Production Possibilities Curves and International Trade
Lecture 4

Production Possibilities Curve (PPC)

• Resources
  1. Land
  2. Capital, i.e. machines and equipment
  3. Labor
  4. Entrepreneur

1. Point X - indicates society is not using resources efficiently, e.g. recession
   • Unemployment - not all workers are working
   • Within the interior
2. Point Y - beyond the resources for society to produce
   • Possible with free trade
3. Point A - The U.S. produces 5 thousand units of food and 0 clothes
4. How to get to Point B from Point A?
   • Opportunity costs
   • The U.S. wants to produce more clothes! The U.S. produces 1 thousand fewer units of food and gains 4 thousand more units of clothes

• Example: Land is input to farms and houses
• Reality - land quality varies

• Starting at the middle, as you go to any extreme, the opportunity cost increases
  • Trade causes an industry to expand
  • The opportunity costs increase
  • Production has increasing cost as production expands

• The top graph is the PPC, while the bottom is the opportunity costs
• The opportunity cost is the slope of the PPC with the negative sign removed

1. PPC shifts outward
2. Economy's resource base increases
   • More labor
   • Investment
   • More machines
   • More education (human capital)
3. Technology progress
4. "Improved legal structure" - Well-defined property rights
5. Investment
   • Asian tigers, China, and Japan have high savings level
     • Deposits savings into banks
     • Banks grant loans to businesses and households
       • Households invest in houses, cars, etc.
       • Businesses invest in buildings, machines, and equipment
     • Requires a developed banking system
   • PPC for U.S. and China
     • Machines and Pizza

1. War
2. Natural disaster
3. Poor legal system

Community Indifference Curves

• Community indifference curves – indifference curve for the whole society
  1. Similar to the standard indifference curves for a consumer
     1. Goods have trade-offs
     2. Higher level indifference curves implies higher utility

2. Problems
   1. People have different preferences; thus one cannot add up people’s indifference curves
   2. Problem defining national welfare
      • Given a production level, will all citizens be satisfied at the production level?
      • As the production level changes, some citizen’s utility may go up while other may go down
3. Autarky
   1. Society produces and consumes at Point A
      • Tangent line is relative price
      • Price of laptops is too high. The slope is too steep.

2. Society produces and consumes at Point B
   • Attain a higher community indifference curve
   • Shift resources from laptops to wheat
   • Costs decrease for laptop industry
   • Price falls for laptops
   • Cost increase for wheat industry
   • Price increases for wheat

Free Trade

• Free trade
  1. Factor mobility – movement of labor, resources, land, etc.
  2. As country opens up to free trade, factors move from import industry to export industry
  3. Export industry has comparative advantage
     • China has comparative advantage in laptops
     • U.S. has comparative advantage in wheat
     • Tangent line is relative prices in laptops per wheat
       • i.e. this is price of wheat
       • U.S. has low wheat price, while China has high wheat price

• Both countries move to a higher community indifference curve
• As industry expands, opportunity cost increases
  • A country cannot lose an entire industry
  • Relative prices are the same for both countries
  • Exports = imports for both countries

The Heckscher-Ohlin Theory

• The Heckscher-Ohlin Theory – a country exports products that uses abundant factor resources and imports products that use scarce factor resources
  1. Labor
     • Labor abundant – a country has a higher ratio of labor to other factors relative to the world
     • Labor intensive – if labor costs are a larger share than the other factor costs
  2. Could apply to land and capital
  3. Technology may play a role; countries with advanced technology exports high-tech goods
  4. Example 1
     • U.S. has abundant farming land and scarce labor
     • Thus, the U.S. exports agricultural products and imports labor intensive products
  5. Example 2
     • China has little land, many people
     • China has 20% of the world's population, but only 10% of the world's farming land
     • China is moving away from agricultural production to labor-intensive production
     • China exports manufactured products, and imports agricultural products
     • Jiangsu has fertile farm land, but makes textiles, steel, and industrial products