Exploring International Trade and PPF Concepts

In order to determine international trade, that is how much a country should produce and how much they should trade away and how much they should import, we have to determine a country's production possibilities frontier. The PPF is just a graph that shows how much we can produce given what we have. That is the combination of output that we can possibly produce given the factors of production, land, labor, capital, and level of technology in our economy. The PPF allows us to illustrate a number of important concepts. First, opportunity cost. Would I have to give up to get something? How much of one good do I have to give up to get another? Tradeoffs, the fact that I can't produce infinite amounts of anything. Efficiency, the maximization of the production. And economic growth, that is, how can I expand what I'm able to produce? Let's take a look at a PPF. We know that our example of the United States and Japan is going to include two goods, computers and wheat. We're going to create what we call a... constant cost PPF. The constant cost PPF refers to a constant opportunity cost. That is, we're looking at computers on one axis, wheat on the other, and our PPF is a straight line with two endpoints. At the endpoints, we only produce one good or the other. So a constant cost PPF tells us that we're constantly giving up the same amount of one good to get the same amount of the other. In other words, I might give up five wheat, and if I do, I give up all the resources to produce that five wheat. All those resources can be used to make one computer. In other words, the amount of land, labor, capital, and technology that I have can be seamlessly converted into the computer industry and make one computer. The benefit of a model like this and a constant cost is that I can always assume that it's the same. So in other words, five wheat giving up the production of five wheat releases enough factors of production in order to make one computer. But under constant opportunity cost, I can double that. And I can say 10 wheat would allow me to make two computers. 15 wheat would allow me to make three computers. And so on and so on. The idea being that every five wheat is going to buy me one more computer. Now you might be thinking to yourself, is this realistic? And the answer is no. If you think about, for example, just the physical capital that's associated with wheat production, you might say, okay, a tractor. Well, is a tractor very useful at producing computers? Probably not. So in the real world, we refer to what we call an increasing cost production possibilities frontier. An increasing cost PPF is one that says that we have to give up more and more of a good to get the same amount of the other. In other words, I'd have to give up more and more wheat every time I wanted one more computer. computer. It's a much more realistic type of PPF, but the problem is for us, it becomes much more mathematically complicated. So we focus our attention just on constant cost PPFs because it's easier to understand, it's easier to interpret, and it doesn't really change the end result of how countries can gain from trade. Now, a couple of points with our production possibilities frontier. As I mentioned, the end points on your PPF reflect the production of only those goods. So only computers, were only wheat. If we're producing at the end points, that means we're using all of our factors just to produce those goods. But of course we could produce anywhere within those end points as well. So if I wanted to produce mostly wheat and only a few computers, I would be up here on the top part of my PPF. If I wanted to produce relatively more computers and less wheat, I'd be down here in the lower part. Where a country chooses to produce, whether they're in an open or closed economy, is largely based on how much they want of each good and how much they could trade away if they're more open. When we look at what we can produce versus what we can't produce, the PPF is also important. So anywhere on the production possibilities frontier, that is anywhere on this line, I am able to produce any of those combinations of computers and wheat. Now let's take a point on our PPF. Let's say we're going to take point A. So point A represents the combination of computers and wheat that I can produce. So let's put some numbers to it. Let's suppose that we're going to produce five computers or 20 wheat. Okay, so I can produce at point A 20 wheat and five computers. Could I, for example, produce at a point here, which represents about half the amount of computers and about half the amount of wheat? And the answer is, of course, if I can produce 20 wheat and five computers, I can certainly produce more. But the question is, could I produce outside my production possibilities frontier? Let's label that at point C. The answer is no, because remember the PPF represents the maximum that you're able to produce. We can produce on our PPF or inside it, but we can't produce outside it. Now, if we're at a point like A, we say a point like A is efficient. That means we're using all of our resources to make the most that we possibly can. But this inside point here, let's call it B, is inefficient. Inefficient simply means we're not using all of our resources to maximize production. Finally, what about economic growth? How can an economy grow? The only way an economy can grow is increasing the resources that they have. So let's say that there's an increase in the number of machines or physical capital. Let's say it's equally distributed in both the wheat industry and the computer industry. The effect that would have is that it would expand out the PPF. It would shift it out. allowing us to produce more of both goods. In order to grow, we have to have more resources. But what our international trade model is going to show us is that we're also going to be able to consume more than we can produce if we open our economy to trade. So let's look at our example. Let's first start with the United States. A couple of assumptions. We're going to assume the United States has 50,000 hours of labor available for production per month. and we're going to assume producing one computer requires 100 hours of labor and one ton of wheat requires 10 hours of labor that is if i take all 50 000 hours of my labor and only produce computers