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Chapter 3

ECO101H1 Chapter Notes - Chapter 3: Absolute Advantage, Comparative Advantage, Second Epistle Of John


Department
Economics
Course Code
ECO101H1
Professor
James Pesando
Chapter
3

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Week 2:
Principles of Economics:
5. Trade Can Make Everyone Better Off
Some people think that nations are competing in manufacturing and production of goods and services,
however, it is untrue to a certain extend. When a nation produces a good or a service and has a
comparative advantage over other nations, it should probably trade and make both nations better off.
The nation that produces gets the price they desire, because they have a comparative advantage, and
the nation that imports gets the good/service to sell to the citizens.
The production-possibility-frontier is used to illustrate the benefits of trade between countries or
individuals. It shows how there is scarcity of resources (and hence, why some combinations are
attaiale ad soe aet, the tade-offs people face and the opportunity cost each person faces in
the production of goods/services. For examples, if Rose is a cattle rancher and Frank is a potato farmer,
they will both get bored of eating the same thing and hence, trade would benefit both. Similarly, if
both were producing meat and potato, they ouldt produce as much in number as they would if
they trade.
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2
Rose produces more of both meat and potatoes compared to Frank. Therefore, we can say that Rose
has an absolute advantage- the ability to produce a good using fewer inputs than another producer.
Hoee, this doest determine whether they should trade or not. Instead, using their ability to
produce a good at a lower opportunity cost than another producer would show us who has a
comparative advantage over whom, making the decision of trade much easier. For example, for the
given data above the opportunity cost for Rose and Frank are as follows.
We can see that Frank has a lesser OC in producing potatoes and Rose has a lesser OC in producing
meat, therefore, they both have a comparative advantage in that good. Although Rose had an absolute
advantage in both goods, Frank still had a comparative advantage in producing potatoes. It is
impossible for a person/country to have a comparative advantage in both as the OC of producing one
good is reciprocal of the OC of producing the other good. If OC for Rose to produce meat is low then
her OC to produce potatoes will be more because the number gets divided by 1. Therefore, unless two
people have the same OC, one person will have a comparative advantage in one good and the other
in the other good.
The gains from specialization and trade are based not on absolute advantage but on comparative
advantage. When each person specializes in producing the good for which he or she has a comparative
advantage, total production in the economy rises. In our example, the total production of potatoes
rises from 40 to 44 and the total production of meat rises from 16 to 18. Not only this, trade also
benefits the individuals in getting the other product at a cheaper price than their OC to produce that
good. If the trade ratio is 5 ounces of meat: 15 ounces of potatoes then both benefit. How? For Frank
the OC of producing 1 ounce of meat is 4 ounces of potato, however, the trade ratio is less- 1 ounce
of meat for 3 ounces of potato. For Rose, the OC to produce potatoes is ½ ounce of meat, however,
the price for a potato after trade is 1/3rd ounce of meat. Therefore, trade can benefit everyone in
society because it allows people to specialize in activities in which they have a comparative advantage.
The exact price of trade is not easy to answer; however, a general rule is: For both parties to gain from
trade, the price at which they trade must lie between the two opportunity costs. In our examples, the
trade ratio is 1 ounce of meat for 3 ounces of potato, which is between 1:2 and 1:4. Had it been more
or less both of them would produce their own goods. Hence it is important to have the trade ratio
between the OCs of both parties. One has to have a comparative advantage to trade.
Lecture examples:
Cloth
Corn
John
10
2
Jane
16
8
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3
Jane has an absolute advantage. However, if we calculate the OC:
Cloth
Corn
John
0.2 corn
5 cloths
Jane
0.5 corn
2 cloths
We can see that John has a comparative advantage in producing cloth and Jane has a comparative
advantage in producing Corn.
Befoe tade, oth diide thei tie eually ad so…
Cloth
Corn
John
5
1
Jane
8
4
Total
13
5
After trade,
Cloth
Corn
John
10
0
Jane
4
6
Total
14
6
Having a comparative advantage and making a trade not only increases the total unit produced but
also increases the unit of good per person for consumption. For example, if we take one point on the
PPF of John and consider it to be the consumption ratio- 1 corn and 5 cloths. As John can produce 10
cloths, he has 5 extra cloths to trade. If he produces 10 cloths and trades them, he produces 0 corn.
After trade, with a trade ration of 3 cloths to 1 corn, John can consume 5 cloths and 1.67 corns.
Trade ratio- 3 cloths for 1 corn
Consumption ratio- 5 cloths for ?? corn
5/3 corn for 5 cloths = Consumption ratio
0
2
4
6
8
10
12
14
16
18
0 2 4 6 8 10
CLOTH
CORN
John Jane
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