Unit 1 - The Production Possibilities Frontier


Scarcity, Choice and the Production Possibilities Frontier

The Economic Problem of Scarcity

Scarcity occurs because human wants exceed the limits of available resources.

Economics deals with the basic fact that scarcity exists in our everyday lives and in our economy. Imagine for a minute that a messenger suddenly knocks on your door. He greets you with the delightful information that a previously unknown distant relative has carefully monitored your progress through life. The relative is pleased with your progress and as a test has decided to give you $5 million. There is one stipulation, however; you must spend this money within three months.

Would you have any trouble spending the money? Unless you are already smothered in wealth, you should have no trouble coming up with a list of expenditures. A car, a beachfront apartment, a ski chalet, a boat, a vacation in paradise, your list suddenly grows longer than you expected. The money would be exhausted in no time. Wake up; a survey of the worn bills in your wallet reveals the basic fact that you face a scarcity of money in relation to the list that we just constructed.

The same idea applies to the economy as a whole. Resources such as raw materials are in finite supply and must be allocated to their best use. For example, in the western United States, water is a relatively scarce resource. The water that originates in Colorado flows westward into the Colorado River, eventually providing cities in Southern California with drinking water. In years when rainfall is below normal, regional water restrictions come into effect and users may be prevented from certain activities such as washing their cars. Virtually all resources are scare, meaning that more of them are desired than is available.

It is not uncommon for the U.S. government to face a shortage of funds. Typically, the federal government has spent more money than it collects. The problem mushroomed during the 1980s when the president and Congress lowered taxes (and thus government revenues) while at the same time increasing spending. The same problem has the potential to repeat itself in the early part of the 21st century. The billowing deficits of the past years have led to an accumulated debt of over $6 trillion. Briefly, for the late 1990s and 2000, the government ran a budget surplus as revenues exceed expenditures. Even with a budget surplus, the government still faces scarcity. The money to fund all of the programs desired by politicians and by society is just not there.

Government budget deficits are nothing new. During the height of the Spanish empire, King Phillip II sent his conquistadors to continuously search for gold and treasure in the New World. He lacked adequate money to pay and equip the troops needed to maintain discipline in the empire. On several occasions, Phillip's government actually went bankrupt waiting for an infusion of new cash - deficit spending was not a common option during that time period.

A deficit refers to the difference between what the government spends each year and government revenues. If annual spending exceeds revenues then a deficit is present.

The national debt refers to the accumulation of deficits over time. If there is a deficit, the debt will increase, while a surplus will reduce the debt.

The major source of government revenues are tax receipts, such as income and social security taxes paid by most working Americans. 

Tariffs are taxes on imported goods and represent another type of tax collected by the government. When President Bush imposed a 30% tariff on steel imports in 2002, U.S. firms that purchase imported steel will pay the government 30 cents for every dollar worth of steel they buy from abroad.

Choice

Given the presence of scarcity, choices must be made as to how resources are allocated.

Our lives are filled with a wide range of choices regarding the use of limited personal funds. Advertisers constantly inform consumers of their consumption possibilities and the choices available. The same principle applies for the economy as a whole. We elect politicians who work with policy makers to allocate government expenditures. Together they make difficult choices concerning how taxes will be spent. Or if a tax reduction is desired, a decrease in government expenditures should accompany the tax cut.

Problems arise when governments try simultaneously to reduce taxes and maintain a high level of expenditures. As pointed out, the U.S. government must make the choice between reduced expenditures today or run the risk of jeopardizing future economic growth and prosperity.

The tradeoff between consumption today and consumption tomorrow deals with the concept of opportunity cost.

Opportunity Cost

The relevant cost of any decision is its opportunity cost - the value of the next-best alternative that is given up.

By making choices in how we use our time and spend our money we give something up. Instead of reading this material, what else could you be doing? Your best alternatives may involve sports, leisure, work, entertainment, and more. Thus, the concept of opportunity cost is your best alternative to the choice that is made. If you choose to go to a restaurant this evening, the money that you spend on dinner will not be available for other uses, even saving.

