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Production Possibilities Curves and International Trade
Lecture 4


Production Possibilities Curve (PPC)

1. Resources are used efficiently

  • Resources

    1. Land

    2. Capital, i.e. machines and equipment

    3. Labor

    4. Entrepreneur

2. No technological progress

A Production Possibilities Curve (PPC)

Production Possibilities Curve (PPC)


3. Results

  1. Point X - indicates society is not using resources efficiently, e.g. recession

    • Unemployment - not all workers are working

    • Within the interior

  2. Point Y - beyond the resources for society to produce

    • Possible with free trade

  3. Point A - The U.S. produces 5 thousand units of food and 0 clothes

  4. How to get to Point B from Point A?

    • Opportunity costs

    • The U.S. wants to produce more clothes! The U.S. produces 1 thousand fewer units of food and gains 4 thousand more units of clothes

4. PPC is straight line if all resources are perfect substitutes

  • Example: Land is input to farms and houses

  • Reality - land quality varies

A PPC with Increasing Opportunity Costs

Production Possibilites Curve-Increasing Opportunity Costs

  • Starting at the middle, as you go to any extreme, the opportunity cost increases

    • Trade causes an industry to expand

    • The opportunity costs increase

    • Production has increasing cost as production expands

5. Curved PPCs have increasing opportunity costs

  • The top graph is the PPC, while the bottom is the opportunity costs

  • The opportunity cost is the slope of the PPC with the negative sign removed

A Production Possibilities Curve (PPC)

Production Possibilities Curve (PPC)


6. Economic growth - economy produces more goods and services over time

  1. PPC shifts outward

  2. Economy's resource base increases

    • More labor

    • Investment

    • More machines

    • More education (human capital)

  3. Technology progress

  4. "Improved legal structure" - Well-defined property rights

  5. Investment

    • Asian tigers, China, and Japan have high savings level

      • Deposits savings into banks

      • Banks grant loans to businesses and households

        • Households invest in houses, cars, etc.

        • Businesses invest in buildings, machines, and equipment

      • Requires a developed banking system

    • PPC for U.S. and China

      • Machines and Pizza
The PPC for ChinaThe PPC for the United States
Machines Machines

China's Production Possibilities Curve (PPC)

Production Possibilites Curve (PPC) for United States

Pizza Pizza

6. Shifting the Production Possibilities Curve Inward

  1. War

  2. Natural disaster

  3. Poor legal system


Community Indifference Curves


  • Community indifference curves – indifference curve for the whole society

    1. Similar to the standard indifference curves for a consumer

      1. Goods have trade-offs

      2. Higher level indifference curves implies higher utility

Community Indifference Curves

Community Indifference Curves

    1. Problems

      1. People have different preferences; thus one cannot add up people’s indifference curves

      2. Problem defining national welfare

        • Given a production level, will all citizens be satisfied at the production level?

        • As the production level changes, some citizen’s utility may go up while other may go down

    2. Autarky

      1. Society produces and consumes at Point A

        • Tangent line is relative price

        • Price of laptops is too high. The slope is too steep.

The PPC for a Country Engaging in Free Trade

Production Possibilities Curve (PPC) for a country engaging in free trade

      1. Society produces and consumes at Point B

        • Attain a higher community indifference curve

        • Shift resources from laptops to wheat

        • Costs decrease for laptop industry

        • Price falls for laptops

        • Cost increase for wheat industry

        • Price increases for wheat


Free Trade


  • Free trade

    1. Factor mobility – movement of labor, resources, land, etc.

    2. As country opens up to free trade, factors move from import industry to export industry

    3. Export industry has comparative advantage

      • China has comparative advantage in laptops

      • U.S. has comparative advantage in wheat

      • Tangent line is relative prices in laptops per wheat

        • i.e. this is price of wheat

        • U.S. has low wheat price, while China has high wheat price

The PPCs for China and the U.S. Engaging in Free Trade

PPCs for China and the United States engaging in free trade

      • Both countries move to a higher community indifference curve

      • As industry expands, opportunity cost increases

        • A country cannot lose an entire industry

        • Relative prices are the same for both countries

        • Exports = imports for both countries


The Heckscher-Ohlin Theory


  • The Heckscher-Ohlin Theory – a country exports products that uses abundant factor resources and imports products that use scarce factor resources

    1. Labor

      • Labor abundant – a country has a higher ratio of labor to other factors relative to the world

      • Labor intensive – if labor costs are a larger share than the other factor costs

    2. Could apply to land and capital

    3. Technology may play a role; countries with advanced technology exports high-tech goods

    4. Example 1

      • U.S. has abundant farming land and scarce labor

      • Thus, the U.S. exports agricultural products and imports labor intensive products

    5. Example 2

      • China has little land, many people

      • China has 20% of the world's population, but only 10% of the world's farming land

      • China is moving away from agricultural production to labor-intensive production

      • China exports manufactured products, and imports agricultural products

      • Jiangsu has fertile farm land, but makes textiles, steel, and industrial products


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