i could create my production possibilities frontier the endpoint on my ppf i could do the same with wheat or i could divide up the 50 000 of hours of labor between a computer and the wheat industry this will allow me to create the entire production possibilities frontier So let's start by creating our endpoints and we can then create our constant cost PPF. We know in this case that one computer is able to be produced in 100 hours. So in a constant cost PPF, that also tells me that two computers can be produced in 200 hours, three computers in 300 hours, and so on. So we can ask the question, how many computers or X computers if I use all 50,000 hours of the labor available? That is, I'm creating the endpoint on my PPF. In this case, you can cross multiply and you can get your answer. So we get 50,000 hours times one computer is equal to, in this case, 100x. Divide both sides by 100 and what do you get? You get x is equal to 500 computers. In other words, we can produce up to 500. 500 computers if we devote all 50,000 hours of our labor towards computer production. Now, if we produce 500 computers, how much wheat can we make? None. Why? Because we've used all the resources that we have to only produce computers. We can use the same setup to calculate the endpoint for the wheat. So we know that in this case, one wheat requires 10 hours of labor. So we can produce X wheat in... 50,000 hours. Follow the same cross multiplication and what you'll find is you'll get 5,000 wheat. So if I use all 50,000 hours to only produce wheat, I would get 5,000. Let's put this in a graph. So in our production possibilities frontier, again, we're going to put computers on our x, we're going to put wheat on our y. We know that if we take 50,000 hours of labor, and only devoted it to wheat production, we could make up to 5,000 wheat. If we devoted it only to computer production, we could create 500 computers. If we connect our points because we know that this is a constant cost PPF, we get our production possibilities frontier for the United States. So the United States can operate anywhere on that line and be considered efficient. Anywhere inside that line they can also produce, although it would be considered inefficient. For simplification, to begin as a point of comparison, we're going to assume that the United States chooses to equally divide their labor among the two industries. That is, they're going to put 25,000 hours in wheat and 25,000 hours in computers. That puts them on their PPF at the very middle where we're going to have 2,500 wheat and 250 computers. We're going to assume that this is going to be the closed economy production and consumption point. Why production and consumption? Well, because if you're a closed economy, you're not trading with anyone. If you're not trading with anyone... How much you produce is how much you're also going to be able to consume. Let's turn to Japan. Japan looks a little different. They're a smaller economy with a smaller labor pool. They only have 30,000 hours of labor available for production per month. Producing one computer in Japan requires 125 hours of labor. Producing one ton of wheat requires 25. So in this case, the United States requires fewer hours to produce each good, and they have more hours of labor available. So one thing immediately that should be clear is that the United States PPS is going to look different than Japan's. The United States is going to be able to produce more because they have more labor and because it requires fewer hours to make both goods. The question is going to remain, even though the U.S. has more labor and requires fewer hours to make both goods, does that mean that Japan shouldn't produce anything? Does that mean Japan shouldn't trade? How can we determine that? That's a question that we'll try to answer as we go through the example. Let's set up the same ratios, though, for Japan that we did for the United States to create their production possibilities frontier. So we know in Japan, producing one computer requires 125 hours of labor. We want to know how many computers they can instead produce in 30,000 hours of labor. So if you do the cross multiplication again, you can scale it up and you will find. that they can produce up to 240 computers. That is, if they use all 30,000 hours of their labor, they can produce 240 computers. What about wheat? One wheat requires 25 hours of labor in Japan. We want to know if they devote all 30,000 hours of their labor to wheat production, how much wheat do they get? So how many wheat can we produce in 30,000 hours? Again, cross multiply. and you'll get 1200 wheat. That is, if Japan produces or uses all of their factors of production just to produce wheat, they can make up to 1200 wheat. Let's make Japan's PPF. Now that we have their endpoints, we can create it the same way that we did for the United States. So we're going to draw our axes, computers on our x, wheat on our y. We said that we could produce up to 1200 wheat or 240 computers. Remember, the United States was 5,000 wheat and 500 computers, so you can already see that Japan's is going to be a much, much smaller production possibilities frontier. But those are their endpoints, and if they chose just the production of either of those goods, they'd end up on the x or y-axis. Also a constant cost PPF, so a straight line all the way down. We're going to make the same assumption for Japan that we did for the United States, which is they're going to take half their labor for one industry and half their labor for another. So in the case of Japan, that's 15,000 hours for wheat, 15,000 hours for computers. Now, when we look at how much that means they're going to be able to produce for each, we're going to divide it in half because they're splitting their labor in half. So that represents 120 computers and 600 tons of wheat. So in other words, this is going to be both, again, just like the United States, the production and consumption point for a closed economy in Japan. This is going to be our point of comparison. Remember, our entire point in this chapter is to focus on how much we can gain from trade. What do we get by being an open economy relative to a closed economy? So our closed economy for both the U.S. and Japan are going to represent our starting points. Now we want to determine how much they can trade away and how much they can gain.

