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

Introduction to Macroeconomics
U.S. Trade in Goods, 2000
(billions of dollars)

400

300

200

100

0
Western Canada Japan Mexico China Others
Europe

Imports Exports

Source: U.S. Bureau of Economic Analysis, Survey of Current Business, Table 2, July 2001.

Introduction to Macroeconomics
1. Specialization by Individuals

• Division of Labor
• Opportunity Cost
• Costs of Exchange
• Comparative and Absolute Advantage

Introduction to Macroeconomics
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

Introduction to Macroeconomics
1. Specialization by Individuals
Opportunity Costs

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

Introduction to Macroeconomics
1. Specialization by Individuals
Opportunity Costs

Calculating Opportunity Costs

My Capabilities Your Capabilities
12 coconuts or 8 fish 14 coconuts or 7 fish
in 1 hour in 1 hour

My Opportunity Your Opportunity

Costs Costs
1 coconut = 2/3 fish 1 coconut = 0.5 fish
1 fish = 1.5 coconuts 1 fish = 2 coconuts

Introduction to Macroeconomics
1. Specialization by Individuals
Opportunity Costs
Incentive to Specialize
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

Introduction to Macroeconomics
1. Specialization by Individuals
Opportunity Costs

Exchange Prices
Opportunity Cost
Me You Market Price
Between
0.67 0.5
Coconuts 0.5 and 0.67
fish fish
fish

Between
1.5 2.0
Fish 1.5 and 2.0
coconuts coconuts
coconuts

Introduction to Macroeconomics
1. Specialization by Individuals
Costs of Exchange

• Negotiation costs

• Transportation costs

• Artificial barriers to trade

(e.g., import tariffs)

Introduction to Macroeconomics
U.S. Trade in Goods with Mexico

Percent of Total Imports or Exports 16 NAFTA

14
12 Peso
Crisis
10
8
6
4
2
0
1987
1988

1989
1990

1991

1992
1993
1994

1995
1996
1997

1998
1999

2000
Imports from Mexico Exports to Mexico

Source: U.S. Bureau of Economic Analysis, Survey of Current Business, Table 2, July 2001.
Introduction to Macroeconomics
 Notes Page

Introduction to Macroeconomics
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

Introduction to Macroeconomics
2. Production Possibilities Curve (PPC)

• Assumptions

• Opportunity Costs
• Comparative and Absolute Advantage
• Where Should the Economy Operate?

Introduction to Macroeconomics
2. Production Possibilities Curve (PPC)
Assumptions

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.

Introduction to Macroeconomics
2. Production Possibilities Curve
Assumptions
100
90
Production of Good B B
80 *
* D
70
60
50
* C
40
A*
30
20

10
0
0 10 20 30 40 50 60 70 80 90 100
Production of Good A

Introduction to Macroeconomics
2. Production Possibilities Curve
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

Introduction to Macroeconomics
2. Production Possibilities Curve
Assumptions
Increase in Resources or Technology
70 Improvement that benefits
Production of Clothing

60 both products. PPC shifts

outward (to the right), from
50
PPC1 to PPC2.
40
30 PPC1 PPC
2
20
10
0
0 10 20 30 40 50 60 70

Production of Food
Introduction to Macroeconomics
2. Production Possibilities Curve
Assumptions
Increase in Specialized Resources
60
Improvement that benefits
Production of Clothing

50 Food production only.

40

30
PPC1 PPC
20 2

10

0
0 10 20 30 40 50 60 70

Production of Food

Introduction to Macroeconomics
2. Production Possibilities Curve
Assumptions
Increase in Specialized Resources
70
Production of Clothing

60
Improvement that benefits
50 clothing production only.
40
30 PPC1 PPC
2
20
10
0
0 10 20 30 40 50 60 70

Production of Food

Introduction to Macroeconomics
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

Introduction to Macroeconomics
2. Production Possibilities Curve
Opportunity Cost
Increasing Opportunity Cost
50
As you increase
Production of Clothing
45
production of food you
40
sacrifice increasing
35
quantities of clothing
30
25
20
15
10
5
0
0 5 10 15 20 25 30 35 40 45 50

Production of Food
Introduction to Macroeconomics
2. Production Possibilities Curve
Comparative and Absolute Advantage

Assumptions:
• 2 countries
• 2 products
• Straight-line PPCs to simplify
model (constant opportunity cost)

Introduction to Macroeconomics
2. Production Possibilities Curve
Comparative and Absolute Advantage

110
100 PPC Country A
Production of Butter

90
80
70
60
50
40
30 PPC Country B
20
10
0
0 10 20 30 40 50 60 70 80 90
Production of Guns

Introduction to Macroeconomics
2. Production Possibilities Curve
Comparative and Absolute Advantage

Production of Production of
Guns Butter
Absolute
Country B Country A
Advantage

Comparative
Country B Country A
Advantage

Introduction to Macroeconomics
2. Production Possibilities Curve
Comparative and Absolute Advantage

110
100 PPC Country A
Production of Butter

90
80
70
60
50
40
30
20
10 PPC Country B
0
0 10 20 30 40 50 60 70 80 90 100
Production of Guns

Introduction to Macroeconomics
2. Production Possibilities Curve
Comparative and Absolute Advantage

Production of Production of
Guns Butter
Absolute
Country A Country A
Advantage

Comparative
Country A Country B
Advantage

Introduction to Macroeconomics
3. Applications

• Scarcity and Choice

– the “cruel dilemma” facing less-developed
countries

• Opportunity Costs
– staffing professors in two departments

Introduction to Macroeconomics
3. Applications
The Cruel Dilemma of the Poor

60

50 Subsistence Level
Consumption Goods

40

30 Production
Possibilities
20 Curve

10

0
0 12 24 36 48

Capital Goods

Introduction to Macroeconomics
3. Applications
Staffing University Departments

Economics Department Psychology Department

Number of Pages Number of Pages

Number of Published in Number of Published in
Professors Journals Professors 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

Introduction to Macroeconomics
3. Applications
Staffing University Departments

140

120
Psychology Pages

100

80

60

40

20

0
0 30 50 65 75 80
Economics Pages

Introduction to Macroeconomics