Saturday, 15 October 2011

Economics note: International trade V: trading and PPF

To access the document version of this chapter of notes click the "Notes Corner" above.

Trading and PPF
Production possibilities frontier (PPF) shows all combinations of two goods that a country can produce with all given resource and best technology.
Assumption:
1)       Only two goods (X, Y) are produced.
2)       Resource available and is given.
3)       Technology is given.
4)       The country uses all resource and best technology available.
Implication:
1)       Scarcity: the possible combination is limited but the want is unlimited. The good produced can't satisfy all wants.
2)       Choice: Since scarcity occurs, choices have to be made, the more the Y produced, the less the X is produced.
3)       Cost: The cost of producing 1Y = number of X sacrificed, and in general OC = dY/dX. Negative slope implies one must be sacrificed to produce another good. When the PPF is a straight line/linear, then the marginal cost is constant. When the PPF is concave, the marginal cost is increasing. That implies that more cost have to paid for producing further more one kind of the good.

The increasing marginal cost is due to the heterogeneous nature of resources. Some resources are more suitable to produce X while some are better for Y. When more X need to be produced, the one better for Y is less efficient to produce X, hence more Y is sacrificed to produce later unit of X.
Inversely, constant marginal cost implies homogeneous nature of resources.
1)       Efficiency: When the production point is along the frontier, all resources are best used so the economy is efficient. Otherwise the attainable combination is inefficient since the resources are not best used.
2)       Improvement in technology: the curve extends on one side while the maximum output for another good remains unchanged.
3)       Increase in resources: there's a parallel shift in production curve (because the OC remains unchanged)

Advantages and trading
Absolute advantages: when comparing unit of goods per unit of input (resources), the one with higher productivity has the absolute advantages.
Comparative advantages: when the slope is lower than that of another economy; i.e. dYa/dXa > dYb/dxb, the less of X sacrificed per Y produced states the comparative advantage. Note that it's independent of resources available.

For example, A has both the absolute advantage on good X and Y while A has comparative advantage on Y while B has comparative advantage on X.
Under constant marginal cost, total world output is maximized when they specialize in producing in the goods in which the economy has comparative. Then complete specialization is applied. Under a mutual beneficial TOT, the consumption possibilities frontier (CPF) increases when they trade.
Trading for concave PPF

For concave PPF, complete specialization is not preferred.
1)       At Complete specialization of good X
The slope at the production point is greater than the TOT line. i.e., the cost of producing X is higher than the international price (or the cost to produce equivalent amount of Y to trade a specified amount of X) Therefore the economy will decrease production in X and increase production in Y.
2)       At complete specialization of good Y
Similarly, at complete specialization on Y, the slope at the production point is smaller than the TOT line, the cost of producing Y is higher than the international price, so the economy will produce less Y, more X.
3)       The production point that slope = TOT line
At that point, CPF is maximized and can satisfy most wants (indifference curve), so the production point is fixed at that point.
Gain and consumption determination
At the production point B, the economy can consume any point along the TOT=CPF (satisfaction maximization is not our interest). The amount of exported and imported goods is as shown. At point A, if the original production point is along the blue part of PPF, then A boosts both consumption of good X and Y.

A very tiring topic since many diagrams were drawn. The technical parts ends here so the last one would be the trading situation.

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