At the start of class the Economics professor thanks you for coming and also notes that attending class must be your most highly valued activity during this period? Is the Econ prof correct?
Answer: An assumption frequently made in economics is that individuals are rational. The rational student will allocate his or her time to the activity that is most highly valued. A student has many other activities that could be enjoyed rather than attending class: watching a favorite TV show, playing pool, hanging out, etc. The opportunity cost of attending class would be the most highly valued of the alternate activities since you can enjoy only one of those activities. If your favorite TV show is a rerun you've already seen then the opportunity cost of attending class may be lower.
The local politician proudly announces the decision to build a new road. The politician claims "the best thing about this project is that it won't cost taxpayers anything because the money will come out of the lottery revenues." Why does the Econ prof sadly shake his head when he hears this?
Answer: There ain't no such thing as a free lunch. This represents spending of government funds that could have gone to some other public good such as schools, hospitals, other roads, etc. Not building the road with lottery money may mean we could build another elementary school. Cost is not measured by taxes paid but by the value of the best opportunity that cannot be pursued.
Why would you buy a gallon of milk at a convenience store rather than a grocery store where it is much less expensive??
Answer: The cash cost of the milk may be higher in a convenience store, but if the opportunity cost of time for the individual is high the total cost of buying the milk at the convenience store may be lower. The opportunity cost of an activity (e.g., buying milk at a convenience store) includes more than just the cash cost.
Why do people specialize?
Answer: Rational self-interested individuals maximize the net benefits of their efforts by concentrating on those activities that yield the lowest opportunity cost. Individuals act in their own self-interest to maximize productivity.
Answer: Because I wrote this question, I have an absolute advantage over you in producing everything. I can supply more coconuts and fish with one hour of labor than you can. But, I can't have comparative advantage in everything. You have comparative advantage over me in producing coconuts because the opportunity cost for for you to produce 1 coconut is that you give up the production of 1/2 fish, which is lower than my opportunity cost of 2/3 fish. I have comparative advantage over you in producing fish because the opportunity cost for for you to produce 1 fish is that you give up the production of 1-1/2 coconuts, which is lower than your opportunity cost of 2 coconuts.
| Me | You | |
| Opportunity cost of producing coconuts | 12 coconuts = 8 fish or 1 coconut = 2/3 fish |
10 coconuts = 5 fish or 1 coconut = 1/2 fish |
| Opportunity cost of producing fish | 12 coconuts = 8 fish or 1-1/2 coconuts = 1 fish |
10 coconuts = 5 fish or 2 coconuts = 1 fish |
If we do not specialize, I can produce 12 coconuts and 8 fish in two hours (spending 1 hour doing each). You can produce 10 coconuts and 5 fish in two hours. Our total supply is 22 coconuts and 13 fish. If we specialize based on comparative advantage, I will produce 16 fish in two hours and you will produce 20 coconuts in two hours. Right now it's not obvious that we are better off through specialization and exchange (although the question doesn't ask if we are better off). But, what if I produce 3 fewer fish. Since my opportunity cost for each fish is 1-1/2 coconuts, I can supply 4-1/2 coconuts. Now our total with you specializing and me almost specializing is 24-1/2 coconuts and 13 fish, which is 2-1/2 coconuts more than if we did not specialize.
Note: What if your production capabilities hadn't been 10 coconuts and 5 fish but 6 coconuts and 4 fish? Who has comparative advantage now? Nobody. The opportunity costs are identical and there is no incentive to specialize and exchange.
The benefits of specialization and exchange are limited by transaction (exchange) costs. What are these costs?
Answer: Transaction costs are all costs related to the exchange or trade of goods including negotiation costs, transportation costs, and artificial barriers to trade (e.g., import tariffs). Transaction costs reduce the net benefit and incentive to specialization.
Answer: (g) and (h). Answers (a) and (b) represent the definition of the PPC. Answers (c) and (d) refer to assumptions made in deriving the PPC. Answers (e) and (f) characterize one of the implications of the PPC, that there are opportunity costs. Answer (g) is wrong because represents the production technology for a particular good, i.e., how much of what resources are required to produce the good, rather that the PPC, i.e., how much can be produced from a given level of resources. Answer (h) is wrong because a point on the PPC does not represent one of equal benefits but only a point at which all resources are fully utilized. The PPC does not by itself reveal where on the curve an economy should operate. Additional information regarding the relative values consumers place on these goods (i.e., market prices) is needed.
We can ask several different questions regarding the characteristics of the Production Possibilities Curve giving the same multiple choice of answers. For example:
Answer:
Alpha can produce 60 bottles of wine or 40 pounds of cheese. Beta can produce 90 bottles of wine or 30 pounds of cheese. Both have constant (opportunity) costs of production. Draw their production possibilities curves. What is Alpha's cost of 1 pound of cheese? What is Beta's cost of 1 pound of cheese? If they trade, who should specialize in cheese?
Answer: Alpha's cost of one pound of cheese is 3/2 bottles of wine (60 bottles wine/40 pounds of cheese = 3/2). Beta's cost of one pound of cheese is three bottles of wine (90/30 = 3). If trade took place, Alpha should produce cheese because it has the lowest opportunity cost of doing so. To produce more cheese Alpha must sacrifice fewer bottles of wine production.
Answer: The false statements are (c), (e), (f), (g).
