ECO1000EconomicsSemester One, 2004

Lecture Two

Outline or Plan of Today’s Lecture Material Covered: Module

One, Part Two Reading: Chapter 3 of the

Text and Chapter 3 of the Study Guide (Hakes and Parry)

Topics Considered: Interdependence and Gains From Trade

Objectives of Today’s Lecture You will learn about:

The benefits of trade Absolute and comparative advantage How comparative advantage explains the

benefits of trade How comparative advantage and trade applies to

your daily lives and your nation’s policies

Relevant Economic Principles The cost of something is what you give up

to get it Trade can make everyone better off

How do we satisfy our wants and needs? We can be economically self-

sufficient; or We can specialise and trade with

others, leading to economic interdependence.

The Production Possibilities Frontier

A Model of Production Capacity

The Production Possibility Frontier A representation of two choices of

production based on full utilisation of known resources

All points within the PPF are also combinations of production of goods

Illustrates opportunity cost movement along the frontier means giving up

production of one to gain production in another

Building the Model Start with individual behaviour & capacity

‘Robinson Crusoe’ economics

Add more people to the model Used to illustrate a general tendency, not

detailed reality Assume the principles are still valid in a

complex society

Scenario One person (George) on an island Only producing two goods

Food & cloth

Limited by: Physical capacity Skill

Trade-off between the 2 goods

George’s production possibilities in relation to food & cloth

Food (kgs/wk)

Cloth (m/wk)

10 & 0

or

8 & 3

or

6 & 6

or

4 & 9

or

2 & 12

or

0 & 15

Graphing George’s PPF

Food(Kgs/wk)

Cloth (m/wk)

8

10

6

3 6 9 15

4

*

*

*

Point A

Point B

Point C

*

*

Point D

Point E

0

Principles of a PPF

Food(Kgs/wk)

Cloth (m/wk)

8

10

6

3 6 9 15

4

**

Point A: possible but can produce more

Point B: At full capacity*Point C: Not possible under current conditions

02

Shifting along the PPF

Food(Kgs/wk)

Cloth (m/wk)

8

10

6

3 6 9 15

4

Give up 2 kgs of food

Give up 2 kgs of food

Give up 2 kgs of food

Gain 3 m of cloth

Gain 3 m of cloth

Gain 3 m of cloth

**

*

Calculating opportunity cost George gives up 2 kgs of food/wk to gain 3

m of cloth/wk Converting this to single units, each extra

metre of cloth ‘costs’ 2/3 (0.66) kgs of food Therefore, the opportunity cost of

increasing cloth production by 1 m/wk = 0.66 kgs/wk of food

Points to note

George could gather 10 kgs/wk of food and make no cloth or make 15 m of cloth and gather no food

NB. There is always a time factor per/day, per/wk, per month etc

It is likely that opportunity cost will vary, usually increasing with any shift of resources

This is based on constant opportunity cost

John’s PPF

Food 12 9 6 3 0 Cloth 0 3 6 9 12

Comparing PPFsFood

(Kgs/wk)

Cloth (m/wk)

9

6

3 6 9 15

3

12

12

John

George

*

*

*

*

*

Gives up 3 kgs/wk

Gains 3 m/wk

Comparing the Cost of Food: John’s Absolute Advantage

Absolute advantage is a term used when comparing productivity.

In our example, John has an absolute advantage in producing food because he requires less time than George to produce a unit of this good.

Another Way of Comparing Costs: Opportunity Cost and Comparative Advantage John’s opportunity cost of producing cloth:

John gives up 3 kgs of food/wk to gain 3 m of cloth/wk

Opportunity cost for 1 m/wk of cloth = 1 kg of food/wk Compared with George’s opportunity cost of 0.66 kg

of food/wk George has a lower opportunity cost than John for

the production of cloth (he gives up less food) John has a lower opportunity cost than George for

the production of food (he gives up less cloth) WORK IT OUT!

Comparative Advantage

The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

George has a comparative advantage in cloth production and John has a comparative advantage in food production

Comparative Advantage and Specialisation George could specialise in cloth production

(where he has a comparative advantage) and John could specialise in food production (where he has a comparative advantage)

The result of specialisation is a greater total production of both goods

The logic of specialisationFood

(Kgs/wk)

Cloth (m/wk)

9

6

3 6 9 15

3

12

12

Maximum combined production

john

george

George & John Trade… George specialises in cloth production and

produces 15 m/wk John specialises in food production and

produces 12 kgs/wk John eats 6 kgs of food and trades the

other 6 kgs for 8 m of cloth He ends up with 6 kgs of food and 8 m of cloth

John’s Consumption PossibilitiesFood

(Kgs/wk)

Cloth (m/wk)

9

6

3 6 9 15

3

12

12

* *

The PPF (does not change)

Consumption with trade

8

Consumption without trade

George’s Situation With Trade George uses 7 m of cloth and trades the

other 8 m for 6 kgs of food. George ends up with 7 m of cloth and 6 kgs

of food.

