1. The Production Possibility Model,
Trade, and Globalization 2
CHAPTER 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

2. The Production Possibility Model,
Trade, and Globalization 2
Chapter Goals
• Demonstrate opportunity cost with a production
possibility curve
• Discuss the increasing marginal opportunity cost
• Relate the concept of comparative advantage to the
production possibility curve
• Show how through comparative advantage and trade, a
country can consume beyond their production possibility
• Explain how globalization and outsourcing are part of a
global process guided by the law of one price
2-2

3. The Production Possibility Model,
Trade, and Globalization 2
The Production Possibilities Model
• The production possibilities model can be presented
in both a table and in a graph
• A production possibility table lists a choice’s
opportunity cost by summarizing what alternative
outputs you can achieve with your inputs
• An output is a result of an activity
• An input is what you put in production process
to achieve an output
2-3

4. The Production Possibility Model,
Trade, and Globalization 2
Application: A Production Possibilities Table
History Economics
Hrs of Study Grade Hrs of Study Grade
20 98% 0 40%
What is the
18 94% 2 46%
16 90% 4 52% output?
14 86% 6 58%
12 82% 8 64% What is the
10 78% 10 70%
input?
8 74% 12 76%
6 70% 14 82%
4 66% 16 88%
2 62% 18 94%
0 58% 20 100%
2-4

5. The Production Possibility Model,
Trade, and Globalization 2
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 is a graphical representation of the opportunity
cost concept
• A PPC is created from a production possibility
table by mapping the table in a two-dimensional
graph
2-5

6. The Production Possibility Model,
Trade, and Globalization 2
Application: A Production Possibilities Curve
Econ Grade
100 A PPC demonstrates:
16 hrs for Econ and 4
hrs for History • There is a limit to what you
88
can achieve, given existing
10 hrs for each institutions, resources, and
70 History and Econ technology
• Every choice you make has
PPC an opportunity cost
40
58 66 78 100 History grade
2-6

7. The Production Possibility Model,
Trade, and Globalization 2
Increasing Marginal Opportunity Cost
The principle of increasing marginal
Butter
opportunity cost states 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
2-7

8. The Production Possibility Model,
Trade, and Globalization 2
Comparative Advantage
• The reason the opportunity cost of guns increases
as we produce more guns is that some resources
have comparative advantage over other resources
• A resource has comparative advantage if it has
the ability to be better suited to the production of
one good than another
2-8

9. The Production Possibility Model,
Trade, and Globalization 2
Efficiency
Productive efficiency is achieving as
Butter
much output as possible from a given
amount of inputs or resources
• A
• Point of efficiency
•D • Unattainable with given
amounts of inputs
•C • Point of inefficiency
•B
Guns
2-9

10. The Production Possibility Model,
Trade, and Globalization 2
Efficiency and Technological Change
Neutral technological increase Biased
or an increase in resources technological increase
A A
B B
2-10

11. The Production Possibility Model,
Trade, and Globalization 2
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
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12. The Production Possibility Model,
Trade, and Globalization 2
Trade and Comparative Advantage
• The PPC
is bowed
because
individuals
• For a society to produce on its PPC, individuals must
specialize
produce those goods for which they have a comparative
in the
advantage and trade for other goods
production
of goods
• According to Adam Smith, humankind’s proclivity to
trade leads to individuals using their comparativewhich
for
advantage they have
a
comparati
ve
advantage 2-12

13. The Production Possibility Model,
Trade, and Globalization 2
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 2010
• What caused this growth?
2-13

14. The Production Possibility Model,
Trade, and Globalization 2
The Benefits from Trade
• When
people
Textiles (yds)
freely enter
into trade,
5,000 Without trade, each
both
country can only consume
4,000 parties can
those combinations of
be
Pakistan goods along their PPCs
3,000 expected
to benefit
2,000 Belgium from trade
1,000
1 2 3 4 5 Chocolate (tons)
2-14

15. The Production Possibility Model,
Trade, and Globalization 2
The Benefits from Trade
Textiles (yds)
5,000
4,000
Why should Pakistan
3,000 Pakistan specialize in textiles
and Belgium specialize
2,000 Belgium in chocolates?
1,000
1 2 3 4 5 Chocolate (tons)
2-15

16. The Production Possibility Model,
Trade, and Globalization 2
Comparative Advantage and the Combined PPC
Combined PPC with trade
Textiles (yds)
Pakistan + Belgium
5,000
The slope of the combined
4,000 PPC is determined by the
country with the lowest
Pakistan opportunity cost
3,000
2,000
Belgium
1,000
1 2 3 4 5 Chocolate (tons)
2-16

17. The Production Possibility Model,
Trade, and Globalization 2
Application: U.S. Textile Production and Trade
• Two hundred years ago, the U.S. had a comparative
advantage in textile production
• Now, countries with cheaper labor (such as Bangladesh)
have the comparative advantage in textiles
• The gains from trade are higher wages for workers in
Bangladesh and lower-priced cloth for U.S. consumers
2-17

18. The Production Possibility Model,
Trade, and Globalization 2
Outsourcing, Trade and Comparative Advantage
Outsourcing
• Outsourcing is the relocation of production once done
in the United States to foreign countries
• Outsourcing occurs because many other countries have
a comparative advantage in labor costs
• The U.S. has comparative advantage in technology,
institutional structure, and specialized knowledge
2-18

19. The Production Possibility Model,
Trade, and Globalization 2
Outsourcing, Trade and Comparative Advantage
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
• T
h
e
g
l
o
2-19

20. The Production Possibility Model,
Trade, and Globalization 2
Outsourcing, Trade and Comparative Advantage
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
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21. The Production Possibility Model,
Trade, and Globalization 2
Outsourcing, Trade and Comparative Advantage
The Law of One Price
• The law of one price is the wages of equal workers in
one country will not differ significantly from the wages of
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. has
been living better than it could have otherwise
because of trade and outsourcing
2-21

22. The Production Possibility Model,
Trade, and Globalization 2
Chapter Summary
• The production possibility curve embodies the
opportunity cost concept
• Increasing marginal opportunity cost exists
• Trade allows people to use their comparative advantage
and shifts out society’s combined production possibility
curve
• Efficient, inefficient and unattainable points on the PPC
• Through specialization and trade, countries can increase
consumption
2-22

23. The Production Possibility Model,
Trade, and Globalization 2
Chapter Summary
• The typical outward bow of the PPC is the result
of comparative advantage and trade
• Because many goods are cheaper to produce in foreign
countries, production of goods formerly in the U.S. is being
outsourced
• Outsourcing is the product of the law of one price
• Globalization is the increasing integration of economies,
cultures, and institutions across the world
2-23

24. The Production Possibility Model,
Trade, and Globalization 2
Preview of Chapter 3:
Economic Institutions
• Define market economy
• Compare and contrast capitalism with socialism
• Describe how businesses, households, and government interact
in a market economy
• Summarize briefly the advantages and disadvantages of various
types of businesses
• Explain why, even though households have the ultimate power,
much of the economic decision making is done by business and
government
• State six roles of government
• Explain why global policy issues differ from national policy
issues
2-24