Production Possibility Frontier

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

The Production Possibilities Frontier

Lets

introduce the Production Possibilities Frontier

better known as the PPF.

The

PPF is a basic workhorse in economics. Important for understanding some basic issues in economics.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

The PPF
Great

application is with international trade theory. Helps one understand and distinguish between comparative advantage and absolute advantage. An important historical figure in all this is David Ricardo.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

David Ricardo
Famous

19th century British economist. Some consider him the grandfather of international trade theory. Very influential in pioneering the theory of comparative advantage, inter alia. Very interesting, very bright guy. Had a lot of say about the corn laws in England.
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 4

The Production Possibility Frontier - What Is It?

The

description of the best possible combinations of two goods to produce using all of the available resources. Shows the trade-off between more of one good in terms of the other. Assumes: input endowments given, technology given, time given and efficient production.
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 5

Opportunity Cost
The opportunity cost of an activity is the value of the resources used in that activity when they are measured by what they would have produced when used in their next best alternative. The slope of the Production Possibility Frontier measures the marginal opportunity cost of producing one good in terms of the amount of the other good foregone.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

A Typical PPF Picture

Butter just attainable unattainable

The marginal opportunity cost of guns in terms of butter is increasing as we move down the PPF!
just attainable

inefficient

The PPF is typically bowedout or linear. It is not bowed-in

Guns

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

Comparative Advantage
The

person with the lower marginal opportunity cost of an activity has the comparative advantage at that activity. This means that the person with the comparative advantage can produce the activity by giving up the smallest amount of the alternative activity.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

The Idea of Comparative Advantage and Trade

Specialization

and free trade will benefit all trading parties, even when some are absolutely more efficient producers than others. Need to understand absolute vs. comparative advantage.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

Absolute vs. Comparative Advantage Applied to Trade

Absolute advantage: if your country uses fewer resources to produce a given unit of output than the other country. Comparative advantage: if your country can produce the output at a lower marginal cost in terms of other goods foregone than the other country. Every country (or person, or economy) has a comparative advantage at some activity. Absolute advantage is not important and may not always happen. Sometimes people or countries have the absolute advantage in nothing! Yet trade possibilities still exist. Its all about comparative advantage.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

10

PPFs and Comparative Advantage

Maximum Production Rates Production P Random Relative Price Relative Price Access of RAM (kg of Corn Meal Corn meal Memory (k corn per k (k chips per Producer (kg/day) chips/day) chips) kg corn meal) Juanita 12 4 3.00 0.33 Julio 8 2 4.00 0.25

In this example, there are two goods being produced: Corn meal and RAM. Juanita has an absolute advantage at both: she can produce more of each than Julio. Juanita has a comparative advantage at producing RAM compared to Julio: she gives up 3.00 kg/day of corn meal to make an additional 1k of chips. Julio has a comparative advantage at producing corn meal compared to Juanita: he gives up 0.25 k chips to make an additional kg of corn meal.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

11

Production Possibilities

When we draw the production possibilities for Juanita and Julio, there is a kink at 8 kg/day corn meal and 4.00 k chips/day RAM. The chart shows who specializes in corn meal and RAM at each production level.

Production Possibilities (2)

8.00

7.00

6.00

Julio varies production of both while Juanita stays specialized in RAM. Slope equals Julio's price of corn meal in terms of RAM = -0.25 k chips/kg corn meal. Juanita varies production of both while Julio stays specialized in corn meal. Slope equals Juanita's price of corn meal in terms of RAM = -0.33 k chips/kg corn meal.

RAM (k chips/day)

5.00

4.00

3.00

2.00

1.00

0.00 0 1 2 3 4 5 6 7 8 9 10 111213 141516 171819 202122 232425 262728 2930 Corn m eal (kg/day)

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

12

Adding a Third Producer

Maximum Production Rates Production P Random Relative Price Relative Price Access of RAM (kg of Corn Meal Corn meal Memory (k corn per k (k chips per Producer (kg/day) chips/day) chips) kg corn meal) Juanita 12 4 3.00 0.33 Julio 8 2 4.00 0.25 Sergio 2 1 2.00 0.50

Sergio has no absolute advantage; however, he has a comparative advantage over both Juanita and Julio in the production of RAM. He sacrifices 2.00 kg of corn meal to make an additional 1k of chips.
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 13

Adding a Fourth Producer

Maximum Production Rates Producti Random Relative Price Relative Price Access of RAM (kg of Corn Meal Corn meal Memory (k corn per k (k chips per kg Producer (kg/day) chips/day) chips) corn meal) Juanita 12 4 3.00 0.33 Julio 8 2 4.00 0.25 Sergio 2 1 2.00 0.50 Maria 8 1 8.00 0.13

Question: What is Marias comparative advantage with respect to each of the other three producers?
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

14

Comparative Advantage and Specialization

As more and more producers enter the economy, the production possibility curve gets more and more bowed out (concave). Along any segment, most of the producers are fully specialized. Only one producer is producing both goods along any segment.

