Growth and Trade

August 22, 2017

Opportunity Cost

When the economy produces goods efficiently, changing the output of one of the goods always leads to a tradeoff related to production of another good. This holds only if change in production is still efficient.
Opportunity cost is a quantitative measurement of the tradeoff and is defined as a ratio of quantity of one product foregone to gain the quantity of the other product.
Opportunity cost at a certain combination is measured as the slope of the tangent line (or the PPF itself if it is linear) to the point of a combination.

The question that arises frequently: Which point on the PPF is better than the others?
One good example is guns vs. butter: given the available resources, should a country produce military weapons and invest into defense or produce civilian goods and services?
In 1942, GM largely switched its operation of producing auto bodies and started producing military vehicles and ammunition. By the end of the war in 1945, it produced more than a million of different military engines and transporting trucks.
The point of PPF shifted from one axis to another.

At the end of 1940's, RAND ran several simulations about war between USA and USSR.
The two goods were the "degree of victory" and the financial cost of the operation.
After careful analysis, they found an optimal point on the PPF that will ensure a complete victory under minimal costs.
It was a good solution, except that they forgot to account for another variable - crew casualties, which were enormous.
Oops!
There is no one size fits all. Each point must be carefully considered and it is only better that the other under specific circumstances.

When the amount of resources or the state of technology shifts, the PPF will change as well.
If the amount of resources increases or the technology progresses, we observe the shift of the PPF to the right or outward. We associate this situation with economic growth.
If resources deplete or the part of the technology is lost, we observe the shift of PPF to the left.

For countries, PPF slowly grows over time. It happens due to technological progress or growth of the population (labor).
Sharp increases in PPF are rare. Usually they are associated with the discovery of natural resources and implementation of an economic policy.
Sharp decreases are usually associated with the natural disasters. For example, the Black Death, which resulted in death toll of 30-60% European population, did increase the wages of agricultural worker, but the overall effect of the economy was drastically negative.

Suppose you are CEO of the oil company and your company produces and sells two goods: crude oil and refined gasoline. You can produce up to 100 gallons of gasoline ($3 a gallon) or 5 barrels ($50 a barrel) of oil a year. Suppose your PPF is linear. This year government discovered new oil field and will sell the license to extract oil from it for $200. If you buy the license, you can extract additional 40 gallons (140 in total) or 2 barrels (7 barrels in total) next year. Assuming prices stay the same, draw three PPF: the initial PPF, PPF in the current year after rights for oil field extraction has been purchased, and PPF for the next year.

A country A can either produce 10 units of good X and 0 units of good Y or 6 units of good X and 4 units of good Y. Assuming linear PPF, what is the opportunity cost of production in this economy?
Suppose country A decided to produce 8 units of good X and 1 unit of good Y. What is the opportunity cost of producing additional one unit of Y?

Consider two economies (countries or companies), how can we compare them in terms of PPF?
Let us say that if one economy spends its resources to produce only one good out of two, it specializes in that good.
If a country can produce any combination of two goods in amount higher than the other country, we say that the first country holds an absolute advantage over the other country.

In most situations, different economies have different opportunity cost in producing goods.
Opportunity cost of producing good 1 with respect to good 2 is reciprocal to opportunity cost of producing good 2 with respect to good 1.
Because of that, if the countries differ in opportunity costs, even when one country holds an absolute advantage over the other, we say that each country has a comparative advantage in producing a certain good.
Because of that, almost any two economies can specialize and benefit from trade by acquiring a combination, that would otherwise be unattainable.

Suppose we have two companies: company A and company B. Both companies can produce goods C and D. PPF's for both companies are linear. The production possibilities are defined by the following table:
Company/Good C D

A 5 5

B 20 10
Draw PPF for both countries. Which company holds an absolute advantage? Which company holds a comparative advantage and in which good? If countries can exchange 1 unit of good D for 1.5 units of good D, what would be total production of goods C and D? Give an example of combination that would only attainable if companies trade.

Company/Good	C	D
A	5	5
B	20	10

Suppose there is a country that only produces cotton and wheat. Capacity of its fields is such that it can produce either 100 ton of cotton or 75 ton of wheat per year. The PPF is linear. Scientists of this country developed a new method of irrigation, that allows increased production of wheat up to 100 ton per year.
Draw PPF and find opportunity cost of the economy a) before new irrigation was implemented. b) after.
Suppose there is another country that wants to trade and offers 2 ton of wheat for 1 ton of cotton. Show which country hold comparative advantage in which good and find any unattainable combination that can be achieved through trade?

We defined opportunity cost of production as a ratio of two goods and showed how it is related to the tradeoff of production of two goods.
We showed situations in which PPF can shift and linked it to economic growth and natural disasters.
We discussed the gains from trade and showed that any economy holds comparative advantage over production of some of the goods.