Topic 2 - Gains from Trade Production Possibility Frontier; Absolute & Comparative Advantage; trade and specialization; exchange rate and trade line. Comprehensive, clear, with detailed graphs and numerical examples.
Topic 2 – Gains from Trade
(Week Two Sep 20th – Sep 24th)
Sep 20th – 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
i Production Possibilities
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)
2 5 Chocolates
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 PPF For John and Jane
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
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.
Jane and John’s production
Jane and John’s production
2 4 Corn
Calculating Opportunity Costs
John: OC per cloth = 2/10 = 0.2 corn/cloth;
OC per corn = 10/2 = 5 cloth/corn;
Jane: OC per cloth = 4/8 = 0.5 corn/cloth;
OC per corn = 8/4 = 2 cloth/corn
a. Before trade, John and Jane each divide their time
equally between the productions of cloth & corn:
b. Suppose John and Jane specialize in the
production of the good in which each has a
comparative advantage (and produce only that
good), and hen agree to trade.
c. The total output of both cloth and corn is higher
if John and Jane specialize and trade.
*Insights: “the pie is bigger”, but not necessarily
everyone is better off.
e.g.2 John and Jane PPF for John and Jane
Can Jane and John both gain from trade if Jane’s PPF lies everywhere to the right of John’s?
(i.e. Jane has absolutely advantages in producing both goods)
(this is an example of trade between a strong/rich country and a weak/poor country)
Answer: YES. Jane has absolute advantage in productions of both cloth and corn, yet comparative
advantage is the key to gains from trade.
5. Exchange Rate(consumption opportunities)
e.g.3. John and Jane
a. Suppose John and Jane agree to trade 3 cloth for one corn;
b. John and Jane can both consume combination of cloth and corn outside their own PPF.
PPF for John (before Trade) PPF for John (after trade)
In trade, John’s Consumption lies everywhere to the right of PPF except for the point that he produces all
the goods which he has comparative advantage of (cloth).
Question: If trade ratio were 5 for 1, would John benefit from trade?
If John produces 10 cloth and trades them for 2 corns, he could consume 2 corns; Yet John,
without trade, could produce (and thus consumes) 2 corns. The consumption opportunities are unchanged.
Question: If trade ratio were 5 for 1, would Jane benefit from trade?
If Jane produces 4 corns and trades 2 for 10 cloth, she can thus consume 2 corns and 10 cloth,
which is more than the goods she can consume before trade (2 corns 4 cloth).
2 8 Corn
1 2 Corn
PPF = Consumption
Before trade, John
produces 5 cloth and 1 corn ;
He consumes 5 cloth and 1 corn.
1 1.67 2 3.33 Corn
PPF is less than Consumption
At this time, John produces 10 cloth,
trade 5 cloth for 1.67 corn (5/3);
He consumes 5 cloth and 1.67 corn.