Lesson Overview
Chapter 2 Trade
Production Possibility Frontier
Opportunity Cost
Specialization and Trade
Comparative vs. Absolute Advantage
International Trade
Efficient Markets
Controversy: Sweatshop Labor
Summary
Review Questions
BA 210 Lesson I.3 Trade
1
Production Possibility Frontier
One important economic model is the production possibility
frontier. It illustrates:
Opportunity cost, showing how much less of one good can be
produced if more of the other good is produced.
Efficiency, with an economy efficient in production if it produces
on the production possibility frontier, and efficient in allocation if
it produces the mix of goods and services that people want to
consume.
BA 210 Lesson I.3 Trade
2
Production Possibility Frontier
• The production possibility frontier illustrates the trade-offs
facing an economy that produces only two goods. It shows the
maximum quantity of one good that can be produced for any
given production of the other.
BA 210 Lesson I.3 Trade
3
Production Possibility Frontier
One important conclusion is comparative advantage, which
explains the source of gains from trade between individuals and
countries. Everyone has a comparative advantage in something -- some good or service in which that person has a lower
opportunity cost than everyone else. But it is often confused with
absolute advantage, an ability to produce a particular good or
service better than anyone else. This confusion leads some to
erroneously conclude there are no gains from trade between
people or countries unless each country has some absolute
advantage.
BA 210 Lesson I.3 Trade
4
Production Possibility Frontier
Production Possibility Frontier
Quantity of
coconuts
D
30
Not
feasible
Feasible and
efficient
in production
A
15
B
9
Feasible but
not efficient
C
Production possibility frontier
0
20
28
BA 210 Lesson I.3 Trade
40
Quantity of fish
5
Opportunity Cost
Increasing Opportunity Costs
Quantity of
coconuts35
…requires giving up
5 coconuts
Producing the first
20 fish . . .
But producing
20 more fish . . .
30
A
25
20
…requires giving up
25 more coconuts…
15
10
5
PPF
0
10
20
30
40
50
Quantity of fish
BA 210 Lesson I.3 Trade
6
Specialization and Trade
Question: Consider the individual consumption and individual
production possibilities for Tom and Hank on these two slides.
Determine trade to make production efficient, and make Tom and
Hank better off.
30
(a) Tom’s Production Possibilities
Quantity of
coconuts
Tom’s consumption
without trade
9
Tom’s
PPF
0
28
BA 210 Lesson I.3 Trade
40
Quantity of fish
7
Specialization and Trade
(b) Hank’s Production Possibilities
Quantity of
coconuts
20
Hank’s consumption
without trade
8
Hank’s
PPF
0
6
10
Quantity of fish
BA 210 Lesson I.3 Trade
8
Specialization and Trade
Answer: Opportunity Costs determine efficient trade and
mutually-beneficial trade.
T om's
Hank's
Opportunity Opportunity
Cost
Cost
One Fish
3/4 coconut
2 coconuts
One Coconut
4/3 fish
1/2 fish
BA 210 Lesson I.3 Trade
9
Specialization and Trade
• Production becomes efficient and both castaways are better off
when they each specialize in what they are good at and trade.
• It’s efficient for Tom to catch the fish for both of them, because
his opportunity cost of a fish in terms of coconuts not gathered
is only 3/4 of a coconut, versus 2 coconuts for Hank. If Tom
specializes, he can catch 40 fish total.
• It’s efficient for Hank to gather coconuts for the both of them.
If Hank specializes, he can gather 20 coconuts total.
• Without trade, total production is 28+6=34 fish and 9+8=17
coconuts. So, specialization increases production by 6 fish and
3 coconuts.
• If the gains from increased production are split 50-50, both
Tom and Hank can have 3 more fish and 1.5 more coconuts.
BA 210 Lesson I.3 Trade
10
Comparative vs. Absolute Advantage
Comparative vs. Absolute Advantage
• An individual has a comparative advantage in producing a
good or service if the opportunity cost of producing the good
is lower for that individual than for other people.