We sometimes like to think that our cuntry has an absolute advantage in the production of all goods and services. Why then should be willing to trade with other countries?
Answer: Although a country may have an absolute advantage in the production of all goods, it will still find specialization and trade beneficial because it will have a comparative advantage in some goods and a comparative disadvantage in other goods.
How does an individual producer, such as a farmer, know if he is producing the product in which he has a comparative advantage?
Answer: Individuals choose to produce products that will yield the greatest profits. By doing this, the owners of firms automatically produce the product in which they have a comparative advantage. By maximizing profit, the producer chooses the product that he can produce with the lowest relative cost or resource expenditure. If the producer can successfully compete (survive) in competition with other domestic and foreign producers then it must be the case that he or she has a comparative cost advantage.
Suppose Beth and David agree to work together mowing and raking lawns to earn extra money. After a few days they discover that it takes Beth 2 hours to rake a 500 square foot area and 30 minutes to mow it. It takes David 2-1/2 hours to rake 500 square feet and 45 minutes to mow it. Can they gain from specialization? Why or why not? According to comparative advantage, who should mow and who should rake?
Answer: According to the data, in 1 hour of work Beth can rake 250 square feet or mow 1000 square feet; 1 raked square foot costs Beth 4 mowed square feet. In 1 hour David can rake 200 square feet or mow 666.67 square feet; 1 raked square foot costs David 3.33 mowed square feet. Since David's opportunity cost of raking is less than Beth's, the two can gain by allowing David to rake and Beth to mow.
5. PPC Problems
| A | B | ||
| Computers | Web Sites | Computers | Web Sites |
| 1200 | 0 | 900 | 0 |
| 1000 | 20 | 750 | 10 |
| 800 | 40 | 600 | 20 |
| 600 | 60 | 450 | 30 |
| 400 | 80 | 300 | 40 |
| 200 | 100 | 150 | 50 |
| 0 | 120 | 0 | 60 |
Answer:
The graph should display two separate straight-line curves with the quantities of computers on one axis and the quantity of web sites on the other. A's curve should intersect at 1200 on the computers axis and at 120 on the web sites axis. B's curve should intersect at 900 on the computers axis and at 60 on the web sites axis.
Because the opportunity costs for both countries are constant their production possibilities curves should be straight lines. We have constant opportunity costs because in country A, for each 20 unit increase in the production of web sites, a constant 200 unit drop in computer production occurs. In country B, for each 10 unit increase in the production of web sites, a constant 150 drop in computer production occurs.
While A can produce more of both computers and web sites than B, we can not say whether A has an absolute advantage or not. The information given does not include the total amounts of resources available in countries A or B--a necessary determinant of absolute advantage.
In A, 200 computers cost 20 web sites (i.e., if we go from production of 0 to 200 computers, we must go from 120 to 100 web sites), or 1 computer costs 1/10 web site (20 divided by 200). In B, 150 computers cost 10 web sites or 1 computer costs 1/15 web site. Country B gives up 1/15 web sites to produce 1 computer while A gives up 1/10 web sites to produce 1 computer. Since B's computers cost less, B has a comparative advantage in computers.
For country A to increase production web sites by 20 it must reduce production of computers by 200. Each web site costs 10 computers each in country A while each web site in country B costs 15 computers each. A's web sites cost less, thus A has a comparative advantage in web sites.
We can also ask the previous question with multiple choice answers. For example:
Answer: First, we can immediately strike answers (c) and (d) because a country can not have comparative advantage in both products. So, all we have to decide is either who has comparative advantage in the production of computers, or who has comparative advantage in the production of web sites. A country has comparative advantage in the production of computers if it has to give up the least amount of production in web sites. From the logic in the previous question, the correct answer is (b).
This next problem is very similar to the previous one but the table is simplified by giving only the intercepts of the production possibilities curves (0 quanity of X and maximum quantity of Y, and vice versa). This implies that the countries have constant opportunity costs (i.e., the production possibilities curves are straight lines.
| A | X | 0 | 60 |
| Y | 75 | 0 | |
| B | X | 0 | 90 |
| Y | 120 | 0 |
Answer: In country A the total tradeoff is 60 X = 75 Y, so 1 Y costs 0.80 X (the opportunity cost of producing Y) and 1 X costs 1.25 Y (the opportunity cost of producing X). In country B, 90 X = 120 Y, so 1 X costs 1.33 Y (the opportunity cost of producing X) and 1 Y costs 0.75 X (the opportunity cost of producing Y).
Because the two countries have different opportunity costs they can gain from specialization and trade. Because country B can produce Y at a lower opportunity cost than A (0.75 X versus 0.80 X), country B has a comparative advantage in the production of Y. Because country A can produce X at a lower opportunity cost than B (1.25 Y versus 1.33 Y), country A has a comparative advantage in the production of X.
If they trade, the terms of trade, or the price of 1 X will fall somewhere between the two opportunity costs, or between 1.25 Y and 1.33 Y. For example, because of the lower opportunity cost, country B should specialize in producing Y and exchange for product X. If the price of X were greater than country B's opportunity cost of producing X, then country B has an incentive not to specialize and produce some X instead. If the price of X were less than country A's opportunity cost of producing X, then country A would not have an incentive to produce product X for exchange.
File last modified: September 1, 2002
© Tancred Lidderdale (Tancred@Lidderdale.com)