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Lecture 3

Lecture 3 on Comparative Advantage and the Gains from Trade

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James Pesando

-If you could save $25 on a $50 textbook, would you travel downtown to buy it (rather than at the UofT bookstore)? -If you could save $25 on a $1,000 computer, would you travel downtown to buy it (rather than at the UofT bookstore)? Rational Decision-Making MB = $25 If MC (OC) < $25, buy both downtown If MC > $25, buy both at UofT In fact, some would travel to save $25 on book, but not to save $25 on computer - NOT rational Insight: 1. Predictions of economic analysis (rational decision- making) ARE usually accurate 2.Study of non-rational decision-making is a subfield : Behavioural Economics Production Possibilities Frontier (PPF) 1. Scarcity (attainable vs. not attainable) 2. Tradeoffs (choices - decisions) 3. Opportunity Cost Key Application: Used to illustrate the benefits of trade, between countries and between individuals Productional Possibilities Frontier (Constant OC) Gumdrops Chocolates 10 0 8 1 6 2 4 3 2 4 0 5 1. Switch from all Gumdrops to all Chocolates OC of one Chocolate = 10/5 = 2 Gumdrops 2. Switch from all Chocolates to all Gumdrops OC of one Gumdrop = 5/10 = 0.5 Chocolates Straight-line (linear) PPF implies that these OC do not change along the PPF To simplify examples in Class: I assume that OC are constant along the PPF (and, thus, the PPF is linear) For discussion of PPF that is not linear, see Mankiw, Ch 2, Pg 26-28 Comparative Advantage and the Grains 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 OC than anyone else. The existence of comparative advantage is the key to: 1. Specialization 2. The gains from trade Example 1: Production Possibilities (per week)
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