Market Power

Musings by an academic economist on the power of markets and the power over markets.

Sunday, October 24, 2004

Comparative Advantage or Production Possbilities

It has been several years since I taught the production possibilities frontier (PPF) in my Principles of Economics classes. In its place, I teach the concept of comparative advantage.

When teaching the PPF, the professor can show students how choices between goods are choices between how productive inputs are used. It is also used to develop the idea of opportunity cost - producing additional units of one good necessitates taking resources from another good. Society, therefore, loses some of that other good. It can also be used to talk about the concept of increasing opportunity costs. While these are important topics, I have found I can make most of the same arguments by teaching Ricardo's concept of comparative individuals trade with one another.

In a simple two-person two-good economy, a person has a comparative advantage in the production of a good if he/she has to sacrifice the least to obtain it (i.e. has the lowest opportunity cost). For example although I can brew beer fairly well, Schell's Brewery in New Ulm, Mn. can produce it at lower cost (it costs me about $40-$50 to purchase the materials to brew 44 12-ounce bottles of Octoberfest plus several hours of cooking, cleaning, and bottling plus several weeks of waiting). On the other hand, I can go to the local liquor store and get 2 cases for $56 + 9% sales tax and have a beer with dinner that night.

In short, Schell's has a comparative advantage in beer production. They should since they have economies of scale!

Alternatively, Schell's could train their employees about economics and other general business education courses. But this means taking resources out of beer production and putting them into teaching. Instead, Schell's hires people educated outside the factory and focuses on beer production. This provides income for teachers (like me) who then go out and buy beer from someone, like Schell's, who have lower costs of beer production. This enables teachers to acquire more stuff with their given resources. This gives them a higher standard of living.

Basicaly, according to the principle of comparative advantage, we trade with others because they do some things at a lower cost than we do and trading improves our standard of living. That's the mainstream view in economics and those are the main points I try to make when teaching comparative advantage.

I realize that Schell's decision not to teach general business education classes to their employees is more involved than in my simple case. We don't live in a two-person two-good economy. Additionally, since general business education courses are just that - generally applicable - the students could take what they learn in those classes and put it to use in other businesses - the skills are easily transferable and may even be harmful to Schell's.

The sorts of things learned from studying the PPF that I don't get to while teaching comparative advantage, namely increasing opportunity costs, are things that I find I can teach elsewhere in Macro and Micro. For example, I can talk about diminishing returns and increasing marginal costs in macro when discussing a country's production function. Moreove, since international trade is often such a hot topic (outsourcing anyone?), I find I can expose students to the mainstream economics position of the benefits of international trade.

That's why I don't teach the PPF anymore.