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topic 2 - Gains from Trade.pdf

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James Pesando

Topic 2 – Gains from Trade (Week Two Sep 20 – Sep 24 ) th th Sep 20 – Comparative Advantage & Specialization 2. PPF – Production Possibility Frontier: s a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology; e.g.1 Gumdrops and Chocolates Assume a society can only produce gumdrops and chocolates: PPF of Gumdrops and Chocolates Gumdrops i Production Possibilities Gumdrops Chocolates 10 0 10 8 1 unattainable 6 2 6 4 3 2 4 attainable 0 5 2 5 Chocolates Insights: Calculate OC: a. Cause of PPF: scarcity of resources; OC of one gumdrop is 0.5 chocolate; b. Result of PPF: tradeoff (5 chocolates / 10 gumdrops = 0.5 C/G) c. Slope of PPF: Opportunity Cost OC of one chocolate is 2 gumdrops; (10 gumdrops / 5 chocolates = 2 G/C); The opportunity cost (slope and shape of the PPF): a. For now, always assume constant opportunity cost, which means PPF is always linear; b. In the economy, opportunity cost is not always linear, but depends on how many of each product is being produced. As we produce more and more of any particular good, the opportunity cost per unit tends to rise because resources are specialized. (i.e. recourses are not equally well suited for producing each output; it also means that tradeoffs between the production of any two goods are not constant.) Therefore PPF always bends outward. (Mankiw study guide pg13-14) 3. Comparative Advantage: An individual (or country) has a comparative advantage in an activity if the individual (or country) can perform that activity at a lower OC than anyone else. The existence of comparative advantage is the key to: a. Specialization; b. The gain from trade e.g.2 John and Jane ii PP for John and Jane Cloth PPF For John and Jane Cloth Corn 10 John 10 2 8 Jane 8 4 Observations: 2 4 Corn a. John has an absolute advantage in production of cloth (i.e. is more efficient in the production of cloth); b. Jane has an absolute advantage in production of corn; (i.e. can produce corn using fewer resources); iiii- OC of producing one unit of Calculating Opportunity Costs John: OC per cloth = 2/10 = 0.2 corn/cloth; Cloth Corn OC per corn = 10/2 = 5 cloth/corn; Jane: OC per cloth = 4/8 = 0.5 corn/cloth; John 0.2 corn 5 cloth OC per corn = 8/4 = 2 cloth/corn Jane 0.5 corn 2 cloth Observations: a. John has a comparative advantage in the production of cloth (i.e. produce cloth at a lower OC); b. Jane has a comparative advantage in the production of corn (i.e. produce corn at a lower OC); Insight: it is impossible for one to have comparative advantage in both goods because one cannot have lower opportunity cost in producing everything. (a>b, 1/a < 1/b); 4. Trade and Specialization With unchanged resources (unchanged PPF), total output is higher if trade is allowed. a. Before trade, John and Jane each divide their time Jane and John’s production Cloth Corn equally between the productions of cloth & corn: John 5 1 b. Suppose John and Jane specialize in the production of the good in which each has a Jane 4 2 Total 9 3 comparative advantage (and produce only that good), and hen agree to trade. Jane and John’s production c. The total output of both cloth and corn is higher Cloth Corn if John and Jane specialize and trade. John 10 0 Jane 0 4 *Insights: “the pie is bigger”, but not necessarilyTotal 10(+1) 4(+1) everyone is better off. d. e.g.2 John and Jane Cloth PPF for John and Jane Production Possibilities 10 Cloth Corn 8 John 10 2 Jane 10 8 2 8 Corn Question: Can Jane and John both gain from trade if Jane’s PPF lies everywhere to the right o
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