• An individual has an absolute advantage in an activity if he or
she can do it better than other people. Having an absolute
advantage is not the same thing as having a comparative
advantage.
BA 210 Lesson I.3 Trade
11
Comparative vs. Absolute Advantage
Tom vs. Hank – Absolute vs. Comparative
• Tom has an absolute advantage in both activities: he can
produce more output with a given amount of input (in this case,
his time) than Hank.
• But we’ve just seen that Tom can indeed benefit from a deal
with Hank because comparative, not absolute, advantage is the
basis for mutual gain.
• So Hank, despite his absolute disadvantage, even in coconuts,
has a comparative advantage in coconut gathering.
• Meanwhile Tom, who can use his time better by catching fish,
has a comparative disadvantage in coconut-gathering.
BA 210 Lesson I.3 Trade
12
International Trade
Question: Consider the individual consumption and individual production
possibilities for the U.S. and Canada on these two slides. Determine trade to
make production efficient, and make both countries better off.
(a) The U.S. Production Possibilities Frontier
(b) Canadian Production Possibilities Frontier
3,000
Quantity
of
aircraft
Canadian production
with trade
Quantity
of
aircraft
U.S. consumption
without trade
Canadian
consumption
without trade
2,000
1,500
U.S.
production
with trade
1,000
U.S.
PPF
0
1
2
3
Canadian
PPF
0
Quantity of pork (millions of
tons)
BA 210 Lesson I.3 Trade
0.5
1
1.5
Quantity of pork (millions of
tons)
13
International Trade
Answer: Opportunity Costs determine efficient trade and
mutually-beneficial trade.
U.S.'s
Canada's
Opportunity Opportunity
Cost
Cost
One Pork
500 aircraft 2000 aircraft
One Aircraft 1/500 pork 1/2000 pork
BA 210 Lesson I.3 Trade
14
International Trade
• Production becomes efficient and both countries are better off
when they each specialize in what they are good at and trade.
• It’s efficient for U.S. to produce pork for both of them, because
U.S. opportunity cost of pork in terms of aircraft is only 500
aircraft, versus 2000 aircraft for Canada. If U.S. specializes, it
can produce 3 pork total.
• It’s efficient for Canada to produce aircraft for the both of
them. If Canada specializes, it can produce 3000 aircraft total.
• Without trade, total production is 1+.5=1.5 pork and
1000+2000=3000 aircraft. So, specialization increases
production by 1.5 pork, without any reduction in aircraft.
• If the gains from increased production are split 50-50, both U.S.
and Canada can have 0.75 more pork.
BA 210 Lesson I.3 Trade
15
Efficient Markets
Comment: The previous examples of efficient and mutuallybeneficial trade guided by comparative advantage evenly split the
gains from increased production among two individual people or
countries. Now consider richer examples of efficient trade:
 There are three individuals.
 With efficient trade, one of the individuals does not specialize
his production.
 The trade of production among the three individuals is guided
by prices in the marketplace.
BA 210 Lesson I.3 Trade
16
Efficient Markets
Question: Consider the following linear production possibilities
from Tom, Jeffery, and Hank. To be useful, an ad must be both
composed and
televised.
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
BA 210 Lesson I.3 Trade
17
Efficient Markets
For example, Tom can compose
Ads
Ads
2 ads if he specializes in
Composed
T elevised
composing; or televise 2
T om
2 composed 2 televised
previously composed ads if
Jeffery
1 composed 2 televised
he specializes in televising; or
complete an ad (compose and
Hank
6 composed 3 televised
televise) if he spends half his time composing and half his time
televising.
BA 210 Lesson I.3 Trade
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Efficient Markets
Part a. How many ads can be
completed if Tom, Jeffery, and
Hank work separately? That is,
each composes and televises his
own ads. (As usual, fractions
are allowed.)
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
BA 210 Lesson I.3 Trade
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Efficient Markets
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
Answer to Part a: First consider Tom. On one hand, if he spent all
day composing, he would compose 2 ads and televise 0 ads and,
thereby, complete 0 ads. On the other hand, if he spent all day
trying to televise, he would compose 0 ads and try to televise 2
ads and, thereby, complete 0 ads. Obviously, to complete the
maximum number of ads he would split his day evenly: spending
half his day composing and the other half his day televising, he
would compose 1 ad and televise 1 ad and, thereby, complete 1
ad.