Businesses and governments also deal with opportunity costs. As noted, by choosing to maintain large deficits today, the federal government may reduce future economic growth. Or laws that protect wilderness areas and endangered species will ensure a better environment tomorrow at the opportunity cost of reduced access to resources today.

Businesses must choose what type of goods to produce and the quantity. Given limited funds, the opportunity cost of producing one type of good will arise from not being able to produce another.

Production

Introduction to Production

Production occurs when we apply labor and capital to resources in order to increase the value of the resources.

Given a scarcity of resources, it is desired that society will allocate them to their best uses. In many economies, the market performs most of the resource allocation role. Consumers indicate their preferences by purchasing goods and services. Producers wish to satisfy the demands of consumers by using scarce resources to produce those goods and services that consumers demand.

One of the primary topics of a course in principles of Microeconomics or macroeconomics is to explain how the market functions and the role of the government in dealing with market imperfections.

The Factors of Production

There are three major factors of production:

  1. Land includes all natural resources, such as land, air, water, forests, wildlife, etc.
  2. Labor
  3. Capital refers to the improvements made to natural resources. Capital includes items such as buildings and machinery. While the definition of land and labor is readily apparent, let us briefly discuss the economic meaning of capital.

Capital is used to assist labor in the production process and increase our capacity to produce goods and services. Workers use tools and machinery to become more productive and increase their output. In addition to machinery and equipment used in production, people often think of capital markets. Capital markets refer to debt (bonds) and equity (stocks) markets where a company raises money. Be careful to note the difference. Corporations use capital markets to raise the money needed to buy more capital.

For example, a new company may sell stocks in order to raise funds. The money is used to build the plant and purchase the machinery to produce a good. In an economic sense we consider capital as the actual purchases of plant and equipment used in production. Investment is the term used to describe the additions to capital. By investing, a firm purchases new machinery that adds to its capital stock. Investment in the economic sense is very different than personal investments in stocks and bonds. To clarify between the two, think of your purchase of a bank certificate of deposit or the purchase of a corporation's stock as saving, investment is the purchase of capital by a firm.

This is a very important concept. When you purchase financial assets such as stocks and bonds, you are saving in our definition.

Financial intermediaries such as banks and stock markets help to link together savers and firms that borrow for investment in capital. When you save your money in the bank, the money becomes available for others to borrow. When a firm borrows your savings, they will most likely use the money to purchase new capital. The bank is the financial intermediary in this case.

 When a firm issues new stocks, they sell these stocks to savers through a financial intermediary such as the New Your Stock Exchange or through the NASDAQ market.

The Production Possibilities Frontier (PPF)

Introduction to the Production Possibilities Frontier (PPF)

The production possibilities frontier is used to illustrate the economic circumstances of scarcity, choice, and opportunity cost.

To describe the concept of the production possibilities frontier, assume that we live on an island that has only two cities (Seattle and Detroit), and two industries (automobiles and airplanes). Given the resources available on our island economy, the table below shows how labor and capital can be allocated to the production of autos and airplanes.

The Production Possibilities for a Single Country

Option

Automobiles

Airplanes

A

150

0

B

125

4

C

80

9

D

30

16

E

0

25

The table gives five production possibilities, options A through E. Each option shows what alternative mixes of automobiles and airplanes that society can choose to produce. Option A is one where our island dedicates all of its resources to the production of automobiles, entirely forsaking airplane production. Option B shows a preference for the production of a few airplanes, but giving up some automobiles in the process. The tradeoff of airplanes for autos continues to point E, where our country dedicates itself to the production of airplanes (25), producing zero automobiles.

