Introduction to Macroeconomics

2. Opportunity Cost, Specialization, and Trade - Sample Problems


Contents

  1. Opportunity Cost
  2. Specialization and Exchange
  3. Production Possibilities Curve
  4. Comparative and Absolute Advantage
  5. PPC Problems


1. Opportunity Cost

  1. 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.

  2. 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.

  3. 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.


2. Specialization and Exchange

  1. 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.

  2. You and I are stranded on a tropical island. In 1 hour I can cut down 12 coconuts or catch 8 fish. In 1 hour you can cut down 10 coconuts or catch only 5 fish.
    1. Who has absolute advantage in cutting down coconuts? Who has absolute advantage in catching fish?
    2. Who has comparative advantage in cutting down coconuts? Who has comparative advantage in catching fish?
    3. If we each spend one-half of our time cutting down coconuts and catching fish, how many coconuts and fish can we produce in total between us in two hours?
    4. If we decide to specialize, how many coconuts and fish can we produce in total between us in two hours?

    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.

     MeYou
    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.

  3. 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.


3. Production Possibilities Curve

  1. Which of the following is NOT true concerning a society's production possibilities curve (PPC)?
    1. It reveals the maximum amount of any 2 goods that can be produced from a given quantity of resources.
    2. The PPC represents the productive capacities of a nation when resources and technology are limited.
    3. The level of technology remains unchanged.
    4. Full and efficient use of resources occurs.
    5. It reveals the opportunity cost of one good in terms of another.
    6. In order to increase the production of one good some amount of another good must be foregone.
    7. All the possible combinations of resources that may be used to produce a good.
    8. Consumers will receive equal benefits from the two goods.

    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.

  2. We can ask several different questions regarding the characteristics of the Production Possibilities Curve giving the same multiple choice of answers. For example:

    1. a movement from one point on the PPC to another point on the PPC.
    2. an inward shift of the PPC.
    3. an outward shift of the PPC.
    4. a point located inside the PPC.
    5. a point located outside the PPC.

    Answer:

  3. 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.


4. Comparative and Absolute Advantage

  1. Which of the following statements is false?
    1. Two individuals can only gain from trade when their opportunity costs of production are different.
    2. An individual should produce only that good in which he has a comparative advantage in production.
    3. An individual should produce only that good in which he has an absolute advantage in production.
    4. One country has comparative advantage over another if it can produce a good at a lower opportunity cost than the other.
    5. One country has absolute advantage over another if it can produce a good at a lower opportunity cost than the other.
    6. If a country has a competitive advantage in producing a good then it must also have an absolute advantage in producing that good.
    7. If a country has an absolute advantage in producing a good then it must also have a competitive advantage in producing that good.
    8. Artificial barriers to trade (e.g., import duties, tariffs, and quotas) reduce per capita GDP.

    Answer: The false statements are (c), (e), (f), (g).

  2. 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.

  3. 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.

  4. 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

  1. Two countries, A and B, are populated by computer nerds and can produce both computers and Internet web sites. At full employment the countries can produce the following:

    AB
    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

    1. Graph the production possibilities curve of the two countries.
    2. Do the production possibilities curves exhibit constant opportunity costs?
    3. Who has the absolute advantage in production of computers? Who has the absolute advantage in production of web sites?
    4. Who has the comparative advantage in the production of computers?
    5. Who has the comparative advantage in the production of web sites?

    Answer:

    1. 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.

    2. 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.

    3. 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.

    4. 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.

    5. 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.

  2. We can also ask the previous question with multiple choice answers. For example:

  3. Two countries, A and B, are populated by computer nerds and can produce both computers and Internet web sites. At full employment the countries can produce according to the table above. From that table we can conclude:
    1. Country A has a comparative advantage in the production of computers, country B has a comparative advantage in the production of web sites.
    2. Country B has a comparative advantage in the production of computers, country A has a comparative advantage in the production of web sites.
    3. Country A has a comparative advantage in the production of both computers and web sites.
    4. Country B has a comparative advantage in the production of both computers and web sites.

    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.

  4. Suppose countries A and B have the following production possibilities for products X and Y:

    A X 060
    Y 750
    B X 090
    Y 120 0

    1. What does one Y cost in country A?
    2. What does one X cost in country B?
    3. Can these countries gain from specialization and trade? Why?
    4. Which country has a comparative advantage in the production of Y?
    5. If these countries trade, what will be the price of one X?

    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)