Opportunity Cost And Production Possibility Curve In International Trade And Absolute Advantage Theory

Question 1

Lack of resources is a basic problem and faced by every economy. This kind of problem is faced by countries because wants are limitless, and thus to overcome this problem of scarcity, countries must take decisions regarding choices. Here comes the powerful economic concept which is Opportunity cost. Opportunity cost thus defined as amount of value of any commodity forgone in order to get value of another commodity (Jablonski, Schmit and Kay, 2016).

Now considering two countries and two commodities model i.e., 2 *2 model the concept of opportunity cost can be explained. Let the two countries be India and Thailand and the two commodities are rice and cloth. Both countries are self sufficient and can produce both commodities. But specializing in the commodity for which they have comparative advantage and then trading that commodity allows both economies to consume more. Below table 1 shows how much units of rice and cloth produced by each country.

Countries	Rice (kg)	Cloth (meter) Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper
India	10	5
Thailand	5	2

Table1: Production figure

The above table shows India produces 10kg of rice and 5 meter of cloth while Thailand produces 5kg of rice and 2 meter of cloth. Graphically it can be shown using production possibility curve. PPC shows the efficiency in production and possible allocation possibility for a given level of resources (Ruijs et al.2013). Here it mainly used to shows the tradeoff between producing two commodities.

Diagram 1 PPC of India

Diagram 2 PPC of Thailand

The above diagram 1 and diagram 2 shows PPC of Thailand and India, presently countries are producing rice and cloth using a specific bundle.

Now for showing the opportunity cost of rice and cloth by India and Thailand below table is considered.

Countries	Opportunity cost of 1kg of rice	Opportunity cost of 1 meter of cloth
India	0.5	2
Thailand	0.4	2.5

Table 2: Opportunity cost

The above table shows opportunity cost incurred by India for producing 1 kg of rice is 0.5 and that of Thailand is 0.4. With respect to cloth, opportunity cost of producing 1 meter of cloth is 2 and 2.5 by India and Thailand respectively. Here it is thus observed that Thailand has low opportunity cost of producing rice compared to cloth. Thus Thailand will produce more rice and will export rice in order to gain from international trade. On the other hand India will specialize in producing cloth and will export cloth. Hence, it can be observed that country that has low opportunity cost of producing a commodity then that country will specialize in producing that commodity (Kurzban et al.2013). This is the reason why Thailand will be producing less cloth for producing more of rice and this is due to the fact rice will provide more economical benefit to country.

Production possibility curve (PPC) mainly shows that efficient production bundles attained by a country to achieve efficiency in production. It mainly addresses the issue of scarcity which is a common problem faced by economies in producing goods(Ruijs et al.2013). This concept of PPC is best understood by considering examples.

	Hamburgers	T-shirt
Mike	10	3
Johnson	7	4

Table 1: Production  figure

Considering the above table it is observed that Mike if produce 10 hamburgers then Johnson will produce 7 hamburgers while with respect to T-shirt, Mike produces 3 T-shirts and Johnson produces 4 T-shirts.

Question 2

Diagram 1 Production Possibility Curve (PPC)

The above diagram shows production possibility curve CD. A and B are two commodity bundles. Mike and Johnson can attain either bundle. Mike if attain bundle A then more hamburgers are produced and less shirt is produced and Johnson if attain bundle B he will produce more of shirts less of T-shirts. However, it is clear that although low T-shirts are produced less but selling T-shirts is more profitable than hamburgers.

Absolute advantage theory was first described by Adam smith. This theory mainly shows the ability of an individual to produce greater quantity of a commodity given the resource constraint (Schumacher, 2012).

	Hamburgers	T-shirt
Mike	10	3
Johnson	7	4

Table 1:Production figure

According to table 1, Mike produces 10 hamburgers using 24 hours or can produce 3 T-shirts using same hours of labor. On the other hand Johnson produces 7 hamburgers and 4 T-shirts a day. From the point of view of absolute advantage theory, Mike has absolute advantage in producing hamburgers while Johnson has absolute advantage in producing T-shirts. But the absolute advantage enjoyed by Johnson is less than Mike so Mike will enjoy absolute advantage in producing both the goods.

Opportunity cost plays an important role in determining the production of commodities. It mainly gives idea about the benefit received by producing one commodity at the cost of forgoing the production of another commodity.  If a person incur low opportunity cost then that person have a tendency to produce more of that commodity in order to achieve desired results .However, high opportunity cost if incurred then production of that commodity does not provide much benefit (Kurzban et al., 2013).

	Opportunity cost of 1 hamburger	Opportunity cost of 1 T-shirt
Mike	0.3	3.3
Johnson	0.5	1.75

Table 2: Opportunity cost

The above table shows that Mike incurs high opportunity cost while making T-shirts. The reason behind this – Johnson can produce T-shirts at a low opportunity cost and Mike can produce hamburger at a low opportunity cost. Hence, Johnson will produce more of T-shirts and Mike should produce more of hamburgers.

Comparative advantage theory shows the advantage that an individual can have by producing a commodity more efficiently for getting economic benefit rather than producing another commodity. Thus comparative advantage provides a framework that country’s should follow, the frameworks shows that a country should produce that commodity in which efficient production is achieved (at lower opportunity cost) than other commodities (Laursen, 2015).