The table presented here can be used to describe the economic problems of scarcity, choice and opportunity cost. Scarcity is present because finite amounts of each good can be produced. We may want a combination of 150 autos and 25 airplanes, but given the limited labor and capital inputs available, this is not a feasible combination. To produce 150 autos requires that all labor and capital available be used in the assembly of automobiles, leaving nothing for the production of airplanes.

Only by giving up some autos (moving from Option A to Option B) do we gain airplanes. In a practical sense, labor and capital is switched from producing automobiles to airplanes. This presents opportunity cost – the best alternative that we give up (autos) to increase airplane output.

Finally, choice is demonstrated by the five options of the table. How are choices made? Perhaps the firm or the market will determine the combination of autos and airplanes that are produced. There can be a central planning agency that makes this determination or the democratic process will let citizens vote for their preferences.

Throughout this course we will use graphs to illustrate important economic concepts. To help you better understand the material, many of the graphs are interactive. Place your mouse courser over a part of the graph below and left-click. In the graph shown here, there are three sections. Click along the horizontal axis, the vertical axis and on the curve itself. Be sure to try this for the other graphs found throughout the course.

 

 

 

 

Figure 1-1 is a graphical representation of the information presented in table above. The boundary presented in the graph represents the different possibilities that society has in the allocation of resources. The frontier boundary and its interior represent what is achievable given our island's currently available resources. In contrast, points outside the frontier are not attainable given the resources and technology present.

Note two characteristics of the production possibilities frontier. First, it slopes downward to the right. This represents the tradeoff present in production. By producing more automobiles, workers and capital must migrate from Seattle to Detroit. An increase in auto production necessitates a reduction in the output of airplanes.

In addition, the production possibilities frontier is "bowed outward." The curvature of the production possibilities frontier reflects the increasing opportunity cost when substituting one type of production for another. This situation is caused by the specialization of workers. If society initially favors auto production over airplanes so that we are located in the southeast portion of the frontier, workers become skilled in auto production. But as we move to the left along the curve, increasing airplane output and decreasing auto production, some workers switch to building airplanes. For many workers, the skills used in producing autos are not perfectly transferable. In addition, the machinery used for auto production may not be well suited to making airplanes. As a result, the output per worker falls as they are relocated to making goods in which they are less skilled.

Just as the previous table described the economic problems of scarcity, choice and opportunity cost, the PPF does the same. Points outside the frontier may be desirable, but are not obtainable given the inputs of labor and capital available to society. As we change out preferences and move to the Northwest along the frontier, airplane manufacturing increases at the opportunity cost of automobile assembly.

It is important to note when studying economics that in a general sense, more is preferred to less. Greater output is “better” than lower output levels, higher income is more desirable that a lower income. Certainly, this is a simplification that only focuses on material values, and as the course develops we will develop a broader concept of well-being.
 

Assumptions of the Production Possibilities Frontier

There are 3 assumptions that must be satisfied if our country is to achieve a point along the production possibilities frontier.

  1. Finite resources - at any given time, the total amounts of labor, land and capital are fixed.
  2. Full and efficient use of the resources - at any point along the PPF we have productive efficiency. We cannot increase the output of one good without decreasing the output of another.
  3. A given state of technology - the production possibilities frontier represents the technology available to producers.

For our society to end up at a point along the production possibilities frontier we assume that resources are used fully and efficiently and that the best available technology is utilized. By satisfying these assumptions, the production possibilities frontier shows the maximum amount of any two products that can be produced at a given time from a fixed quantity of resources.

Given that we satisfy our assumptions, what point along the production possibilities frontier we choose depends on society's preferences. If the majority of our citizens want to drive, then we will favor automobile production. On the other hand, if flying is the preferred way to travel, then more airplanes and fewer autos will be produced.

Characteristics of the Production Possibilities Frontier (Summary)

  1. Points along the frontier show the tradeoff between two different goods for society; to get more of one, we must give up some of the other.
  2. Points outside the curve are unobtainable with given resources and technology.
  3. Points inside the frontier are attainable, but do not utilize society's resources efficiently.
  4. The production possibilities frontier illustrates concepts of
    1. Scarcity - resources are limited.
    2. Choice - choices in the production of different goods need to be made.
    3. Opportunity cost - to gain more of a good something else must be given up.

