Chapter 2: Problem 7

Why is it that the pre-trade production points have a bearing on comparative costs under increasingcost conditions but not under constant-cost conditions?

Short Answer

Expert verified

In increasing-cost conditions, the cost of producing each subsequent unit of a good increases. Thus, the starting production point (pre-trade production point) matters as it impacts the cost of future production. In contrast, under constant-cost conditions, where each subsequent unit cost remains the same, the pre-trade production point doesn't affect the cost. Hence, it's the varying nature of cost under different conditions that make the pre-trade production points relevant for comparative cost under increasing-cost conditions, and irrelevant under constant-cost conditions.

Step by step solution

Understanding Production Points

Production points refer to combinations of different goods or services a country or firm could produce using all of its resources efficiently. Under increasing-cost conditions, as more of a good is produced, resources that are less and less well-suited to the production of that good are utilized, raising the cost. Therefore, where a country or firm starts producing (its pre-trade production point) will impact the costs of producing subsequent units.

Understanding Comparative Costs

Comparative cost refers to the relative cost of producing a certain good in one country compared to that of another. It's the driving factor of specialization and trade. The lower the opportunity cost, the greater the chance of yielding benefits from trade for that good.

Increasing-Cost vs Constant-Cost Conditions

Under increasing-cost conditions, the comparative costs of production change based on the quantity produced due to variable factors of production. This means the starting point matters, as the more a country produces of a particular good, the higher the cost to produce even more of it. Meanwhile, under constant-cost conditions, the cost to produce an additional unit of a good remains the same no matter how much is already being produced. Hence, the pre-trade production point does not influence comparative costs, as the cost does not vary with quantity produced.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Production Points

Production points are critical to understanding economic efficiency and the allocation of scarce resources. Imagine a country with limited resources faced with the decision of how many units of two different products, say corn and wheat, to produce. Each combination of corn and wheat that can be produced using all available resources effectively is represented by a production point on a graph called the production possibility frontier (PPF).

In a real-world context, if a country employs more workers to harvest corn, fewer workers are available to harvest wheat, creating a trade-off. This trade-off defines the opportunity cost of choosing one good over the other. In essence, the information encoded in production points helps to visualize the best possible use of resources at a given time.

Increasing-Cost Conditions

Increasing-cost conditions occur when the production of more goods leads to a rise in the average cost of production. This often happens because resources are not perfectly adaptable to the production of all goods. For instance, land that is excellent for growing oranges may be only mediocre for producing computers, making the latter more expensive as production increases.

Implications for Comparative Costs

Under increasing-cost conditions, the pre-trade production point has a significant impact on comparative costs due to resource reallocation inefficiencies. If a country is already producing a large amount of a good, producing more will increasingly cost more due to the less suitable resources being used. Hence, its position before trade (the pre-trade production point) can influence the marginal costs of increasing production, which in turn affects its comparative advantage and trade decisions.

Constant-Cost Conditions

Unlike the increasing-cost scenario, constant-cost conditions are characterized by the ability to maintain the same costs of production, irrespective of the scale of output. In this case, additional production does not increase the cost because resources are perfectly adaptable, or because there is easy access to the inputs required at the same prices.

Why Pre-trade Points Don't Affect Comparative Costs

In an environment with constant-cost conditions, expanding production does not influence the opportunity cost of producing one good over another. As a result, the pre-trade production point is irrelevant for determining comparative costs since additional units of a good can be produced at a constant cost. This simplifies economic decisions, as trade-offs between producing different goods remain stable, regardless of the quantity produced.

Opportunity Cost

Opportunity cost is a core concept in economics that represents the benefits an individual, investor, or business misses out on when choosing one alternative over another. It isn't always measured in terms of monetary value but in terms of the next best alternative given up.

For example, if a factory uses its resources to produce cars, the opportunity cost is the profit that could have been made from producing buses instead. In comparative costs analysis, opportunity cost plays a pivotal role since it enables countries to determine their comparative advantages. If the opportunity cost of producing oranges is lower than that of producing apples, a country or firm should specialize in oranges to maximize efficiency and trade.