Introduction:

Thinking Like an 1
CHAPTER
Economist
2

The Production Possibility Model, Trade,

and Globalization

No one ever saw a dog make a fair and

deliberate exchange of one bone for
another with another dog.

Adam Smith

McGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 12
The Production Possibility
Model, Trade, and
Globalization

Chapter Goals

Demonstrate trade-offs with a production possibility

curve
Relate the concepts of comparative advantage and
efficiency to the production possibility curve
State how, through comparative advantage and trade,
countries can consume beyond their individual production
possibilities
Explain how globalization is guided by the law of one
price

2-2
 12
The Production Possibility
Model, Trade, and
Globalization

The Production Possibilities Model

The production possibilities model can be presented
both in a table and in a graph

A production possibility table is a table that lists the

trade-offs between two choices

An output is a result of an activity

An input is what you put in a production
process to achieve an output

2-3
 12
The Production Possibility
Model, Trade, and
Globalization

The Production Possibilities Model

A production possibility curve (PPC) is a curve
measuring the maximum combination of outputs that
can be obtained from a given number of inputs
It gives you a visual picture of the tradeoff
embodied in a decision
A PPC is created from a production possibility
table by mapping the table in a two-dimensional
graph

2-4
 12
The Production Possibility
Model, Trade, and
Globalization
Increasing Opportunity Costs of the Trade-
off
The principle of increasing marginal opportunity
Butter
cost tells us that opportunity costs increase the
more you concentrate on the activity
A
Slope is flat at A
This means there is a low opportunity
cost to produce more guns

Slope is steep at B
This means there is a high opportunity
B
cost to produce more guns
Guns

2-5
 12
The Production Possibility
Model, Trade, and
Globalization

Comparative Advantage
The reason we must give up more and more butter
as we produce more guns is that some resources
are relatively better suited to producing guns, while
others are relatively better suited to producing
butter.
A resource has a comparative advantage if it is
better suited to the production of one good than to
the production of another good

2-6
 12
The Production Possibility
Model, Trade, and
Globalization

Efficiency
Productive efficiency is achieving as
Butter
much output as possible from a given
amount of inputs or resources
A
Points of efficiency
D Unattainable with given
amounts of inputs
Point of inefficiency
C
B
Guns

2-7
 12
The Production Possibility
Model, Trade, and
Globalization

Distribution and Productive Efficiency

The productive possibility curve focuses on efficiency
and ignores distribution

If a method of production will change income distribution

we cannot determine if that method is efficient or not
Efficiency has meaning when analyzing a
particular goal

In our society, most people prefer more to less, and

many policies have relatively small distribution effects

2-8
 12
The Production Possibility
Model, Trade, and
Globalization

Trade and Comparative Advantage

The PPC is bowed outward because individuals
specialize in the production of goods for which they
have a comparative advantage
For a society to produce on its PPC, individuals must
produce those goods for which they have a comparative
advantage and trade for other goods

According to Adam Smith, humankinds proclivity to

trade leads to individuals using their comparative
advantage

2-9
 12
The Production Possibility
Model, Trade, and
Globalization

Markets, Specialization, and Growth

Growth in per capita income during the past 2000 years
$6,000

Income $5,000

$4,000

$3,000

$2,000

$1,000

Year
0 500 1000 1500 2020

What caused this growth?

2-10
 12
The Production Possibility
Model, Trade, and
Globalization

The Benefits from Trade

When people freely enter into trade, both parties can be
expected to benefit from trade
Textiles (yds)

5,000 Without trade, each

country can only consume
4,000 those combinations of
Pakistan goods along their PPCs
3,000

2,000 Belgium
1,000

1 2 3 4 5 Chocolate (tons)

2-11
 12
The Production Possibility
Model, Trade, and
Globalization

Globalization and the Law of One Price

Globalization

Globalization is the increasing integration of

economies, cultures, and institutions across the world
A positive effect of globalization is that it provides
larger markets than the domestic economy
The global economy increases the number of
competitors and this increased competition can be a
negative effect of globalization

2-12
 12
The Production Possibility
Model, Trade, and
Globalization

Globalization and the Law of One Price

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

2-13
 12
The Production Possibility
Model, Trade, and
Globalization

Globalization and the Law of One Price

The Law of One Price
The law of one price states that wages of workers in
one country will not differ significantly from the wages of
(equal) 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

The reality is that the citizens in the U.S. have

been living better than they could have
otherwise because of globalization

2-14
 12
The Production Possibility
Model, Trade, and
Globalization

Chapter Summary
The production possibility curve illustrates maximum
outputs from a given number of inputs
To get increasing amounts of something, we must give
up ever-increasing quantities of something else
Trade allows people to use their comparative
advantage and shift out societys PPC
Efficient, inefficient, and unattainable points on the PPC
Through specialization and trade, countries can increase
consumption

2-15
 12
The Production Possibility
Model, Trade, and
Globalization

Chapter Summary
Globalization is the increasing integration of economies,
cultures, and institutions across the world
Because many goods are cheaper to produce in
foreign countries, production that formerly took place in
the U.S. now takes place in foreign countries
If the U.S. can maintain its strong comparative
advantage using new technologies and innovation, lost
jobs can be replaced with other high-paying jobs
Production shifts to countries where it is cheapest to
produce is guided by the law of one price

2-16