PPC illustrates the economic concepts of

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					 Lecture 2A - Production Possibilities: The
economics behind specialization and trade.

   PPC illustrates the economic concepts of
 • absolute advantage: ability to produce more
   output
 • comparative advantage: ability to produce output
   at a lower opportunity cost
 • law of comparative advantage: production
   specialization and trade yields more output than
   self sufficiency when opportunity costs among
   producers differ
 • terms of trade: rate at which 2 goods are traded
                                                  1
   Exchange possibilities exist when
opportunity costs differ among producers

  Wisconsin                   Alabama
Corn     Cotton          Corn      Cotton

 80        0              40         0

 60       10              30        10

 40       20              20        20

 20       30              10        30

  0       40              0         40
                                            2
Wisconsin   Alabama




                      3
  opportunity cost in Wisconsin   opportunity cost in Alabama


     2 corn = 1 cotton               1 corn = 1 cotton
             or
     1 corn = ½ cotton

Wis. has comparative advantage in corn production
       (1 corn = ½ cotton vs. 1 corn = 1 cotton)


Ala. has comparative advantage in cotton production
       (1 cotton = 1 corn vs. 1 cotton = 2 corn)
                                                                4
Total production of corn and cotton can be
   increased if Wis. and Ala. specialize
according to their comparative advantage

               without specialization
                  Ala.    Wisc.       Total
     Cotton       20       20          40
      Corn        20       40          60


                with specialization
                   Ala.    Wisc.        Total
      Cotton       40        0           40
       Corn         0       80           80
                                                5
Specialization and trade can enable both
states to “gain.”

          Assume both states want 20 cotton
• to trade cotton, Ala. must receive at least its
  opportunity cost 1 cotton = 1 corn
• to trade for cotton, Wis. will pay at most its
  opportunity cost 1 cotton = 2 corn
• if terms of trade are 1 cotton = 1.5 corn both
  states benefit:
   – Ala. gets 30 corn (vs. 20) for 20 cotton
   – Wis. gives up only 30 corn (vs. 40) for 20 cotton

                                                         6
         Wisconsin                                  Alabama




                           Gains From Trade
1. Through specialization and trade both states are able to consume
   outside their production possibilities.
2. Economists support free trade because it increases consumption
   possibilities.

What are some of the caveats associated with the free trade
argument?                                                             7
          Wa-Da-Ya-Think Quiz




Q1. Why do you think you’re not self
    sufficient?                        8
              End Point Assignment

1. What is the difference between absolute and
   comparative advantage?
2. What is the law of comparative advantage?
3. Under what circumstances would 2 producers
   be willing to specialize in production and then
   trade?
4. Why do economists encourage free trade?



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