BA 210 Lesson I.3 Trade
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Efficient Markets
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
Next consider Jeffery. Like Tom, to complete the maximum number of ads he
splits his day between composing and televising. Let’s find that split with
algebra. Let c be the fraction of his day spent composing; that leaves the
fraction 1−c for televising. Spending c of his day composing and 1−c of his
day televising, he would compose c letters and televise 2(1−c) letters. If c <
2(1−c), then some televising exceeds composing, which is wasted effort.
Likewise, c > 2(1−c) has some composing exceeding televising, which is also
wasted effort. Therefore, to complete the maximum number of ads he would
set c = 2(1 − c), which implies 3c = 2 and c = 2/3. That is, Jeffery spends 2/3
of his day composing and 1/3 of his day televising and, thereby, composes,
televises, and completes 2/3 ads, which is approximately .66 ads.
BA 210 Lesson I.3 Trade
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Efficient Markets
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
Finally consider Hank. Let c be the fraction of his day spent
composing; that leaves the fraction 1−c for televising. Spending c
of his day composing and 1−c of his day televising, he would
compose 6c letters and televise 3(1−c) letters. To complete the
maximum number of ads he would set 6c = 3(1 − c), which
implies 9c = 3 and c = 1/3. That is, Jeffery spends 1/3 of his day
composing and 2/3 of his day televising and, thereby, composes,
televises, and completes 2 ads.
Altogether, the three complete 3.66 ads when working separately.
BA 210 Lesson I.3 Trade
22
Efficient Markets
Part b. Who has the absolute
advantage in televising ads?
who is next? On the basis of
absolute advantage in televising
ads, how would production be
organized? What is the total
output of ads per day?
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
BA 210 Lesson I.3 Trade
23
Efficient Markets
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
Answer to Part b: Hank has the absolute advantage in televising,
so consider this trial solution: Hank spends all day televising and,
thereby, televises 3 ads. Both Tom and Jeffery spend all day
composing and, thereby, compose 3 ads. Since the number
televised equals the number composed, that is the absoluteadvantage solution. In particular, total output is 3 completed ads
per day.
Comment: That output is less than when they worked separately.
BA 210 Lesson I.3 Trade
24
Efficient Markets
Part c. How should production be
organized? What is the total
output of ads per day?
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised
Jeffery
1 composed
2 televised
Hank
6 composed
3 televised
BA 210 Lesson I.3 Trade
25
Efficient Markets
Opportunity
Cost of
T elevising
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised 2/2 composed
Jeffery
1 composed
2 televised 1/2 composed
Hank
6 composed
3 televised 6/3 composed
Answer to Part c: To find efficient production, compute the
opportunity cost of televising ads. For Larry, each ad televised
takes 1/2 of a day (since in one day he can televise 2 letters), and
in that 1/2 of a day he could have composed 1 letter (since in one
day he can compose 2 ads). Hence, Tom’s opportunity cost of
televising a letter is 1 composed letter.
BA 210 Lesson I.3 Trade
26
Efficient Markets
Opportunity
Cost of
T elevising
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised 2/2 composed
Jeffery
1 composed
2 televised 1/2 composed
Hank
6 composed
3 televised 6/3 composed
For Jeffery, each ad televised takes 1/2 of a day, and in that 1/2 of
a day he could have composed 1/2 letter. Hence, Jeffery’s
opportunity cost of televising a letter is 1/2 composed letter.
Likewise, Hence, Hank’s opportunity cost of televising a letter is
6/3 composed letter (the ratio of maximum composing output to
maximum televising output).
BA 210 Lesson I.3 Trade
27
Efficient Markets
Opportunity
Cost of
T elevising
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised 2/2 composed
Jeffery
1 composed
2 televised 1/2 composed
Hank
6 composed
3 televised 6/3 composed
Jeffery has the comparative advantage in televising (he gives up
the fewest composed letters), so consider this trial solution:
Jeffery spends all day televising and, thereby, televises 2 ads.
