Class Notes (905,920)
CA (538,532)
UTSG (45,722)
ECO (1,632)
ECO101H1 (575)
Jack Carr (83)
Lecture 3

Lecture 3-Comparative Advantage and the Gains from Trade

8 Pages
151 Views

Department
Economics
Course Code
ECO101H1
Professor
Jack Carr

This preview shows pages 1-3. Sign up to view the full 8 pages of the document.
Friday, September 18th, 2009.
Comparative Advantage and the Gains From Trade
Principles of Economics
Interaction Among Individuals
1. Trade can make everyone better off (³JDLQVIURPWUDGH´
Specialization
Individuals: Produce one (or few) goods
Purchase many goods
Countries: Export goods
Import goods
Trade/Exchange
Source of gains from trade/exchange:
Comparative Advantage
Production Possibilities Frontier
(Constant Opportunity Cost)
Gumdrops
Chocolates
10
0
8
1
6
2
4
3
2
4
0
5
0
2
4
6
8
10
12
0 1 2 3 4 5 6
Chocolates
Gumdrops
Not
Attainable
Attainable
PPF
www.notesolution.com
(1) scarcity
(2) trade-off
(3) opportunity cost
Suppose:
1. Switch from all Gumdrops to all Chocolates
Opportunity cost of one Chocolate = 10/5 = 2 Gumdrops
2. Switch from all Chocolates to all Gumdrops
Opportunity cost of one Gumdrop = 5/10 = 0.5 Chocolates
Opportunity cost of gumdrops: 0.5 chocolates
Opportunity cost of chocolate: 2 gumdrops
Note: Straight-line (linear) PPF implies that these opportunity costs do not change along
the PPF.
Production Possibilities Frontier
(Increasing Opportunity cost)
Possibility
Missiles
A
4.0
B
3.8
C
3.5
D
3.0
E
2.0
F
1.0
G
0.0
xxxxxxxxxx
xxxxxxxxxx
xxxxxxxxxx
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 1 2 3 4 5 6
Video Games
Missiles
b
c
d
e
f
g
PPF
a
www.notesolution.com
From a to b:
Opportunity Cost = ¨missiles = 0.2 = 0.2 missiles
JDPH¨games 1.0
From f to g:
Opportunity cost = ¨missiles = 1.0 = 2.5 missiles
JDPH¨JDPHV0.4
Conclusion: Source of Increasing Opportunity Cost
Resources most suited to the production of a good are used first. As more
of good is produced, resources less suited to its production must be used.
For Simplicity
Assume constant opportunity cost
< = >
Straight-line PPF
Comparative Advantage and the Gains from Trade
Key Result
An individual (or country) has a comparative advantage in an activity if
the individual (or country) can perform that activity at a lower opportunity cost
than anyone else.
The existence of comparative advantage is the key to:
(1) Specialization
(2) The gains from trade
Example:
PPF: John and Jane
Production Possibilities (Per Week)
Corn
John
2
Jane
4
www.notesolution.com

Loved by over 2.2 million students

Over 90% improved by at least one letter grade.

Leah — University of Toronto

OneClass has been such a huge help in my studies at UofT especially since I am a transfer student. OneClass is the study buddy I never had before and definitely gives me the extra push to get from a B to an A!

Leah — University of Toronto
Saarim — University of Michigan

Balancing social life With academics can be difficult, that is why I'm so glad that OneClass is out there where I can find the top notes for all of my classes. Now I can be the all-star student I want to be.

Saarim — University of Michigan
Jenna — University of Wisconsin

As a college student living on a college budget, I love how easy it is to earn gift cards just by submitting my notes.

