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Introduction to Macroeconomics
Chapter 2. Opportunity Cost, Specialization, and Trade
Chapter 2. Opportunity Cost, Specialization, and Trade
• Microeconomics– Specialization by Individuals
• Macroeconomics– Production Possibilities Curve
• Applications
U.S. Trade in Goods, 2000(billions of dollars)
0
100
200
300
400
WesternEurope
Canada Japan Mexico China Others
Imports Exports
Source: U.S. Bureau of Economic Analysis, Survey of Current Business, Table 2, July 2001.
Specialization by Individuals and Exchange
• Reasons for Specialization by individuals (Division of Labor)
• Exchange required
• Costs of exchange
Reasons for Specialization(Division of Labor)
• Increase skill from repetition• Reduce time wasted shifting between
tasks• Incentive to invest resources in developing
specialized tools and machines• Opportunity Cost
Opportunity Cost
The highest valued alternative foregone (given up) in making any choice.
Calculating Opportunity Costs
My Capabilities Your Capabilities
16 coconuts or 12 fish in 1 hour
14 coconuts or 7 fish in 1 hour
My Opportunity
Costs Your Opportunity
Costs
1 coconut = 0.75 fish 1 fish = 1.25 coconuts
1 coconut = 0.5 fish 1 fish = 2 coconuts
Incentive to Specialize
Production in 1 hour Me You Total Without Specialization Coconuts 8 7 15 Fish 6 3.5 9.5 With Specialization Coconuts 0 14 14 Fish 12 0 12
Exchange prices
Opportunity Cost
Me You Market Price
Coconuts 0.75 fish
0.5 fish
Between 0.5 and 0.75
fish
Fish 1.25 coconuts
2.0 coconuts
Between 1.25 and 2.0
coconuts
Costs of Exchange
• Negotiation costs
• Transportation costs
• Artificial barriers to trade (e.g., import tariffs)
U.S. Trade in Goods with Mexico
0
2
4
6
8
10
12
14
16
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Per
cen
t o
f T
ota
l Im
po
rts
or
Exp
ort
s
Imports from Mexico Exports to Mexico
NAFTA
PesoCrisis
Source: U.S. Bureau of Economic Analysis, Survey of Current Business, Table 2, July 2001.
Notes Page
Production Possibilities Curve(PPC)
Identifies all combinations of the maximum amount of any two goods or services that can be produced by a given economy.
Production Possibilities Curve
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Production of Good A
Pro
du
ctio
n o
f G
oo
d B
A
B
C
D*
*
*
*
PPC Assumptions
• Only 2 goods or services (or aggregates of goods or services) are produced
• Full and efficient use of all available resources
• Supplies of resources (i.e., land, labor, and capital) are fixed
• Technology is held constant
Increase in Available Resourcesor Technology
0
10
20
30
40
50
60
70
0 10 20 30 40 50 60 70
Production of Food
Pro
du
ctio
n o
f C
loth
ing Improvement that benefits
both products. PPC shifts outward (to the right), from PPC1 to PPC2.
PPC1 PPC2
Increase in Available Resourcesor Technology
0
10
20
30
40
50
60
0 10 20 30 40 50 60 70
Production of Food
Pro
du
ctio
n o
f C
loth
ing Improvement that benefits
Food production only.
PPC1 PPC2
Increase in Available Resourcesor Technology
0
10
20
30
40
50
60
70
0 10 20 30 40 50 60 70
Production of Food
Pro
du
ctio
n o
f C
loth
ing
Improvement that benefits clothing production only.
PPC1 PPC2
Opportunity Cost and the PPC
Two important characteristics of the PPC:
• Opportunity Cost - The PPC slopes downward and to the right
• Increasing Opportunity Cost - The PPC is "bowed outward" (concave) from the origin
Increasing Opportunity Cost
0
5
10
15
20
25
30
35
40
45
50
0 5 10 15 20 25 30 35 40 45 50
Production of Food
Pro
du
ctio
n o
f C
loth
ing
As you increase production of food you sacrifice increasing quantities of clothing
Applications
• Scarcity and Choice– the “cruel dilemma” facing less-developed
countries
• Opportunity Costs– staffing professors in two departments
• Specialization– comparing 2 PPCs (comparative vs absolute
advantage)
Scarcity and Choicethe Cruel Dilemma of the Poor
0
10
20
30
40
50
60
0 12 24 36 48
Capital Goods
Co
nsu
mp
tio
n G
oo
ds Subsistence Level
ProductionPossibilitiesCurve
Staffing University Departments
Economics Department Psychology Department
Number ofProfessors
Number of PagesPublished in
JournalsNumber ofProfessors
Number of PagesPublished in
Journals
0 0 5 120
1 30 4 115
2 50 3 100
3 65 2 75
4 75 1 40
5 80 0 0
PPC - Staffing University Departments
0
20
40
60
80
100
120
140
0 30 50 65 75 80
Economics Pages
Psy
cho
log
y P
ages
Comparative and Absolute Advantage
• Absolute Advantage - a person can produce a good or service with fewer resources than can another person
• Comparative Advantage - a person can produce a good or service with lower opportunity cost than can another person
Comparative vs Absolute Advantage
Assumptions:• 2 countries• 2 products• Straight-line PPCs to simplify model
(constant opportunity cost)
Comparative vs Absolute Advantage
0102030405060708090
100110
0 10 20 30 40 50 60 70 80 90
Production of Guns
Pro
du
ctio
n o
f B
utt
er
PPC Country A
PPC Country B
Comparative vs Absolute Advantage
Production of Guns
Production of Butter
Absolute Advantage
Country B Country A
Comparative Advantage
Country B Country A
Comparative vs Absolute Advantage
0102030405060708090
100110
0 10 20 30 40 50 60 70 80 90 100
Production of Guns
Pro
du
ctio
n o
f B
utt
er
PPC Country A
PPC Country B
Comparative vs Absolute Advantage
Production of Guns
Production of Butter
Absolute Advantage
Country A Country A
Comparative Advantage
Country A Country B