	Opportunity cost of 1 hamburger	Opportunity cost of 1 T-shirt
Mike	0.3	3.3
Johnson	0.5	1.75

Table 2: Opportunity cost

The above table shows that Mike has comparative advantage in producing hamburgers. The reason behind this is, producing hamburger incurs low opportunity cost to Mike than producing T-shirts which incurs high opportunity cost. Hence in order to benefit from trading, Mike will produce hamburgers in order to reap benefits from trade.

a) Production possibility frontier shows the maximum output possibilities of two goods, given the inputs and factors of production. Labor, capital and technology all are factors of production. Thus PPF provides different production bundle represented in form of points on the curve and point lying on PPF are efficient ones while points inside PPF are considered inefficient points and points outside PPF is impossible to attain (Benhabib and Nishimura, 2012).Let us now consider two countries home and foreign, both produces two goods good 1 which uses labor and capital and good 2 which use labor and land. The production functions of two goods are:

Question 3

Production Function of good 1 Q₁=Q₁ (K₁, L1)

Here Q₁ refers to economy’s output of good 1, K₁ is economy’s capital stock and L₁ is the labor force employed in good 1.

Production Function of good 2 Q₂=Q₂ (K₂, L2)

Here Q₂ refers to economy’s output of good 2, K₂ is economy’s capital stock and L₂ is the labor force employed in good 2.

The condition for full employment requires the supply of labor employed in good 1 plus supply of labor employed in good 2

L₁+ L₂=L

Initially both countries have same supply of labor, capital and land. Now if capital stock of home country increases then it impacts PPF. Due to lack of land, home will produce a high ratio of good 1 to good 2 at any given prices.

Diagram 1: Changing capital stock

Diagram 1 shows relative supply curve is P₂XMPL₂ and relative demand curves are P₁XMP₁L₁  and P₁XMP₁L₁2 , W₁ and W ₂ are wage rates . Now increase in capital supply shifts supply curve to outward and increase in supply of labor shifts supply curve to inward. Thus home has more capital per worker than foreign on the other hand foreign has more land per worker. Thus in autarky situation relative price of good 1 in home country is lower than the relative price in foreign in autarky situation. Thus trade leads to convergence of relative price.

b) Both countries have same supply of labor in autarky situation. Now with trade capital stock of home country increases then it impacts PPF. Due to lack of land, home will produce more good 1 and foreign will produce more good 2.

Diagram 1: Changing capital stock

Diagram 1 shows relative supply curve is P₂XMPL₂ and relative demand curves are P₁XMP₁L₁  and P₁XMP₁L₁2 , W₁ and W ₂ are wage rates . Now increase in capital supply shifts supply curve to outward and increase in supply of labor shifts supply curve to inward. Thus home has more capital per worker than foreign on the other hand foreign has more land per worker. Thus in autarky situation relative price of good 1 in home country is lower than the relative price in foreign in autarky situation. Thus trade leads to convergence of relative price.

Opening up to trade between home and foreign country provides benefit to both the countries. The pattern of trade is thus given below.

Diagram 2: Pattern of trade

The above diagram shows that country that cannot participate in trade then the output of that country equals its consumption. Now if the country involves itself in trade then, international trade makes it possible to consume the goods which the country doesn’t even produce, thus the mix of two goods can be consumed. Opening up to trade shifts relative prices of good 1 and good 2. Thus pattern of trade shows that home will export good 1 and foreign will export good 2. This pattern is followed because capital stock increases in home and good 1 uses capital and labor and good 2 uses labor and land.

Considering diagram 2, opening up to trade shows that trade benefits the factors that are specific to export, here capital and land will be affected as these factors used in the export commodities. Home country exports good 1 which involves use of capital and labor and foreign country exports good 2 which involves use of land and labor. Thus trade affects factors that are specific to export, but affects the import sector. Effect of trade on labor is ambiguous.

1. A country does not engage in trade can benefit from trade only if-Pre-trade and

Free-trade relative prices are not identical.

1. The effect of trade on specialized employees of exporting industries will be more jobs and higher pay because they are relatively immobile.
2. The Ricardian model of international trade demonstrates that trade can be mutually beneficial. Why, then, do governments restrict imports of some goods?

Answer-Trade can have substantial effects on a country’s distribution of income

1. In the specific factor model, a country’s production function is a curved line because of diminishing marginal returns.
2. The effect of trade on income distribution can be significant in the short run

References

Benhabib, J. and Nishimura, K., 2012. Competitive equilibrium cycles. In Nonlinear Dynamics in Equilibrium Models (pp. 75-96). Springer Berlin Heidelberg.

Jablonski, B.B.R., Schmit, T.M. and Kay, D., 2016. Assessing the economic impacts of food hubs on regional economies: A framework that includes opportunity cost. Agricultural and Resource Economics Review, 45(1), pp.143-172.

Kurzban, R., Duckworth, A., Kable, J.W. and Myers, J., 2013. An opportunity cost model of subjective effort and task performance. Behavioral and Brain Sciences, 36(6), pp.661-679.

Laursen, K., 2015. Revealed comparative advantage and the alternatives as measures of international specialization. Eurasian Business Review, 5(1), pp.99-115.

Ruijs, A., Wossink, A., Kortelainen, M., Alkemade, R. and Schulp, C.J.E., 2013. Trade-off analysis of ecosystem services in Eastern Europe. Ecosystem services, 4, pp.82-94.

Schumacher, R., 2012. Adam Smith’s theory of absolute advantage and the use of doxography in the history of economics. Erasmus Journal for Philosophy and Economics, 5(2), pp.54-80.