Production Possibilities (All)

8.00

7.00

6.00

RAM (k chips/day)

5.00

4.00

3.00

2.00

1.00

0.00 0 1 2 3 4 5 6 7 8 9 1011 1213 141516 1718 192021 2223 242526 2728 2930 Corn m eal (kg/day)

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

15

The Supply Curve from the PPF

At each relative price of RAM in terms of foregone corn meal, we can determine the market supply The table shows how much is supplied and who is producing.

Maximum Production Rates Producti Random Relative Price Relative Price Access of RAM (kg of Corn Meal Corn meal Memory (k corn per k (k chips per kg Producer (kg/day) chips/day) chips) corn meal) Juanita 12 4 3.00 0.33 Julio 8 2 4.00 0.25 Sergio 2 1 2.00 0.50 Maria 8 1 8.00 0.13

Supply Curve for RAM

Quantity of RAM (k Chips) 0 1 5 7 8

Relative Price of RAM (kg corn/k RAM) 0.00 2.00 3.00 4.00 8.00

Who is Producing RAM Chips No one Sergio Sergio, Juanita Sergio, Juanita, Julio Sergio, Juanita, Julio, Maria
16

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

The Supply Curve for RAM

Supply Curve for RAM
10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00 0 1 2 3 4 5 RAM (k chips/day) 6 7 8 9 10

The graph shows the supply curve for RAM based on the data in the previous table. Each additional supplier is shown above the segment where that supplier determines the relative price. The supply curve of RAM is rising, reflecting the increasing opportunity cost (also called marginal cost) of RAM in terms of foregone corn meal.
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

Relative Price (kg corn m eal/k chips)

17

Supply Curve for Corn Meal

Do

the exact same thing... But in reverse!

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

18

Supply Curve for Corn Meal: Graph

Supply Curve for Corn Meal
Relative Price (k chips/kg m eal)
0.700 0.600 0.500 0.400 0.300 0.200 0.100 0.000 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 Corn Meal (kg/day)

The supply curve for corn meal is shown above. The new producer along each segment is indicated above.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 19

International Trade
Maximum Production Rates Random Relative Price Relative Price Access of RAM (kg of Corn Meal Corn meal Memory (k corn per k (k chips per kg Producer (kg/day) chips/day) chips) corn meal) Country U 12 4 3.00 0.33 Country M 8 2 4.00 0.25 International price 3.50 0.29

All the facts are the same as in the previous example except that now we are talking about countries that can trade at an international price. The international price is between the relative prices that prevail in each country when no trade is permitted. There are many countries in the market in addition to the two shown so that a country can buy or sell as much as it wants or produces at the international price.
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 20

Country Us Production and Gains from Trade

Country U has a comparative advantage in RAM production. The blue line shows its production possibilities without trade. Slope = 0.33. The red line shows the possibilities at the international price of 0.29 k chips per kg corn (or 3.50 kg corn/ k chips RAM). Slope = 0.29. The gain to trade is the distance between the two production possibility curves.

Country U Production Possibilities

4.00 3.50

RAM (k chips/day) no Trade RAM (k chips/day) with Trade

RAM (k chips/day)

3.00 2.50 2.00 1.50 1.00 0.50 0.00 0 1 2 3 4 5 6 7 8 9 10

11

12

13

14

15

Corn Meal (kg/day)

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

21

Country Ms Production and Gains from Trade

Country M has a comparative advantage in corn meal production. The blue line shows its production possibilities without trade. Slope = 0.25. The red line shows the possibilities at the international price of 0.29 k chips/ kg corn (or 3.50 kg corn/ k chips RAM). Slope = 0.29. The gain to trade is the distance between the two production possibility curves.