Both Tom and Hank spend all day composing and, thereby,
compose 8 letters. Since the number televised is less than the
number composed, we need another televiser and, so, must
consider another trial solution:
BA 210 Lesson I.3 Trade
28
Efficient Markets
Opportunity
Cost of
T elevising
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised 2/2 composed
Jeffery
1 composed
2 televised 1/2 composed
Hank
6 composed
3 televised 6/3 composed
After Jeffery, Tom has the comparative advantage in televising,
so consider this trial solution: Jeffery and Tom spend all day
televising and, thereby, televise 4 ads. Hank spends all day
composing and, thereby, composes 6 ads. Since the number
televised is less than the number composed, we need another
televiser (at least part time) and must consider another trial
solution:
BA 210 Lesson I.3 Trade
29
Efficient Markets
Opportunity
Cost of
T elevising
Ads
Composed
Ads
T elevised
T om
2 composed
2 televised 2/2 composed
Jeffery
1 composed
2 televised 1/2 composed
Hank
6 composed
3 televised 6/3 composed
Clearly, if Hank joins Jeffery and Tom to spend all day televising, then the
number televised is greater than the number composed. Hence, Hank splits his
time between composing and televising, spending the fraction c composing
and the fraction 1−c televising and, thereby, composing 6c and televising
3(1−c). As before, Jeffery and Tom spend all day televising and, thereby,
televise 4 ads total. All together, the three compose 6c and televise 4+3(1−c).
To complete the maximum number of ads, set 6c = 4 + 3(1 − c), which implies
9c = 7 and c = 7/9. That is, Hank spends 7/9 of his day composing and 2/9 of
his day televising and, thereby, the three compose, televise, and complete
6(7/9) = 4 + 3(2/9) = 14/3 ads, which is approximately 4.66 ads.
That is the maximum number of ads that can be completed per day.
BA 210 Lesson I.3 Trade
30
Efficient Markets
Part d. Show how the market
Ads
Ads
can organize production
Composed
T elevised
efficiently. Specifically, suppose
T om
2 composed 2 televised
the market price per unit for
Jeffery
1 composed 2 televised
televising ads is $100. Find
the price PC per unit for
Hank
6 composed 3 televised
composing ads so that, when the output of completed ads is
maximized, then Tom, Jeffery and Hank are each choosing the
work that maximizes their income.
BA 210 Lesson I.3 Trade
31
Efficient Markets
Ads
Composed
Ads
T elevised
Income at
Prices
P C and P T=100
T om
2 composed
2 televised
2P C or 200
Jeffery
1 composed
2 televised
P C or 200
Hank
6 composed
3 televised
6P C or 300
Answer to Part d: When the output of completed ads is
maximized, Hank spends part of his day composing and part of
his day televising, so his daily income must equal from the two
jobs, 6PC = 300, or PC = 50. And Tom and Jeffery each specialize
in televising, so at PC = 50 their daily incomes from composing
must lower than from televising, 100 < 200 and 50 < 200.
So, at the price PC = 50 per unit for composing ads, when the
output of completed ads is maximized, then Tom, Jeffery and
Hank are each choosing the work that maximizes their income.
BA 210 Lesson I.3 Trade
32
Controversy: Sweatshop Labor
Controversy: Sweatshop Labor
BA 210 Lesson I.3 Trade
33
Controversy: Sweatshop Labor
A sweatshop is a working environment with unhealthy conditions
that are considered by many people of industrialized nations to be
difficult or dangerous, usually where the workers have few
opportunities to address their situation. This can include exposure
to harmful materials, hazardous situations, extreme temperatures,
or abuse from employers. Sweatshop workers often work long
hours for little pay, regardless of any laws mandating overtime
pay or a minimum wage. Child labor laws may also be violated.
