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Chapter 3 Notes.docx

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Bridget O' Shaughnessy

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Chapter 3 Notes • Suppose there are 2 people trapped on an island: Robert the potato farmer and Aaron the beef rancher. • Only two goods are produced: potatoes and meat, and each person can produce both goods. • The following table gives information on how much they can produce of each good: • • MEAT or POTATOES • Robert 8 oz 32 oz • Aaron 24 oz 48 oz Suppose Robert and Aaron fend for themselves: • Each consumes what they each produce. • So, the production possibilities frontier is also a consumption possibilities frontier. • Let’s compute the opportunity costs of producing each good for each person: (let’s ignore the units of measurement for now). • For Robert: • To get 32 potatoes, give up 8 meat To get 1 potato, give up ¼ meat The opp.cost of a potato = ¼ meat The opp.cost of a meat = 4 potatoes For Aaron: • To get 48 potatoes, give up 24 meat To get 1 potato, give up ½ meat The opp.cost of a potato = ½ meat The opp.cost of a meat = 2 potatoes. • Let’s compare their opportunity costs: • Opp.Cost of Opp.Cost of a Potato a Meat Robert ¼ meat *lower o.c 4 potatoes Aaron ½ meat 2 potatoes ** lower Robert has a lower opportunity cost of producing potatoes (1/4 meat compared to 1/2 meat forAaron). • We say Robert has a comparative advantage in potatoes: he can produce them at a lower opportunity cost than someone else. • Aaron has a lower opportunity cost of producing meat (2 potatoes compared to 4 potatoes: Aaron has a comparative advantage in meat. Robert should specialize in the production of potatoes and trade potatoes for meat. Aaron should specialize in producing meat and trade meat for potatoes. When they trade with each other, they can consume more of both goods! Suppose that when they fend for themselves: • Aaron produces and consumes 24 potatoes and 12 meat. • Robert produces and consumes 16 potatoes and 4 meat. In summary, when there exists a comparative advantage, each individual should specialize in the production of the good in which they have comparative advantage. They should trade with each other. There will be gains from trade for both. • Aaron has an absolute advantage in the production of both meat and potatoes. • Absolute Advantage: the producer who requires a smaller quantity of inputs (fewer resources) to produce a good (ie is more productive) has an absolute advantage in producing that good) WHY? Aaron only needs 10 min to produce a potatoe and 20 for a meat compared to Robert who needs 15 and 60. Aaron
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