Country M Production Possibilities

2.50

2.00

RAM (k chips/day) no Trade RAM (k chips/day) with Trade

RAM (k chips/day)

1.50

1.00

0.50

0.00 0 1 2 3 4 5 6 7 8 9 10

Corn Meal (kg/day)

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

22

Question
If

country U chooses to consume 7 kg/day of corn meal, what is the gain to trade from specializing in RAM production, measured in k chips/day of RAM?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

23

Answer

The vertical distance between the blue and red PPFs at a corn meal consumption of 7 kg/day measures country Us gain to trade in k chips RAM/day. The point on the blue PPF is the best country U can do without trade. With trade country U can consume more RAM per day, up to the point on the red PPF.

Country U Production Possibilities

4.00 3.50

RAM (k chips/day) no Trade RAM (k chips/day) with Trade

RAM (k chips/day)

3.00 2.50 2.00 1.50 1.00 0.50 0.00 0 1 2 3 4 5 6 7 8 9 10

11

12

13

14

15

Corn Meal (kg/day)

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

24

Question
What

is country Ms gain if it chooses to consume 1.5 k chips per day, measured in kg/day of corn meal?

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

25

Answer

The horizontal distance between the red and blue PPFs measures country Ms gain to trade at a RAM consumption of 1.5 k chips/day. The blue PPF is the best that country M can do without trade. Trade allows country M to specialize in the production of corn meal and still benefit from a higher consumption of RAM.

Country M Production Possibilities

2.50

2.00

RAM (k chips/day) no Trade RAM (k chips/day) with Trade

RAM (k chips/day)

1.50

1.00

0.50

0.00 0 1 2 3 4 5 6 7 8 9 10

Corn Meal (kg/day)

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

26

The International Supply Curve for RAM

The international supply curve for RAM is a rising function of the opportunity cost of RAM in terms of foregone corn meal. Which countries actually produce RAM for the international market will depend upon where the demand curve crosses this supply curve.

Relative Price (kg corn meal/k chips)

Least Efficient Producers

Most Efficient Producers

Demand

RAM (K chips/day)

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

27

The Sources of Comparative Advantage

The Heckscher-Ohlin Theorem is a theory that explains the existence of a countrys comparative advantage by its factor endowments.
Factor endowments: the quantity and quality of labor, land, and natural resources of a country. From Sweden in the early 1900s

According to the H-O theorem, a country has a comparative advantage in the production of a product if that country is relatively well endowed with inputs used intensively in the production of that product.
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 28

The Sources of Comparative Advantage

Edward Leamer of UCLAs five biggies:

Natural resources
Knowledge capital

Physical capital
Land

Skilled and unskilled labor

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

29

Other Explanations for Observed Trade Flows

Product

differentiation and competitive

markets Acquired comparative advantage Natural comparative advantages Economies of scale Trading Environments Openness of Economy

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

30

Note of Caution

Information on comparative advantage is often given in many other forms - pay careful attention to the information you are given. Two more ways to present the same kind of information:
1 yd. of cloth 1 barrel of wine England 2 hours 40 hours Portugal 1 hour 10 hours

England Portugal 1 hour of labor in cloth .5 yd. of cloth 1 yd. of cloth 1 hour of labor in wine 1/40 bl. of wine 1/10 a bl. of wine

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

31

Absolute Advantage and Comparative Advantage

1 yd. of cloth 1 barrel of wine England 2 hours 40 hours Portigal 1 hour 10 hours

England Portigal 1 hour of labor in cloth .5 yd. of cloth 1 yd. of cloth 1 hour of labor in wine 1/40 bl. of wine 1/10 a bl. of wine

Portugal has the A.A. in both wine and cloth. England has the C.A. in cloth. Portugal has the C.A. in wine. Can you figure out the marginal opportunity cost for each output in each country?
Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 32

From Opportunity Cost to Marginal Cost

The concept of marginal cost is the most important concept in the theory of producer supply behavior. Marginal cost is the additional cost associated with increasing production by one unit. In our production possibility examples, marginal cost is the value of the activity that is reduced when the other activity is increased by one unit. Marginal cost is, therefore, the same thing as marginal opportunity cost.

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

33

PPF Gymnastics

Butter

PPF new

PPF old

The PPF is also useful for many other types of questions. Questions about efficiency. Questions about equity. Questions about tax and transfer policy. Questions about composition of output. Questions about growth and productivity.
Guns

Prof. John M. Abowd and Jennifer P. Wissink, Cornell University

34