on a third party not taken into account by the decision maker. • 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.

31. Six Roles of Government in a Market • Ensure economic stability and growth. • The government can correct macroeconomic externalities – externalities that affect the levels of unemployment, inflation, or growth in the economy as a whole.

32. Six Roles of Government in a Market • 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.

33. Six Roles of Government in a Market • 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.

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.

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.

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.

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

38. Review Question 2-1 Given the following PPC 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.

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.