Production Possibilities Curve and Comparative Advantage

Production Possibilities Curve and Comparative Advantage

1. Production Possibilities Curve

1. General Assumptions

1. Example

1. The Law of Increasing Costs

II. Comparative Advantage vs Absolute Advantage

1. Definitions

1. Example

Production Possibilities Curve (PPC)

Used to illustrate the opportunity cost of a society in producing various amounts of goods

Assumptions:

3.

On Curve:

Inside Curve:

Outside Curve:

Ex. 2 goods are produced, they are civilian and military goods.

Amount of Military Goods / Amount of Civilian Goods / Points (Label)
0 / 80 / A
20 / 70 / B
40 / 40 / C
50 / 0 / D

Two more points: E (40, 70) and F (20, 30)

Aside:

10 apples cost $1

cost (what you give up) - $1

gain (what you gain) – 10 apples

To find the price per apple:

→ Take ratio of cost to gain (cost/gain)

$1 / 10 apples = $.10 per apple

cost / gain = cost per unit

Society moves form A to B (A B)

B C

C D

The Law of Increasing Costs -As we acquire more of one good, the opportunity cost of each successive unit increases.

Stated differently:As we acquire more of one good, we have to give up an increasing amount of the other good.

Why?

Economic growth

-Occurs if 1) a societies economic resources increase

or

2) new production methods are discovered that increase capacity

 Economic growth

How is economic growth depicted on the PPC?

International Trade

Why would a society engage in international trade?

Because trade allows a society to operate outside its PPC.

Ex: Society operates at pt A on PPC

Society wishes to acquire 40 units of military

goods. It can move to pt C or trade.

Trade agreement: 10 units of civil cost 40 units of military.

 Allows society to operate outside its PPC

Comparative Advantage vs. Absolute Advantage

When will countries engage in trade?

When one country has a comparative advantage in the production of a good.

Absolute advantage- when an individual (or nation) has the ability to produce a good more efficiently – at lower cost of resources – than other producers.

Comparative advantage-when an individual (or nation) can produce a good at a lower opportunity cost than another producer

Ex:

US / Guatemala
Televisions per year / 6 / 1
mp3 players per year / 2 / 1

* production in billion units

● US has anabsolute advantage in production of both mp3 players and televisions (we can produce more of each).

Recall: Calculate opportunity cost → cost/gain

Opportunity Cost:

US / Guatemala
OneTelevision / 1/3 / 1
One mp3 player / 3 / 1

● However, Guatemala has lower opportunity cost in mp3 player production. Therefore, Guatemala has acomparative advantage in mp3 player production.

● US has comparative advantage in tv production.

● Differences in opportunity costsare the reason for international trade.

● A country will produce the good that they have a comparative advantage in producing.

→ country has lower opportunity cost in producing that good.

● Comparative advantage forms the basis of international trade.

→Guatemala will export mp3 players

andUS will export televisions.