First, opportunity cost. Would I have to give up to get something? How much of one good do I have to give up to get another?

Tradeoffs, the fact that I can't produce infinite amounts of anything. Efficiency, the maximization of the production. And economic growth, that is, how can I expand what I'm able to produce?

Let's take a look at a PPF. We know that our example of the United States and Japan is going to include two goods, computers and wheat. We're going to create what we call a...

constant cost PPF. The constant cost PPF refers to a constant opportunity cost. That is, we're looking at computers on one axis, wheat on the other, and our PPF is a straight line with two endpoints.

At the endpoints, we only produce one good or the other. So a constant cost PPF tells us that we're constantly giving up the same amount of one good to get the same amount of the other. In other words, I might give up five wheat, and if I do, I give up all the resources to produce that five wheat. All those resources can be used to make one computer.

In other words, the amount of land, labor, capital, and technology that I have can be seamlessly converted into the computer industry and make one computer. The benefit of a model like this and a constant cost is that I can always assume that it's the same. So in other words, five wheat giving up the production of five wheat releases enough factors of production in order to make one computer. But under constant opportunity cost, I can double that.

And I can say 10 wheat would allow me to make two computers. 15 wheat would allow me to make three computers. And so on and so on.

The idea being that every five wheat is going to buy me one more computer. Now you might be thinking to yourself, is this realistic? And the answer is no. If you think about, for example, just the physical capital that's associated with wheat production, you might say, okay, a tractor.

Well, is a tractor very useful at producing computers? Probably not. So in the real world, we refer to what we call an increasing cost production possibilities frontier. An increasing cost PPF is one that says that we have to give up more and more of a good to get the same amount of the other.

In other words, I'd have to give up more and more wheat every time I wanted one more computer. computer. It's a much more realistic type of PPF, but the problem is for us, it becomes much more mathematically complicated. So we focus our attention just on constant cost PPFs because it's easier to understand, it's easier to interpret, and it doesn't really change the end result of how countries can gain from trade.

Now, a couple of points with our production possibilities frontier. As I mentioned, the end points on your PPF reflect the production of only those goods. So only computers, were only wheat.

If we're producing at the end points, that means we're using all of our factors just to produce those goods. But of course we could produce anywhere within those end points as well. So if I wanted to produce mostly wheat and only a few computers, I would be up here on the top part of my PPF. If I wanted to produce relatively more computers and less wheat, I'd be down here in the lower part.

Where a country chooses to produce, whether they're in an open or closed economy, is largely based on how much they want of each good and how much they could trade away if they're more open. When we look at what we can produce versus what we can't produce, the PPF is also important. So anywhere on the production possibilities frontier, that is anywhere on this line, I am able to produce any of those combinations of computers and wheat. Now let's take a point on our PPF. Let's say we're going to take point A.

So point A represents the combination of computers and wheat that I can produce. So let's put some numbers to it. Let's suppose that we're going to produce five computers or 20 wheat. Okay, so I can produce at point A 20 wheat and five computers.

Could I, for example, produce at a point here, which represents about half the amount of computers and about half the amount of wheat? And the answer is, of course, if I can produce 20 wheat and five computers, I can certainly produce more. But the question is, could I produce outside my production possibilities frontier?

Let's label that at point C. The answer is no, because remember the PPF represents the maximum that you're able to produce. We can produce on our PPF or inside it, but we can't produce outside it. Now, if we're at a point like A, we say a point like A is efficient.

That means we're using all of our resources to make the most that we possibly can. But this inside point here, let's call it B, is inefficient. Inefficient simply means we're not using all of our resources to maximize production.

Finally, what about economic growth? How can an economy grow? The only way an economy can grow is increasing the resources that they have. So let's say that there's an increase in the number of machines or physical capital.

Let's say it's equally distributed in both the wheat industry and the computer industry. The effect that would have is that it would expand out the PPF. It would shift it out. allowing us to produce more of both goods.

In order to grow, we have to have more resources. But what our international trade model is going to show us is that we're also going to be able to consume more than we can produce if we open our economy to trade. So let's look at our example. Let's first start with the United States.

A couple of assumptions. We're going to assume the United States has 50,000 hours of labor available for production per month. and we're going to assume producing one computer requires 100 hours of labor and one ton of wheat requires 10 hours of labor that is if i take all 50 000 hours of my labor and only produce computers i could create my production possibilities frontier the endpoint on my ppf i could do the same with wheat or i could divide up the 50 000 of hours of labor between a computer and the wheat industry this will allow me to create the entire production possibilities frontier So let's start by creating our endpoints and we can then create our constant cost PPF.