BA 210 Lesson I.3 Trade
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Controversy: Sweatshop Labor
Defenders of sweatshops, such as Paul Krugman, claim that
people choose to work in sweatshops because the sweatshops
offer them substantially higher wages and better working
conditions compared to their previous jobs of manual farm labor,
and that sweatshops are an early step in the process of
technological and economic development whereby a poor country
turns itself into a rich country. Economists are focused on “trade
offs” and when it comes to sweatshops, they ask whether the
alternative of unemployment or even worse employment is better.
In addition, sometimes when anti-sweatshop activists were
successful in getting sweatshops to close, some of the employees
who had been working in the sweatshops ended up starving to
death, while others ended up turning to prostitution.
BA 210 Lesson I.3 Trade
35
Controversy: Sweatshop Labor
In 1996, the National Labor Committee, a human rights group,
reported that sweatshop labor in Honduras was used to make
clothes for the Kathie Lee line, sold at Wal-Mart. The biggest
consumer import into Honduras are processed foods. Consider
how Hondurans benefit by exporting clothes to the U.S. and
importing cars.
BA 210 Lesson I.3 Trade
36
Controversy: Sweatshop Labor
Question: Consider the following linear production possibilities
from the U.S. and Honduras. Production number are average
monthly production per worker. Describe trade that can make
both countries better off if, currently, both countries do not trade,
the U.S. makes 20 dresses and 20 cans of processed food, and
Honduras makes 4 dresses and 2 cans. What would happen if the
National Labor Committee shut down such trade?
Dresses
Food
U.S.
40 dresses
40 cans
Honduras
8 dresses
4 cans
BA 210 Lesson I.3 Trade
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Controversy: Sweatshop Labor
U.S.'s
Honduras's
Answer: Compute and compare
Opportunity Opportunity
opportunity costs. U.S. has the
Cost
Cost
absolute advantage in both
One Dress
1 Can
1/2 Can
goods, but Honduras has the
One Can
1 Dress
2 Dresses
comparative advantage in
dresses. Hence trade that can make both countries better off is
U.S. making more food and Honduras making more dresses.
Specifically, suppose the U.S. makes one more can of processed
food and Honduras makes one less can of processed food. The
U.S. then has to sacrifice 1 dress but Honduras can make 2 more
dresses. If the gain of 1 dress is split evenly each month, the U.S.
can trade the extra can of food for 1.5 dresses (thus gaining 0.5
dresses), and Honduras can trade 1.5 dresses for the 1 can of food
(thus gaining 0.5 dresses). If the National Labor Committee shut
down such trade, then Honduras looses their gain from trade.
BA 210 Lesson I.3 Trade
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Summary
Summary
1. Almost all economics is based on models and assumptions in
those models.
2. One important economic model is the production possibility
frontier. It illustrates opportunity cost, efficiency, and
economic growth. There are two basic sources of growth: an
increase in factors of production, resources such as land,
labor, capital, and human capital, inputs that are not used up
in production, and improved technology.
3. One important conclusion is comparative advantage explains
the gains from trade between individuals and countries.
Everyone has a comparative advantage in something. This is
often confused with absolute advantage, an ability to produce
a particular good better than anyone else.
BA 210 Lesson I.3 Trade
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Summary
Summary
4. The efficient trade of production can be guided by either a
comparison of opportunity costs, or by prices in the
marketplace.
BA 210 Lesson I.3 Trade
40
Review Questions
Review Questions
 You should try to answer some of the following questions
before the next class.
 You will not turn in your answers, but students may request
to discuss their answers to begin the next class.
 Your upcoming Exam 1 and cumulative Final Exam will
contain some similar questions, so you should eventually
consider every review question before taking your exams.
BA 210 Lesson I.3 Trade
41
Review Questions
Question: Consider the following linear production possibilities
of Army missions and computer programs from 1 high school
dropout (D), 1 high
school graduate with
Army
Civilian
no college degree (H),
and 1 college
Output
Output
graduate (C).