Application

Applications of the Production Possibilities Frontier

1) Inefficient Use of Resources

Economists use the term full employment to indicate the lowest desirable unemployment rate that the economy can comfortably sustain without causing significant inflationary pressures. Unemployment rates greater than at full employment are undesirable because there are more individuals actively seeking employment than there are jobs available.

When unemployment rates are higher than at full employment, we violate one of our three assumptions regarding the production possibilities frontier: full and efficient use of our resources. Consequently, our economic production fails to reach the boundary of the production possibilities frontier. Instead we end up inside the frontier.

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As Figure 1-2 illustrates, if we satisfy all three of our assumptions we can achieve point G on our production possibilities frontier. However, due to high levels of unemployment, we end up at point F, inside the curve.

We see that a high unemployment rate results in a lower level of output of all goods. By reducing unemployment (moving from point F to point G), our country would also increase consumption as more autos and airplanes are produced.

2) Expansion of the Economy's Productive Capacity

There are two factors that will allow our production possibilities frontier to shift outward over time. The first is an increase in our resources. The second is due to improvements in technology.

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Figure 1-3 shows what happens over time as more people immigrate into our country. Assuming that the immigrants are effectively assimilated, our resource base grows and so does our ability to produce goods and services. As long as our three assumptions are satisfied, including full employment, our nation's production possibilities frontier shifts outward (to the right). Eventually, output expands from the original point G to point H. Notice that at point H output, and thus consumption, is greater than at point G.

An alternative scenario would keep population constant but allow technology to improve (or even a combination of the two). Allowing for technological improvement, such as the development of the computer and robotics industries, improves worker productivity and thus our economic capacity to create goods and services.

An essential concept of macroeconomics is what is known as supply side economic growth. The above graph describes supply side growth. Supply side growth refers to the increase in the productive capacity of the economy and is due to a combination of labor force growth and improvements in worker productivity (that arise from better technology and capital).

For example, in the United States, on average the nation’s capacity to produce goods and services increases by about 3% each year. Net increases in the labor force account for approximately 1% of annual supply side growth and gains in worker productivity contribute to the other 2%.

It is important to note that supply side growth represents potential output. Although a person may graduate from college, there is no guarantee that she will find a job. In this course we will deal extensively with the supply side (potential output) and the demand side (what is actually produced).

3) A Contraction of the Production Possibilities Frontier

A country's production possibilities frontier may shift inward due to a depletion of resources. The death and destruction caused by war is one way resources used in production may be reduced, leading to a contraction of the production possibilities frontier.

A historical example of a dramatic contraction of the production possibilities frontier was caused by the bubonic plague. Between 1347 and 1350, rats infested with plague-ridden fleas spread the disease, reducing the population of various European countries by 33% to 65%.

One consequence of the plague was a reduction of the labor pool, so that producers required labor saving devices. This led to a rapid escalation of capital innovation, investment, and the substitution of capital for labor in production. New uses for water-power, agricultural implements, and other labor-saving developments occurred.

4) The Tradeoff between Current Consumption and Capital Investment

One of the most important choices a society makes deals with the opportunity cost of enjoying consumption today or having a greater level of consumption tomorrow. We may ask how fast an economy should grow in conditions where economic growth allows for greater consumption of goods and services in the future.

Think of this issue on a personal level. When we are working and earning an income, a choice is made between consumption and saving. After paying the bills, many individuals have some disposable income remaining. We can spend our checking account down to the last dime on clothing, travel, entertainment and other pleasurable activities, or we can save some of that remaining disposable income. Assuming a positive return on our savings, thrift today allows for greater consumption in the future.

