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Lecture 3

Lecture 3-Comparative Advantage and the Gains from Trade


Department
Economics
Course Code
ECO101H1
Professor
Jack Carr
Lecture
3

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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
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(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
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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
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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
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