Introduction to Macroeconomics Chapter 2 Opportunity Cost, Specialization, and Trade

Introduction to Macroeconomics

Chapter 2

Opportunity Cost, Specialization,

and Trade


Chapter 2. Opportunity Cost, Specialization, and Trade

1. Microeconomics

– Specialization by Individuals

2. Macroeconomics

– Production Possibilities Curve (PPC)

3. 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.


1. Specialization by Individuals

• Division of Labor

• Opportunity Cost

• Costs of Exchange

• Comparative and Absolute Advantage


1. Specialization by Individuals Division of Labor

Reasons for Specialization

• Increase skill from repetition

• Reduce time wasted shifting between tasks

• Incentive to invest resources in developing specialized tools and machines

• Opportunity Cost


1. Specialization by Individuals Opportunity Costs

Opportunity Cost

The highest valued alternative foregone (given up) in making any choice.



My Capabilities Your Capabilities

12 coconuts or 8 fish in 1 hour

14 coconuts or 7 fish in 1 hour

My Opportunity

Costs Your Opportunity

Costs 1 coconut = 2/3 fish 1 fish = 1.5 coconuts

1 coconut = 0.5 fish 1 fish = 2 coconuts

Calculating Opportunity Costs



Production in 1 hour Me You Total Before Specialization and before Trade Coconuts 6 7 13 Fish 4 3.5 7.5 After Specialization but before Trade Coconuts 0 14 14 Fish 8 0 8 After Specialization and before Trade Coconuts 6.5 7.5 14 Fish 4.25 3.75 8

Incentive to Specialize



Opportunity Cost

Me You Market Price

Coconuts 0.67 fish

0.5 fish

Between 0.5 and 0.67

fish

Fish 1.5

coconuts 2.0

coconuts

Between 1.5 and 2.0 coconuts

Exchange Prices


1. Specialization by Individuals 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


1. Specialization by Individuals 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


2. Production Possibilities Curve (PPC)

• Assumptions

• Opportunity Costs

• Comparative and Absolute Advantage

• Where Should the Economy Operate?


2. Production Possibilities Curve (PPC) Assumptions

Identifies all combinations of the maximum amount of any two goods or services that can be produced by a given economy.

Production Possibilities Curve (PPC)


2. Production Possibilities Curve Assumptions

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*

*

*

*



• 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



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 Resources or 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 Specialized Resources



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

Increase in Specialized Resources


2. Production Possibilities Curve Opportunity Cost

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


2. Production Possibilities Curve 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

Increasing Opportunity Cost


2. Production Possibilities Curve Comparative and Absolute Advantage

Assumptions:

• 2 countries

• 2 products

• Straight-line PPCs to simplify model (constant opportunity cost)



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



Production of Guns

Production of Butter

Absolute Advantage

Country B Country A

Comparative Advantage

Country B Country A



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



Production of Guns

Production of Butter

Absolute Advantage

Country A Country A

Comparative Advantage

Country A Country B


3. Applications

• Scarcity and Choice– the “cruel dilemma” facing less-developed

countries

• Opportunity Costs– staffing professors in two departments


3. Applications The Cruel Dilemma of the Poor

0

10

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0 12 24 36 48

Capital Goods

Co

nsu

mp

tio

n G

oo

ds Subsistence Level

ProductionPossibilitiesCurve


3. Applications 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


3. Applications Staffing University Departments

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140

0 30 50 65 75 80

Economics Pages

Psy

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log

y P

ages

Documents

Introduction to Macroeconomics Chapter 2 Opportunity Cost, Specialization, and Trade