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The same principle holds for the economy. Our country can allocate all of its resources to current consumption of goods and services and save nothing (point N - Figure 1-4) or it can forsake some consumption and allow for a positive level of domestic savings (point O). We assume that the money saved is with financial institutions and thus is available for firms to borrow to undertake capital investment.

The catalyst for a country's growth is saving, and thus investment. The amount of investment a country undertakes has a positive relationship to economic growth. In general, countries that have higher levels of investment in new capital will also grow more rapidly than those countries that dedicate less of their resources to capital investment.

As an illustration, compare two hypothetical countries. The first country (Thrift, e.g., point O) is relatively well-off, has a thriving middle class, and its workers have enough income to allow for both consumption and a positive level of savings.

In contrast is a less-developed country (Poor, e.g., point N) that has a stagnant economy. This country is characterized by citizens earning a wage that barely affords them a life of subsistence. Due to the lack of economic growth, incomes are constant. The net result is that all of this economy's resources are dedicated to providing the consumption of necessities for its residents with nothing left over for savings.

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For simplicity, let us assume that at time zero both countries have equivalent production possibilities frontier. We can assume what the poor country lacks in capital it compensates for with a greater abundance of labor and natural resources. We also assume that both countries have access to the same technology.

What happens over time is illustrated in Figure 1-5. The country of Thrift has a positive level of savings, and through financial markets this money is channeled to business that borrow the money to invest in capital equipment. The country of Thrift is able to utilize the best current technology to assist workers in production. The result is greater output per worker, an increase in production, and a rightward shift of the production possibilities frontier. The economic output moves from point O to point O'. For a thrifty country, investment in capital goods is the critical catalyst for economic growth, which allows for a higher level of consumption of goods and services in the future.

The situation for the poor country is a lack of savings and investment, no economic growth (the production possibilities frontier fails to shift outward over time), and an economy characterized by a continuing cycle of poverty.

In conclusion, investment is essential for future economic growth. Note, however, that even with growth, our model says nothing about income distribution or fairness. There are no guarantees that all citizens in a growing economy will share equally in the economic gain, and some individuals may even end up worse off.

Given the critical role that investment and savings play in economic growth, there is a good deal of concern regarding the impact that large federal budget deficits have on a country's future growth rate. While this issue will be dealt with throughout this course, we can conclude that when the government runs large deficits it reduces the supply of savings available for businesses to invest. Large budget deficits imply that current consumption increases; the cost may be a reduction in future growth rates.

5) The Tradeoff between Current Consumption and Improved Environmental Quality

At the present time, there is a debate in the United States regarding the economic impact of environmental regulations. Some people argue that current environmental standards and regulations impact businesses adversely and create inefficient economic distortions. The argument emphasizes that by reducing, even abolishing environmental regulations production will increase and the country will be better off.

This is a complex argument, but let us use our economic model to shed some light on the hypothesis. First, we need to take a snapshot of current economic activity. At the present time the economic growth rate is predominately controlled by the Federal Reserve Board (Fed). The Fed uses interest rate policy to either stimulate economic growth of GDP (our macroeconomic measure of economic growth) when it is considered too slow and there is a potential recession, or the Fed will slow the economy when economic growth is considered undesirably rapid and increased inflation is a possible consequence. Certainly, the Fed does not have precise control over the economic growth rate, but is considered effective.

To give an example, the Fed raised interest rates several times during 1994 in order the slow the growth rate of the economy. This is an important point for our discussion regarding environmental regulation: if laws and regulations are causing a drag on economic growth, resulting in economic output at a point inside the PPF, the Fed has the ability to use monetary policy to counteract these influences, and bring the economy to a point along the PPF.

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Let us use Figure 1-6 to show the opportunity cost of improved environmental standards. Our country's production possibilities frontier shows the tradeoff between the production of current consumption on the horizontal axis and an improved environment on the vertical axis. Let us assume that we start at point A on the production possibilities frontier.

