Question

Plot the PPC of a nation given by the following data. $$ \begin{array}{lrr} \text { Combination } & \text { Health Care } & \text { All Other Goods } \\ \hline \text { A } & 0 & 100 \\ \text { B } & 25 & 90 \\ \text { C } & 50 & 70 \\ \text { D } & 75 & 40 \\ \text { E } & 100 & 0 \\ \hline \end{array} $$ a. Calculate the marginal opportunity cost of each combination. b. What is the opportunity cost of combination C? c. Suppose a second nation has the following data. Plot the PPC, and then determine which nation has the comparative advantage in which activity. Show whether the two nations can gain from $$ \begin{array}{lcc} \text { Combination } & \text { Health Care } & \text { All Other Goods } \\ \hline \text { A } & 0 & 50 \\ \text { B } & 20 & 40 \\ \text { C } & 40 & 25 \\ \text { D } & 60 & 5 \\ \text { E } & 65 & 0 \end{array} $$

Short answer

Can the two nations gain from each other? Explain your answer briefly. Answer: Nation 1 has a comparative advantage in producing Health Care, while Nation 2 has a comparative advantage in producing All Other Goods. Both nations can benefit from trading with each other, as they can specialize in their respective advantages and maximize their production and consumption possibilities, ultimately leading to gains for both nations.

Step-by-step solution

Plotting the PPC for the first nation

First, create a graph with Health Care on the horizontal axis and All Other Goods on the vertical axis. Then plot the data points for each combination (A to E) on the graph. Once plotted, connect the points with a smooth curve to form the PPC for the first nation.

Calculate the Marginal Opportunity Cost (MOC)

To calculate the MOC, you need to find the slope between two consecutive points. The MOC between A and B is the change in All Other Goods divided by the change in Health Care, which is \(\frac{90-100}{25-0} = \frac{-10}{25} = -0.4\). Similarly, calculate the MOC for the remaining combinations: MOC between B and C: \(\frac{70-90}{50-25} = -\frac{20}{25} = -0.8\) MOC between C and D: \(\frac{40-70}{75-50} = -\frac{30}{25} = -1.2\) MOC between D and E: \(\frac{0-40}{100-75} = -\frac{40}{25} = -1.6\)

Find the Opportunity Cost of Combination C

The opportunity cost of combination C is the foregone production of All Other Goods as more Health Care is produced. Since combination C is between combinations B and D, we find the opportunity cost by calculating the average MOC between B and D: \(-0.5*(-0.8 + -1.2) = -0.5*(-2) = 1\) unit of Health Care costs 1 unit of All Other Goods.

Plot the PPC for nation 2

Repeat Step 1 for the second nation using their data points and create their PPC.

Determine Comparative Advantage

To determine the comparative advantage, calculate the opportunity cost of producing Health Care in both countries using the MOC calculated above. Consider the MOC for combination B in each nation. Nation 1: (B) MOC = -0.4 -> Opportunity cost for Health Care = 0.4 All Other Goods Nation 2: (B) MOC = \(\frac{40-50}{20-0} = -0.5\) -> Opportunity cost for Health Care = 0.5 All Other Goods Since nation 1 has a lower opportunity cost for producing Health Care (0.4 vs. 0.5), it has a comparative advantage in Health Care. Meanwhile, nation 2 has a comparative advantage in producing All Other Goods, because it has a lower opportunity cost for producing Health Care (0.5 vs. 0.4). We can compare each combination and create a table showing the comparative advantages.

Determine Gains from Each Other

As nation 1 has a comparative advantage in Health Care production and nation 2 has a comparative advantage in producing All Other Goods, they can both benefit by specializing in their respective advantages and engaging in trade. This allows each nation to maximize its production and consumption possibilities, ultimately leading to gains for both nations.

Key concepts

Marginal Opportunity Cost

Understanding marginal opportunity cost is crucial when analyzing the production possibility curve (PPC). It shows the trade-off of producing more of one good at the expense of another. In simpler terms, it is how much of one product you must give up to produce a little more of another. When moving from combination A to B, we noted a marginal opportunity cost of -0.4 for Health Care, meaning for every additional unit of Health Care, the nation sacrifices 0.4 units of All Other Goods.
Each subsequent combination displays a higher marginal opportunity cost, signifying that as resources are reallocated, they become less efficient at producing extra units, demonstrating the law of increasing opportunity costs. This mirrors the concept of diminishing returns as we continue reallocating scarce resources away from producing comfort goods to essential services.

Comparative Advantage

Comparative advantage enables nations to decide which goods they can produce more efficiently. When a nation possesses a comparative advantage, it means that it can produce a good with a lower opportunity cost than its trading partners.
In our exercise, by comparing the opportunity costs calculated from the marginal opportunity costs of health care, between nation 1 and nation 2, we found that nation 1 has a comparative advantage in Health Care since it has a lower opportunity cost of 0.4 units of All Other Goods per unit of Health Care. Conversely, nation 2 is better at producing All Other Goods, evident by its comparative advantage, as it can productively manufacture it at a lower opportunity cost per Health Care unit.
The essence of comparative advantage highlights the strategic benefit of nations focusing on fields where they have lower relative opportunity costs, thereby maximizing their productive efficiencies.

Opportunity Cost

Opportunity cost represents the benefits or value that one forgoes when choosing an alternative option. For instance, in the context of combination C from the first nation, we calculated the opportunity cost as the amount of All Other Goods we lose to gain more units of Health Care. Precisely, it was determined to have an opportunity cost that equates 1 unit of Health Care with 1 unit of All Other Goods. This means resources used to produce one more unit of Health Care could have alternatively produced 1 more unit of All Other Goods.
Understanding opportunity costs is central when making economic decisions, as it aids in weighing the potential benefits of various choices. Nations too can apply this principle to decide which commodities to specialize in, thereby optimizing resource allocation.

Trade Gains

Trade gains emerge when countries specialize according to their comparative advantages, then exchange with one another. The principle behind trade gains is that through specialization and trade, countries can extend their consumption boundaries, moving beyond their individual production possibilities.
In our exercise, nation 1 specializes in Health Care, and nation 2 in All Other Goods. By each country focusing on producing what they are relatively more efficient at and then trading, both nations enjoy access to more goods than they would produce on their own.

• Maximizing production efficiency
• Expanding consumption possibilities
• Improving the standard of living

Via these mechanisms, trade can significantly boost the economic welfare of the participating countries, offering them greater diversity and quantity of goods and services.