Jenna — University of Wisconsin
Anne — University of California

OneClass has allowed me to catch up with my most difficult course! #lifesaver

Anne — University of California
Description
Friday, September 18th, 2009. Comparative Advantage and the Gains From Trade Principles of Economics Interaction Among Individuals 1. Trade can make everyone better off (³JDLQVIURPWUDGH´ Specialization Individuals: Produce one (or few) goods Purchase many goods Countries: Export goods Import goods Trade/Exchange Source of gains from trade/exchange: Comparative Advantage Production Possibilities Frontier (Constant Opportunity Cost) Gumdrops Chocolates 10 0 8 1 6 2 4 3 2 4 0 5 0246810120 1 2 3 4 5 6ChocolatesGumdropsNot Attainable Attainable PPF www.notesolution.com (1) scarcity (2) trade-off (3) opportunity cost Suppose: 1. Switch from all Gumdrops to all Chocolates Opportunity cost of one Chocolate = 10/5 = 2 Gumdrops 2. Switch from all Chocolates to all Gumdrops Opportunity cost of one Gumdrop = 5/10 = 0.5 Chocolates Opportunity cost of gumdrops: 0.5 chocolates Opportunity cost of chocolate: 2 gumdrops Note: Straight-line (linear) PPF implies that these opportunity costs do not change along the PPF. Production Possibilities Frontier (Increasing Opportunity cost) Possibility Games Missiles A 0.0 4.0 B 1.0 3.8 C 2.0 3.5 D 3.0 3.0 E 4.0 2.0 F 4.6 1.0 G 5.0 0.0 00.511.522.533.544.50 1 2 3 4 5 6Video GamesMissilesb c d e f g PPF a www.notesolution.com From a to b: Opportunity Cost = ¨missiles = 0.2 = 0.2 missiles JDPH¨games 1.0 From f to g: Opportunity cost = ¨missiles = 1.0 = 2.5 missiles JDPH¨JDPHV0.4 Conclusion: Source of Increasing Opportunity Cost Resources most suited to the production of a good are used first. As more of good is produced, resources less suited to its production must be used. For Simplicity Assume constant opportunity cost < = > Straight-line PPF Comparative Advantage and the Gains from Trade Key Result An individual (or country) has a comparative advantage in an activity if the individual (or country) can perform that activity at a lower opportunity cost than anyone else. The existence of comparative advantage is the key to: (1) Specialization (2) The gains from trade Example: PPF: John and Jane Production Possibilities (Per Week) Cloth Corn John 10 2 Jane 8 4 www.notesolution.com John has absolute advantage in the production of cloth (i.e., is more efficient in the production of cloth) Jane has absolute advantage in production of corn Opportunity Costs (Constant) John Opportunity Cost (1 cloth) = 2/10 = 0.2 corn Opportunity Cost (1 corn) = 10/2 = 5 cloth Jane Opportunity Cost (1 cloth) = 4/8 = 0.5 corn Opportunity Cost (1 corn) = 8/4 = 2 cloth Because PPF is linear, opportunity costs are constant 8 4 Cloth Corn Jane 10 2 Cloth Corn John www.notesolution.com Opportunity Cost of Producing One Unit of: Cloth Corn John 0.2 corn 5 cloth Jane 0.5 corn 2 cloth Observation: John has a comparative advantage in the production of cloth (since he can produce cloth at a lower opportunity cost, 0.2 corn versus 0.5 corn) Jane has a comparative advantage in the production of corn (since she can produce corn at a lower opportunity cost, 2 cloth versus 5 cloth) Before trade, John and Jane each divide their time equally between the production of cloth and corn. Production (Before Trade) Cloth Corn John 5 1 Jane 4 2 Total 9 3 Suppose John and Jane specialize in the production of the good in which each has a comparative advantage (and produce only this good), and then agree to trade. Production (After Trade) Cloth Corn John 10 0 Jane 0 4 Total 10(+1) 4(+1) The total output of both cloth and corn is higher, and the potential gains from trade are evident. Example #2: PPF: John and Jane Production Possibilities (Per Week) Cloth Corn John 10 2 Jane 16 8 www.notesolution.com Opportunity Cost of Producing One Unit of: Cloth Corn John 0.2 corn 5 cloth Jane 0.5 2 cloth Jane now has an absolute advantage in the production of both cloth and corn. Yet John has a comparative advantage in the production of cloth, while Jane has a comparative advantage in the production of corn. Before trade, john and Jane divide their time equally between the production of cloth and corn. Production (Before Trade) Cloth Corn John 5 1 Jane 8 4 Total 13 5 After trade, John specializes completely in the production of cloth, while Jane now allocates 75% of her time to the production of corn. Production (After Trade) Cloth Corn John 10 0 Jane 4 6 Total 14(+1) 6(+1) 16 10 2 8 Cloth Corn Jane John PPF: John and Jane www.notesolution.com Perspective: Jane has Absolute Advantage in the production of cloth and corn (i.e., is more productive Ù more output for a given amount of input) Yet Comparative Advantage is key to gains from trade The production Possibilities Frontier and the Gains from Trade 1. Suppose John and Jane agree to trade 3 cloths for one corn 2. John and Jane can both consume combination of cloth and corn outside their own PPF Production Possibilities Frontier (PPF) 1 2 10 5 Cloth Corn John NO TRADE PPF = Consumption Opportunities Example: John produces/consumes 5 cloth and 1 corn 1.67 2 10 5 Cloth Corn John Å----------Consumption opportunities if trade ratio is 3 cloth for 1 corn 3.33 www.notesolution.com Example: John produces 10 cloth Trades 5 cloth for 1.67 corn Consumes: 5 cloth (as before) 1.67 corn (not 1 corn) * Differences in opportunity cost and comparative advantage create the gains from trade. When each person specialized in producing the good for which he or she has a comparative advantage, total production in the economy rises, and this increase in the size of the economic pie can be used to make everyone better off. In other words, as long as two people have different opportunity cots, each can benefit from trade by obtaining a good at a price that is lower than his or her opportunity cost of that good. If trade ratio were 5 cloth for 1 corn, would John benefit from trade? NO If John produced 10 cloth and traded for corn, he could consume 2 corn Yet John, without trade, could produce (and thus consume) 2 corn Consumption opportunities unchanged Student Exercise: Trade lines (cloth per corn) must lie between opportunity costs of John and Jane if both are to benefit from trade. In this example: 2 < Trade Line <5 (cloths per corn) www.notesolution.comFriday, September 18 , 2009. Comparative Advantage and the Gains From Trade Principles of Economics Interaction Among Individuals 1. Trade can make everyone better off (J,L38174297,0 Specialization Individuals: Produce one (or few) goods Purchase many goods Countries: Export goods Import goods TradeExchange Source of gains from tradeexchange: Comparative Advantage Production Possibilities Frontier (Constant Opportunity Cost) Gumdrops Chocolates 10 0 8 1 6 2 4 3 2 4 0 5 12 10 Not Attainable s 8 rp m 6 u G 4 PPF 2 Attainable 0 0 1 2 3 4 5 6 Chocolates www.notesolution.com
More Less
Unlock Document


Only pages 1-3 are available for preview. Some parts have been intentionally blurred.

Unlock Document
You're Reading a Preview

Unlock to view full version

Unlock Document

Log In


OR

Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


OR

By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.


Submit