Production Possibility Frontier

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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 1

The Production Possibilities
Frontier
 Let’s introduce the Production
Possibilities Frontier
– better known as the PPF.
 The PPF is a basic workhorse in
economics.
 Important for understanding some basic
issues in economics.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 2

The PPF
 Great application is with international
trade theory.
 Helps one understand and distinguish
between comparative advantage and
absolute advantage.
 An important historical figure in all this is
David Ricardo.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 3

David Ricardo
 Famous 19th century British economist.
 Some consider him the grandfather of
international trade theory.
 Very influential in pioneering the theory of
comparative advantage, inter alia.
 Very interesting, very bright guy.
 Had a lot of say about the “corn laws” in
England.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 4

The Production Possibility
Frontier - What Is It?
 The description of the best possible
combinations of two goods to produce
using all of the available resources.
 Shows the trade-off between more of
one good in terms of the other.
 Assumes: input endowments given,
technology given, time given and
efficient production.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 5

Opportunity Cost
 The opportunity cost of an activity is the value of
the resources used in that activity when they are
measured by what they would have produced
when used in their next best alternative.
 The slope of the Production Possibility Frontier
measures the marginal opportunity cost of
producing one good in terms of the amount of
the other good foregone.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 6

A Typical PPF Picture
The marginal
Butter opportunity cost of
just attainable unattainable guns in terms of
butter is
increasing as we
move down the
PPF!
inefficient just attainable The PPF is
typically bowed-
out or linear.
It is not bowed-in

Guns
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 7

Comparative Advantage
 The person with the lower marginal
opportunity cost of an activity has the
comparative advantage at that activity.
 This means that the person with the
comparative advantage can produce
the activity by giving up the smallest
amount of the alternative activity.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 8

The Idea of Comparative
Advantage and Trade
 Specialization and free trade will benefit
all trading parties, even when some are
“absolutely” more efficient producers
than others.
 Need to understand absolute vs.
comparative advantage.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 9

Absolute vs. Comparative
Advantage Applied to Trade
 Absolute advantage: if your country uses fewer resources
to produce a given unit of output than the other country.
 Comparative advantage: if your country can produce the
output at a lower marginal cost in terms of other goods
foregone than the other country.
 Every country (or person, or economy) has a comparative
advantage at some activity.
 Absolute advantage is not important and may not always
happen. Sometimes people or countries have the absolute
advantage in nothing! Yet trade possibilities still exist.
 It’s all about comparative advantage.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 10

PPFs and Comparative
Advantage
Maximum Production Rates Production P
Random Relative Price Relative Price
Access of RAM (kg of Corn Meal
Corn meal Memory (k corn per k (k chips per
Producer (kg/day) chips/day) chips) kg corn meal)
Juanita 12 4 3.00 0.33
Julio 8 2 4.00 0.25
 In this example, there are two goods being produced: Corn meal and RAM.
 Juanita has an absolute advantage at both: she can produce more of each than
Julio.
 Juanita has a comparative advantage at producing RAM compared to Julio: she
gives up 3.00 kg/day of corn meal to make an additional 1k of chips.
 Julio has a comparative advantage at producing corn meal compared to Juanita: he
gives up 0.25 k chips to make an additional kg of corn meal.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 11

Production Possibilities
 When we draw the Production Possibilities (2)
production possibilities 8.00

for Juanita and Julio,

there is a kink at 8 7.00 Julio varies production of both while Juanita stays
specialized in RAM. Slope equals Julio's price of corn
kg/day corn meal and 6.00 meal in terms of RAM = -0.25 k chips/kg corn meal.

4.00 k chips/day RAM. Juanita varies production

RAM (k chips/day)
5.00
of both while Julio stays
 The chart shows who specialized in corn meal.
4.00
specializes in corn Slope equals Juanita's
price of corn meal in
meal and RAM at each 3.00 terms of RAM = -0.33 k
chips/kg corn meal.
production level. 2.00

1.00

0.00
0 1 2 3 4 5 6 7 8 9 10 111213 141516 171819 202122 232425 262728 2930
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Corn m eal (kg/day)

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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 12

Adding a Third Producer
Maximum Production Rates Production P
Random Relative Price Relative Price
Access of RAM (kg of Corn Meal
Corn meal Memory (k corn per k (k chips per
Producer (kg/day) chips/day) chips) kg corn meal)
Juanita 12 4 3.00 0.33
Julio 8 2 4.00 0.25
Sergio 2 1 2.00 0.50

 Sergio has no absolute advantage; however, he has a

comparative advantage over both Juanita and Julio in the
production of RAM.
 He sacrifices 2.00 kg of corn meal to make an additional 1k of
chips.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 13

