Paul Krugman and Robin Wells. Microeconomics. Third Edition. Chapter 2 Economic Models: Trade-offs and Trade. Copyright 2013 by Worth Publishers

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1 Paul Krugman and Robin Wells Microeconomics Third Edition Chapter 2 Economic Models: Trade-offs and Trade Copyright 2013 by Worth Publishers

2 The production-possibility frontier 1. shows combinations of goods that can be produced with available resources (labor, machinery, etc.) 2. simple model of production with two goods guns and butter: if we produce 50 guns as efficiently as possible, then, with the workers, machines, etc., that are left, how much butter can we make ( and repeat for all other levels of gun/butter production) 3. shows outer limits of what can be produced, using available resources as efficiently as possible; negative slope shows that more of one good must mean less of the other good(s) opportunity cost! shows that to have more of something, must make tradeoffs 4. at points inside the frontier, some inputs are unemployed or are not being used efficiently; points outside the frontier aren t feasible (require more inputs than are available) 5. as quantity of inputs grows over time, frontier will shift out could being inside the frontier permanently shift it in?

3 The production-possibility frontier (continued) 6. P-P frontier only tells us what options are available, not which option is the right one to choose 7. Differences in the p-p frontiers of different countries mean that the countries have different opportunity costs of producing the same goods so a country can gain by specializing and trading produce the good whose opportunity cost is low, trade it for the good it can only produce at higher opportunity cost (which some other country will produce) e.g., England has lower opportunity cost of cloth production, Portugal has lower opportunity cost of wine production So England will specialize in cloth production, Portugal will specialize in wine production England will trade its cloth for Portugal s wine, and vice-versa. The result will be: both countries become better off!

4 Note: since slope of the frontier is constant, this assumes constant opportunity cost of small jets in terms of Dreamliners in terms of small jets: 8 more small jets always means 6 less Dreamliners (and viceversa). Figure 2.1 The Production Possibility Frontier Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

5 Note: since slope of the frontier is increasing in absolute value as quantity of small jets increases, this assumes increasing opportunity cost of small jets in terms of Dreamliners Figure 2.2 Increasing Opportunity Cost Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

6 Figure 2.3 Economic Growth Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

7 USA: Opportunity cost of 16 small jets = = 12 large jets So opportunity cost of one small jet = 12/16 = 0.75 large jet Opportunity cost of 18 large jets = = 24 small jets So opportunity cost of one large jet is = 24/18 = 1.33 small jets Brazil: Opportunity cost of 6 small jets =10 8 = 2 large jets So opportunity cost of one small jet = 2/6 = 0.33 large jet Opportunity cost of 8 large jets = 30 6 = 24 small jets So opportunity cost of one large jet is = 24/8 = 3 small jets So opportunity cost of SMALL jet is lower in Brazil (0.33 large) than in US (0.75 large). And opportunity cost of LARGE jet is lower in USA (1.33 small) than in Brazil (3 small). So USA should specialize in producing large jets, Brazil in producing small jets.

8 Terms of trade: USA wants to produce large jets, sell them to Brazil in exchange for small jets. It will want to get more than 4/3 of a small jet for each large jet (which is the USA s own opportunity cost). Likewise, Brazil wants to produce small jets, sell them to USA in exchange for large jets. It will want to pay less than 3 small jets for each large jet (which is Brazil s own opportunity cost). So the price of a large jet will be between 4/3 of a small jet and 3 small jets maybe 2 small jets per large jet?

9 With trade, the USA produces 30 large jets but consumes only 20. The other 10 large jets go to Brazil, in exchange for 20 small jets. Thus, the USA has paid a price of 10/20 or 0.50 large jets for each of the small jets it got from Brazil. With trade, Brazil produces 30 small jets but consumes only 10. The other 20 small jets go to the USA, in exchange for 10 large jets. Thus, Brazil has paid a price of 20/10 or 2 small jets for each of the large jets it got from the USA. So the price of a small jet is 0.50 large jets, And the price of a large jet is 2.00 small jets.

10 Figure 2.5 Comparative Advantage and Gains from Trade Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

11 implications for household behavior Consider Fred and Rachel, who can each produce home output (H) and market output (M). Their p-p frontiers look like this: Opportunity cost of producing H (in terms of lost production of M): Fred = 10 M lost for each 5 H gained, = 10/5 = 2 M for each H Rachel = 3 M lost for each 11 H gained, = 3/11 M for each H So Rachel has the lower opportunity cost of production of H. Opportunity cost of M in terms of H = 5/10 for Fred; = 11/3 for Rachel. So Fred should specialize in market production, and Rachel should specialize in home production

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13 Key implications of the model: There are potential gains from trade for both partners. Gains may be greatest for partners who are different from each other. ( Opposites attract ) The traditional household setup is not necessarily irrational, sexist, patriarchal, etc. could be completely rational! Marriage/partnership could become less attractive if women s market earning power increases (reduces M productivity difference between men and women) labor-saving appliances become more available (reduces H productivity difference between men and women)

14 Poor countries have low productivity in all industries, but not as much in clothing manufacture so they have a comparative advantage in clothing manufacture. Unnumbered Figure 2.1 Pajama Republics Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers

15 Figure 2.6 The Circular-Flow Diagram Krugman and Wells: Microeconomics, Third Edition Copyright 2013 by Worth Publishers