George’s Consumption PossibilitiesFood

(Kgs/wk)

Cloth (m/wk)

9

6

3 6 9 15

3

12

12

Consumption with trade

* *

PPF (does not change)

7

Points to Note

Interdependence and trade can allow people to enjoy a greater quantity and variety of goods and services.

The person who can produce a good with a smaller quantity of inputs has an absolute advantage.

The person with a smaller opportunity cost has a comparative advantage.

The gains from trade are based on comparative advantage, not absolute advantage.

National Production Possibilities

Applying the Same Principles to National Economies

A National PPF

Information gigabytes/yr

Textilescu m/yr

750,000

1 m

500,000

8 m4 m 16 m

*Assume full use of resources

Points to note Country produces either textiles or

information At 750,000 gb/yr & 4 m cu metres/yr, an

increase of 4 m cu metres will mean giving up 250,000 gb/yr Opp cost of 4 m cu m. = 250,000 gb of info. Opp cost of 1 cu m = 0.0625 gb of info

A Positive Change in the PPF

Information gigabytes/yr

Textilescu m/yr

* NB: It is a change in potential production

Increase in population, discovery of new resources, invention of new technology, higher education

A Negative Change in the PPF

Information gigabytes/yr

Textilescu m/yr

* NB: It is a change in potential production

Decrease in population, depletion of resources, environmental degradation, natural disaster, human disaster

A Positive Change in Textile TechnologyInformation gigabytes/yr

Textilescu m/yr

Changes within the PPF

Information gigabytes/yr

Textilescu m/yr

*

*

There has been no change in population, resources or technology, but there has been a change in policy or work practices

The Impact of Policy

Information gigabytes/yr

Textilescu m/yr

750,000

1 m

500,000

5m 6.5 m16 m

*

*

1. Government cuts assistance to industry

2. Resources shift to another industry and production moves closer to PPF. (Greater efficiency)

*This is a more realistic situation.There is not full use of all resources.

Initial production

Towards PPF & Away from PPF More efficient use of

resources Low unemployment Change in government

policy

Less efficient use of resources

High unemployment Change in government

policy Political favours for

some inefficient sectors of groups

An Example of Production Without Trade

12

11

10

9

8

7

6

5

4

3

2

1

0

Televisionsmillion/yr

0 2 4 6 8 10 12 13 14 16 18 20 22Wheat million tonnes/yr

Japan

Australia

Opportunity Costs Japan can either produce 1 tonne of wheat

or 1 TV. Opp Cost of 1 t. of wheat = 1 TV Australia can produce 1 TV or 3 tonnes of

wheat. Opp cost of 1 TV = 3 tonnes of wheat

Japan Australia

1 TV 1 tonne of Wheat

1 tonne of Wheat

1 TV

1 tonne of wheat

1 TV 0.33 TVs 3 tonnes of wheat

Opportunity Costs Compared

The Development of Trade Japan wants to get wheat cheaper than

at a cost of 1 TV/tonne if possible Australia wants to get TVs cheaper than

at a cost of 3 tonnes of wheat/TV if possible

Suppose they agree to specialise and trade

New Consumption Possibility with trade

12

11

10

9

8

7

6

5

4

3

2

1

0

Televisionsmillion/yr

0 2 4 6 8 10 12 13 14 16 18 20 22Wheat million tonnes/yr

Australia’s PPF**

Australia produces 16 million tonnes of wheat, keeps 7 million tonnes and trades 9 million tonnes for 5 million televisions.

Australia’s consumption with trade

New Consumption Possibility with trade

12

11

10

9

8

7

6

5

4

3

2

1

0

Televisionsmillion/yr

0 2 4 6 8 10 12 13 14 16 18 20 22Wheat million tonnes/yr

Japan produces 10 million TVs, keeps 5 million and trades the other 5 million for 9 million tonnes of wheat

* *

Japan’s PPF

Japan’s consumption with trade

Points to note The PPF (production) cannot increase,

but consumption can It just shows the potential for an increase

in goods and services No country fully specialises However, this idea is the basis for free

trade arguments

Conclusions

Lower opportunity cost creates the conditions for benefits from exchange

In the absence of other impediments & costs, countries will increase possible consumption through trade

This is true even where one country has an absolute advantage over another

Next Week Next week’s lecture:

Material: Module Two, Part One Reading: Text Chapter Four plus Hakes and

Parry Chapter Four Topics: Supply and Demand

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