Adding a Fourth Producer
Maximum Production Rates Producti
Random Relative Price Relative Price
Access of RAM (kg of Corn Meal
Corn meal Memory (k corn per k (k chips per kg
Producer (kg/day) chips/day) chips) corn meal)
Juanita 12 4 3.00 0.33
Julio 8 2 4.00 0.25
Sergio 2 1 2.00 0.50
Maria 8 1 8.00 0.13

 Question: What is Maria’s comparative advantage

with respect to each of the other three producers?
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 14

Comparative Advantage and
Specialization
 As more and more Production Possibilities (All)
producers enter the
economy, the 8.00

production possibility 7.00

curve gets more and

more bowed out 6.00

(concave).
RAM (k chips/day)
5.00

 Along any segment, 4.00

most of the producers
are fully specialized. 3.00

 Only one producer is 2.00

producing both goods

along any segment. 1.00

0.00
0 1 2 3 4 5 6 7 8 9 1011 1213 141516 1718 192021 2223 242526 2728 2930
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Corn meal (kg/day)

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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 15

The Supply Curve from the
PPF
Maximum Production Rates Producti
Random Relative Price Relative Price
 At each relative Access of RAM (kg of Corn Meal
price of RAM in Corn meal Memory (k corn per k (k chips per kg
terms of foregone Producer (kg/day) chips/day) chips) corn meal)
Juanita 12 4 3.00 0.33
corn meal, we Julio 8 2 4.00 0.25
can determine the Sergio 2 1 2.00 0.50
Maria 8 1 8.00 0.13
market supply
Supply Curve for RAM

 The table shows Relative

how much is Quantity Price of RAM
of RAM (k (kg corn/k Who is Producing RAM
supplied and who Chips) RAM) Chips
is producing. 0 0.00 No one
1 2.00 Sergio
5 3.00 Sergio, Juanita
7 4.00 Sergio, Juanita, Julio
8 8.00 Sergio, Juanita, Julio, Maria
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 16

The Supply Curve for RAM
Supply Curve for RAM

10.00
Relative Price (kg corn

9.00
8.00
m eal/k chips)

7.00
6.00
5.00
4.00
3.00
2.00
1.00
0.00
0 1 2 3 4 5 6 7 8 9 10
RAM (k chips/day)

 The graph shows the supply curve for RAM based on the data in the previous table. Each
additional supplier is shown above the segment where that supplier determines the relative
price.
 The supply curve of RAM is rising, reflecting the increasing opportunity cost (also called
marginal cost) of RAM in terms of foregone corn meal.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 17

Supply Curve for Corn Meal
 Do the exact same thing...
 But in reverse!
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 18

Supply Curve for Corn Meal:
Graph
Supply Curve for Corn Meal
Relative Price (k chips/kg

0.700
0.600
0.500
0.400
m eal)

0.300
0.200
0.100
0.000
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35
Corn Meal (kg/day)

 The supply curve for corn meal is shown above.

 The new producer along each segment is
indicated above.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 19

International Trade
Maximum Production Rates
Random Relative Price Relative Price
Access of RAM (kg of Corn Meal
Corn meal Memory (k corn per k (k chips per kg
Producer (kg/day) chips/day) chips) corn meal)
Country U 12 4 3.00 0.33
Country M 8 2 4.00 0.25
International price 3.50 0.29
 All the facts are the same as in the previous example except that now we are
talking about countries that can trade at an international price.
 The international price is between the relative prices that prevail in each country
when no trade is permitted.
 There are many countries in the market in addition to the two shown so that a
country can buy or sell as much as it wants or produces at the international price.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 20

Country U’s Production and
Gains from Trade
 Country U has a comparative
advantage in RAM
production. Country U Production Possibilities
 The blue line shows its 4.00 RAM (k
production possibilities 3.50 chips/day) no
Trade
without trade. Slope = –0.33. 3.00

RAM (k chips/day)
RAM (k
 The red line shows the 2.50 chips/day) with
possibilities at the 2.00
Trade
international price of 0.29 k
1.50
chips per kg corn (or 3.50
kg corn/ k chips RAM). 1.00

Slope = –0.29. 0.50

 The gain to trade is the 0.00

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
distance between the two
Corn Meal (kg/day)
production possibility curves.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 21

Country M’s Production and
Gains from Trade
 Country M has a comparative
advantage in corn meal
production. Country M Production Possibilities
 The blue line shows its 2.50 RAM (k
production possibilities chips/day) no
Trade
without trade. Slope = –0.25. 2.00
RAM (k