D
2 missions
1 program
H
4 missions
4 programs
C
6 missions
9 programs
BA 210 Lesson I.3 Trade
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Review Questions
Part a. If you need 2.5 missions per month
(for example, 5 every 2 months)
and if the market price (or wage)
D
for producing a computer
H
program is 6 pesos each, then
what should be the unit price
C
paid per mission?
BA 210 Lesson I.3 Trade
Army
Output
Civilian
Output
2 missions
1 program
4 missions
4 programs
6 missions
9 programs
43
Review Questions
Answer to Part a: Step 1. Find whom
Army
Civilian
to draft. That is, who has the
Output
Output
comparative advantage. For D,
D
2 missions 1 program
each mission takes up 1/2 of his
H
4 missions 4 programs
month, during which time he
could complete ½ × 1 = ½
C
6 missions 9 programs
program. For H, each mission takes up ¼ of his month, during
which time he could complete ¼ × 4 = 1 program. For C, each
mission takes up 1/6 of his month, during which time he could
complete 1/6 × 9 = 3/2 programs.
Conclusion: Despite his absolute disadvantage, it’s comparatively
cheaper for D to serve first. Then H, then C. So, for 2.5 missions,
start with D in the military full time, for 2 missions. That leaves
.5 missions, to be completed by H serving part time.
BA 210 Lesson I.3 Trade
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Review Questions
Step 2. Find the price PM per
Army
Civilian
mission. Given that classes pay
Output
Output
6 pesos each, here is what that
D
2 missions 1 program
price PM must satisfy to get the
H
4 missions 4 programs
solution above:
For D to choose the military
C
6 missions 9 programs
full-time, potential income from the military 2 PM must be no less
than potential income from writing computer programs, 1 × 6 = 6.
Conclusion: 2 PM > 6, or PM > 3.
For type H to choose the military part-time, potential income
from the military 4 PM must be the same as potential income from
writing programs 4 × 6 = 24. Conclusion: 4 PM = 24, or PM = 6.
BA 210 Lesson I.3 Trade
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Review Questions
Army
Output
Civilian
Output
D
2 missions
1 program
H
4 missions
4 programs
For C to choose programming
C
6 missions 9 programs
full-time, potential income from the military 6 PM must be no
greater than potential income from writing computer programs, 9
× 6 = 54. Conclusion: 6 PM < 54, or PM < 9.
Putting it all together, the price should be PM = 6 pesos per
mission.
(See how the non-specialist determines price, and that the
specialists inequalities are satisfied at that price.)
BA 210 Lesson I.3 Trade
46
Review Questions
Part b. Now suppose you
need 7 missions per month.
What should be the unit price
paid per mission?
Army
Output
Civilian
Output
D
2 missions
1 program
H
4 missions
4 programs
C
6 missions
9 programs
BA 210 Lesson I.3 Trade
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Review Questions
Answer to Part b: The production
Army
Civilian
possibilities have not changed,
Output
Output
so it is still comparatively
D
2 missions 1 program
cheaper for D to serve first;
H
4 missions 4 programs
then H; then C. So, for
7 missions, start with D in the
C
6 missions 9 programs
military full time, for 2 missions; then H, for 4 missions. That
leaves 1 mission, to be completed by C serving part time.
For type C to choose the military part-time, potential income
from the military 6 PM must be the same as potential income from
writing programs 9 × 6 = 54. Conclusion: 6 PM = 54, or PM = 9.
(As always, the non-specialist determines price, and the
specialists choose the right specialties at that price.)
BA 210 Lesson I.3 Trade
48
Review Questions
Follow the link
http://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set2Answers.pdf
for review questions for Lesson I.3 that practices these skills:
 Draw a linear production possibilities frontier.
 Draw a bowed production possibilities frontier.
 Compute opportunity costs from a production possibilities frontier.
 Identify feasible and infeasible and efficient and inefficient points from a
production possibilities frontier.
 Identify comparative and absolute advantage from a production possibilities
frontier.
 Describe trade based on comparative advantage.
 Identify positive and normative statements.
BA 210 Lesson I.3 Trade
49
BA 210
Introduction to Microeconomics
End of Lesson I.3
BA 210 Lesson I.3 Trade
50