The point we choose to produce along the production possibilities frontier depends on the preferences of society and political representatives. If our society decides it desires a better environmental quality, then we would move to the left along the production possibilities frontier to Point B which allows for improved environmental standards but at the opportunity cost of fewer resources devoted to the production of consumer goods(1). We can see that by favoring an improved environment, factors of production such as labor and capital must be transferred into the environmental quality field. People will need to work in fields and industries that develop improved pollution control equipment. Others will need to monitor environmental quality and enforce regulations. New jobs will be created in association with a better environment in the tourism and recreation areas.

(1) It may be convenient to think of environmental quality as another good. A forest in a wilderness state may give the hiker as much consumption satisfaction as watching a movie.

The key point is that by choosing improved environmental quality, society makes sacrifices in some consumer goods but gains in areas related to the environment. By moving from point A to point B along the production possibilities frontier, we are reallocating resources, but not making their use any less efficient. Point B is a point along the production possibilities frontier and thus satisfies our assumption of the full and efficient use of our productive resources.

Some may argue that we actually end up at point C, inside our production possibilities frontier. If a choice for a better environment does cause inefficiency due to associated regulations on businesses and higher unemployment, then point C is consistent with this viewpoint. However, remember our discussion regarding the role of the Federal Reserve in monitoring and correcting economic growth. If environmental regulations lead our economy to point C, then the Fed will see that economic growth is slower than desired. In this case, the Fed will implement policies to increase economic growth and lead our economy to point B.

A desire for an improved environment can lead us along the production possibilities frontier from point A to B, or temporarily to point C, inside our production possibilities frontier. Regardless of our path, the Fed can use its policy tools to ensure that we actually do end up along the production possibilities frontier where our productive resources are used fully and efficiently.

Another argument made against environmental regulations is the impact on the economy's growth rate. An outward expansion of the production possibilities frontier signifies economic growth. If environmental regulations slow down the long-run growth process, then we can argue that they can be detrimental. This is an argument without an answer. Proponents of deregulation claim that environmental regulations divert resources into less-productive areas and the rate of economic growth will be reduced. However, we can also argue that environmental regulations contribute in ways that are not easily captured by traditional measures of growth such as GDP (Gross Domestic Product). Economists are now trying to construct measures that include resource preservation, not just development.

Including the consequences of environmental regulation in the model developed in this section leads to the conclusion that regulations do not cause high unemployment by themselves. There is no conclusive evidence supporting or refuting the viewpoint that environmental regulations slow that long-run economic growth rate.

Comparative Advantage and Trade

The Specialization and Division of Labor

As noted in the discussion of the production possibilities frontier, a necessary condition to achieve maximum output was efficiency in production. As civilizations develop, one of the most fundamental sources of improved efficiency is specialization, which results from the division of labor. The first economist to systematically analyze the role of specialization in production was Adam Smith, who commented on his observations of a pin factory. In The Wealth of Nations (1776), Smith wrote:

One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even trade by itself to put them into the paper. 1

Smith is describing the division of labor into specialties, a critical component of the Industrial Revolution. As workers specialized, they became more skilled and proficient in their specialty, increasing the productivity and output of the workers. Smith conveyed this observation by:

I have seen a small manufactory of this kind where ten men only were employed ... Those ten persons . . . could make among them upwards of forty-eight thousand pins in a day ... But if they had all wrought separately and independently . . . they certainly could not each of them have made twenty, perhaps not one pin in a day. 2

Smith is describing an essential component of the modern economy. Rather than producing everything they need, workers aspire to specialize in a profession or trade, receiving income for their efforts. The income is then used in exchange for other goods and services. The net result of specialization is higher individual output and income, and potential consumption.

Comparative Advantage

The idea of specialization and the division of labor can be applied to more than individual labor; the concept can be related to an entire economy. Factors such as labor skills, resources, and technology determine the competitive relationship between two countries. An economy characterized by an educated and skilled workforce will enjoy a comparative advantage in the production of higher-technology goods, such as computers and semiconductors. In contrast, a country dominated by rich agricultural lands but a relatively low-skilled workforce will generate high volumes of grain output with minimal fertilizer inputs.