We know in this case that one computer is able to be produced in 100 hours. So in a constant cost PPF, that also tells me that two computers can be produced in 200 hours, three computers in 300 hours, and so on. So we can ask the question, how many computers or X computers if I use all 50,000 hours of the labor available?

That is, I'm creating the endpoint on my PPF. In this case, you can cross multiply and you can get your answer. So we get 50,000 hours times one computer is equal to, in this case, 100x. Divide both sides by 100 and what do you get?

You get x is equal to 500 computers. In other words, we can produce up to 500. 500 computers if we devote all 50,000 hours of our labor towards computer production. Now, if we produce 500 computers, how much wheat can we make?

None. Why? Because we've used all the resources that we have to only produce computers. We can use the same setup to calculate the endpoint for the wheat. So we know that in this case, one wheat requires 10 hours of labor.

So we can produce X wheat in... 50,000 hours. Follow the same cross multiplication and what you'll find is you'll get 5,000 wheat. So if I use all 50,000 hours to only produce wheat, I would get 5,000. Let's put this in a graph.

So in our production possibilities frontier, again, we're going to put computers on our x, we're going to put wheat on our y. We know that if we take 50,000 hours of labor, and only devoted it to wheat production, we could make up to 5,000 wheat. If we devoted it only to computer production, we could create 500 computers. If we connect our points because we know that this is a constant cost PPF, we get our production possibilities frontier for the United States. So the United States can operate anywhere on that line and be considered efficient.

Anywhere inside that line they can also produce, although it would be considered inefficient. For simplification, to begin as a point of comparison, we're going to assume that the United States chooses to equally divide their labor among the two industries. That is, they're going to put 25,000 hours in wheat and 25,000 hours in computers.

That puts them on their PPF at the very middle where we're going to have 2,500 wheat and 250 computers. We're going to assume that this is going to be the closed economy production and consumption point. Why production and consumption?

Well, because if you're a closed economy, you're not trading with anyone. If you're not trading with anyone... How much you produce is how much you're also going to be able to consume. Let's turn to Japan.

Japan looks a little different. They're a smaller economy with a smaller labor pool. They only have 30,000 hours of labor available for production per month. Producing one computer in Japan requires 125 hours of labor. Producing one ton of wheat requires 25. So in this case, the United States requires fewer hours to produce each good, and they have more hours of labor available.

So one thing immediately that should be clear is that the United States PPS is going to look different than Japan's. The United States is going to be able to produce more because they have more labor and because it requires fewer hours to make both goods. The question is going to remain, even though the U.S. has more labor and requires fewer hours to make both goods, does that mean that Japan shouldn't produce anything?

Does that mean Japan shouldn't trade? How can we determine that? That's a question that we'll try to answer as we go through the example. Let's set up the same ratios, though, for Japan that we did for the United States to create their production possibilities frontier.

So we know in Japan, producing one computer requires 125 hours of labor. We want to know how many computers they can instead produce in 30,000 hours of labor. So if you do the cross multiplication again, you can scale it up and you will find. that they can produce up to 240 computers.

That is, if they use all 30,000 hours of their labor, they can produce 240 computers. What about wheat? One wheat requires 25 hours of labor in Japan.

We want to know if they devote all 30,000 hours of their labor to wheat production, how much wheat do they get? So how many wheat can we produce in 30,000 hours? Again, cross multiply.

and you'll get 1200 wheat. That is, if Japan produces or uses all of their factors of production just to produce wheat, they can make up to 1200 wheat. Let's make Japan's PPF.

Now that we have their endpoints, we can create it the same way that we did for the United States. So we're going to draw our axes, computers on our x, wheat on our y. We said that we could produce up to 1200 wheat or 240 computers. Remember, the United States was 5,000 wheat and 500 computers, so you can already see that Japan's is going to be a much, much smaller production possibilities frontier. But those are their endpoints, and if they chose just the production of either of those goods, they'd end up on the x or y-axis.

Also a constant cost PPF, so a straight line all the way down. We're going to make the same assumption for Japan that we did for the United States, which is they're going to take half their labor for one industry and half their labor for another. So in the case of Japan, that's 15,000 hours for wheat, 15,000 hours for computers. Now, when we look at how much that means they're going to be able to produce for each, we're going to divide it in half because they're splitting their labor in half. So that represents 120 computers and 600 tons of wheat.

So in other words, this is going to be both, again, just like the United States, the production and consumption point for a closed economy in Japan. This is going to be our point of comparison. Remember, our entire point in this chapter is to focus on how much we can gain from trade.

What do we get by being an open economy relative to a closed economy? So our closed economy for both the U.S. and Japan are going to represent our starting points. Now we want to determine how much they can trade away and how much they can gain.

Transcript for:Exploring International Trade and PPF Concepts

Transcript for:
Exploring International Trade and PPF Concepts