RAM (k chips/day)
 The red line shows the chips/day) with
1.50
possibilities at the Trade
international price of 0.29 k
1.00
chips/ kg corn (or 3.50 kg
corn/ k chips RAM). Slope = 0.50
–0.29.
 The gain to trade is the 0.00
distance between the two 0 1 2 3 4 5 6 7 8 9 10

production possibility curves. Corn Meal (kg/day)

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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 22

Question
 If country U chooses to consume 7
kg/day of corn meal, what is the gain to
trade from specializing in RAM
production, measured in k chips/day of
RAM?
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 23

Answer
 The vertical distance
between the blue and Country U Production Possibilities
red PPFs at a corn meal 4.00 RAM (k
consumption of 7 kg/day chips/day) no
3.50
measures country U’s Trade
gain to trade in k chips 3.00

RAM (k chips/day)
RAM (k
RAM/day. 2.50 chips/day) with
Trade
 The point on the blue 2.00

PPF is the best country 1.50

U can do without trade. 1.00
 With trade country U can 0.50
consume more RAM per
0.00
day, up to the point on 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
the red PPF. Corn Meal (kg/day)
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 24

Question
 What is country M’s gain if it chooses to
consume 1.5 k chips per day,
measured in kg/day of corn meal?
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 25

Answer
 The horizontal distance
between the red and blue Country M Production Possibilities
PPFs measures country
M’s gain to trade at a 2.50 RAM (k
RAM consumption of 1.5 chips/day) no
k chips/day. 2.00
Trade
RAM (k

RAM (k chips/day)
 The blue PPF is the best
chips/day) with
that country M can do 1.50
Trade
without trade.
 Trade allows country M 1.00

to specialize in the
production of corn meal 0.50

and still benefit from a

higher consumption of 0.00
RAM. 0 1 2 3 4 5 6 7 8 9 10

Corn Meal (kg/day)

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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 26

The International Supply
Curve for RAM
 The international supply
Relative Price (kg corn meal/k chips)
curve for RAM is a rising
function of the opportunity Least Efficient
cost of RAM in terms of Producers

foregone corn meal.

 Which countries actually
produce RAM for the
international market will Most Efficient
Demand
Producers
depend upon where the
demand curve crosses this
supply curve.
RAM (K chips/day)
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 27

The Sources of
Comparative Advantage
 The Heckscher-Ohlin Theorem is a theory that
explains the existence of a country’s comparative
advantage by its factor endowments.
– Factor endowments: the quantity and quality of labor,
land, and natural resources of a country.
– From Sweden in the early 1900s

 According to the H-O theorem, a country has a

comparative advantage in the production of a product
if that country is relatively well endowed with inputs
used intensively in the production of that product.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 28

The Sources of
Comparative Advantage
 Edward Leamer of UCLA’s five biggies:
– Natural resources

– Knowledge capital

– Physical capital

– Land

– Skilled and unskilled labor

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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 29

Other Explanations for
Observed Trade Flows
 Product differentiation and competitive
markets
 Acquired comparative advantage
 Natural comparative advantages
 Economies of scale
 Trading Environments
 Openness of Economy
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 30

Note of Caution
 Information on comparative advantage is often given in
many other forms - pay careful attention to the information
you are given.
 Two more ways to present the same kind of information:
England Portugal
1 yd. of cloth 2 hours 1 hour
1 barrel of wine 40 hours 10 hours

England Portugal
1 hour of labor in cloth .5 yd. of cloth 1 yd. of cloth
1 hour of labor in wine 1/40 bl. of wine 1/10 a bl. of wine
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 31

Absolute Advantage and
Comparative Advantage
England Portigal
1 yd. of cloth 2 hours 1 hour
1 barrel of wine 40 hours 10 hours
England Portigal
1 hour of labor in cloth .5 yd. of cloth 1 yd. of cloth
1 hour of labor in wine 1/40 bl. of wine 1/10 a bl. of wine
 Portugal has the A.A. in both wine and cloth.
 England has the C.A. in cloth.
 Portugal has the C.A. in wine.
 Can you figure out the marginal opportunity cost for
each output in each country?
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 32

From Opportunity Cost to
Marginal Cost
 The concept of marginal cost is the most important
concept in the theory of producer supply behavior.
 Marginal cost is the additional cost associated with
increasing production by one unit.
 In our production possibility examples, marginal cost
is the value of the activity that is reduced when the
other activity is increased by one unit.
 Marginal cost is, therefore, the same thing as
marginal opportunity cost.
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 33

PPF Gymnastics
 The PPF is also useful
for many other types of
Butter
questions.
 Questions about
efficiency.
 Questions about equity.
PPF new  Questions about tax
and transfer policy.
 Questions about
composition of output.
PPF old  Questions about growth
and productivity.

Guns
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Prof. John M. Abowd and Jennifer P. Wissink, Cornell University 34