Factors Which Determine Comparative Advantage

We use comparative advantage to determine trade patterns between countries. Now we ask, what determines comparative advantage? There are a number of important considerations in discussing why a country may enjoy a comparative advantage in the production of certain goods. The reasons for a comparative advantage include:

Beginning with the first entry on the list, natural endowments, change occurs slowly, if at all. In this case, comparative advantage is a relatively static concept, as natural resources are fixed over long periods of time. For example, many Middle Eastern countries have large oil reserves buried beneath the sands of their arid countries. In contrast are the rich agricultural lands of countries like the United States, Argentina, and Australia. Climate, geography, and other natural endowments are very important in determining what type of products a country may enjoy a comparative advantage in.

Just because a country is lacking in abundant natural resources does not mean they will not benefit from specialization and trade. One country is resource poor, yet has a thriving export economy is Japan. Following the concept of comparative advantage, Japan imports scarce natural resources and exports goods which the highly skilled Japanese labor force produces with great efficiency and at low cost. A critical factor for the Japanese economy is a high rate of domestic savings by Japanese citizens. The abundant supply of savings is available for businesses to borrow at a low cost in order to use for investment in capital that can be used by Japanese workers to convert imported natural resources into goods with a greater value. For another example, read how the economy in China is evolving.

Technology changes at an increasingly rapid pace. But the education and skills required to effectively utilize the technology evolve much more slowly. In contrast are factors such as exchange rates. Dramatic shifts in exchange rates can rapidly modify the relative prices of goods traded between two or more countries. For some goods, the historical relationship of comparative advantage based on endowments and skills can rapidly be altered because of changes in the comparable international prices of those goods.

An Example of Comparative Advantage

For simplicity, we narrow our world down to two countries (Spain and Germany) and assume they produce two goods that can be traded (beer and wine). Referring to the table below we can see if all labor and capital inputs in Spain are devoted to only beer production, 30 barrels of beer are produced daily leaving no inputs to produce wine. If instead all domestic inputs of labor and capital in Spain are devoted to wine production, 30 barrels of wine are produced leaving no inputs to produce beer. We can use the same analysis for Germany although different amounts of beer and wine are produced when inputs are devoted to the production of one of the two goods. Germany may have more inputs, combined with a climate that is better suited for beer rather than wine production.

From the table we can see that Germany has an absolute advantage in beer production - 80 barrels for Germany and in comparison 30 for Spain, while Spain has an absolute advantage in wine production. Note that a country can have an absolute advantage in both goods.

Trade is based on comparative advantage and to calculate comparative advantage we calculate the opportunity of producing beer in terms of wine. Spain will give up a barrel of beer for each barrel of wine produced (30/30) for a ratio equal to 1.0. In comparison, German will give up 4 barrels of beer for each barrel of wine produced (80/20) for a ratio equal to 4.0. The opportunity cost of beer in terms of wine for Germany is much greater than for Spain - a ratio of 4:1 for Germany and 1:1 for Spain. As a result we find that Germany has a comparative advantage in the production of beer and it follows in our simple two-party, two-good model that Spain has a comparative advantage in wine.

Having determined comparative advantage, we conclude that Spain should specialize in the production of wine (where it has a comparative advantage) and Germany will specialize in beer production. Spain will engage in trade, exporting wine to Germany and importing beer from Germany. With specialization and trade the citizens of Spain and Germany will find that their living standards (based on consumption of wine and beer) improve in comparison to autarky (no trade).

  Spain Germany
Beer Wine Beer Wine
All time devoted to producing beer 30 barrels 0 barrels 80 barrels 0 barrels
All time devoted to producing wine 0 barrels 30 barrels 0 barrels 20 barrels