1 1 Lesson Overview BA 210 Lesson I.3 Trade Chapter 2 Trade Production Possibility Frontier Opportunity Cost Specialization and Trade Comparative vs. Absolute

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Lesson OverviewLesson Overview

BA 210 Lesson I.3 Trade

Chapter 2 TradeChapter 2 TradeProduction Possibility FrontierProduction Possibility FrontierOpportunity CostOpportunity CostSpecialization and TradeSpecialization and TradeComparative vs. Absolute AdvantageComparative vs. Absolute AdvantageInternational TradeInternational TradeEfficient MarketsEfficient MarketsControversy: Sweatshop LaborControversy: Sweatshop LaborSummarySummaryReview QuestionsReview Questions

2 2BA 210 Lesson I.3 Trade

One important economic model is the production possibility One important economic model is the production possibility frontier. It illustrates:frontier. It illustrates:

Opportunity costOpportunity cost, showing how much less of one good can be , showing how much less of one good can be produced if more of the other good is produced.produced if more of the other good is produced.

EfficiencyEfficiency, with an economy efficient in production if it produces , with an economy efficient in production if it produces on the production possibility frontier, and efficient in allocation if on the production possibility frontier, and efficient in allocation if it produces the mix of goods and services that people want to it produces the mix of goods and services that people want to consume.consume.

Production Possibility FrontierProduction Possibility Frontier

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• The production possibility frontier The production possibility frontier illustrates the illustrates the trade-offstrade-offs facing an economy that produces only two goods. It shows the facing an economy that produces only two goods. It shows the maximum quantity of one good that can be produced for any maximum quantity of one good that can be produced for any given production of the other.given production of the other.




One important conclusion is One important conclusion is comparative advantagecomparative advantage, which , which explains the source of gains from trade between individuals and explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something countries. Everyone has a comparative advantage in something --- some good or service in which that person has a lower --- some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with opportunity cost than everyone else. But it is often confused with absolute advantageabsolute advantage, an ability to produce a particular good or , an ability to produce a particular good or service better than anyone else. This confusion leads some to service better than anyone else. This confusion leads some to erroneously conclude there are no gains from trade between erroneously conclude there are no gains from trade between people or countries unless each country has some absolute people or countries unless each country has some absolute advantage.advantage.


5 5

2820 400

30

9

15

Quantity of coconuts

Production possibility frontier

A

B

D

C

Feasible and efficient

in production

Not feasible

Quantity of fish

Feasible butnot efficient




6 6

A

PPF

10 20 30 40 500

35

30

25

20

15

10

5

Producing the first 20 fish . . .

…requires giving up 25 more coconuts…

…requires giving up 5 coconuts

But producing 20 more fish . . .

Quantity of fish



Increasing Opportunity CostsIncreasing Opportunity Costs

Opportunity CostOpportunity Cost

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Question: Consider the individual Question: Consider the individual consumption and individual consumption and individual production possibilities for Tom and Hank on these two slides. production possibilities for Tom and Hank on these two slides. Determine trade to make production efficient, and make Tom and Determine trade to make production efficient, and make Tom and Hank better off. Hank better off.

28 400

30

9

(a) Tom’s Production Possibilities

Tom’s consumptionwithout trade

Tom’s

PPF


Quantity of fish


Specialization and TradeSpecialization and Trade

8 8

1060

20

8

Hank’s

PPF

Quantity of fish

(b) Hank’s Production Possibilities

Hank’s consumption

without trade




9 9

Answer: Opportunity Costs Answer: Opportunity Costs determine efficient trade and determine efficient trade and mutually-beneficial trade.mutually-beneficial trade.


Tom's Opportunity

Cost

Hank's Opportunity

Cost

One Fish 3/4 coconut 2 coconuts

One Coconut 4/3 fish 1/2 fish


10 10

• Production becomes efficient and both castaways are better off Production becomes efficient and both castaways are better off when they each specialize in what they are good at and trade. when they each specialize in what they are good at and trade.

• It’s efficient for Tom to catch the fish for both of them, because It’s efficient for Tom to catch the fish for both of them, because his opportunity cost of a fish in terms of coconuts not gathered his opportunity cost of a fish in terms of coconuts not gathered is only 3/4 of a coconut, versus 2 coconuts for Hank. If Tom is only 3/4 of a coconut, versus 2 coconuts for Hank. If Tom specializes, he can catch 40 fish total.specializes, he can catch 40 fish total.

• It’s efficient for Hank to gather coconuts for the both of them. It’s efficient for Hank to gather coconuts for the both of them. If Hank specializes, he can gather 20 coconuts total.If Hank specializes, he can gather 20 coconuts total.

• Without trade, total production is 28+6=34 fish and 9+8=17 Without trade, total production is 28+6=34 fish and 9+8=17 coconuts. So, specialization increases production by 6 fish and coconuts. So, specialization increases production by 6 fish and 3 coconuts. 3 coconuts.

• If the gains from increased production are split 50-50, both If the gains from increased production are split 50-50, both Tom and Hank can have 3 more fish and 1.5 more coconuts. Tom and Hank can have 3 more fish and 1.5 more coconuts.



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Comparative vs. Absolute AdvantageComparative vs. Absolute Advantage

• An individual has a An individual has a comparative advantage comparative advantage in producing a in producing a good or service if the opportunity cost of producing the good good or service if the opportunity cost of producing the good is lower for that individual than for other people.is lower for that individual than for other people.

• An individual has an An individual has an absolute advantage absolute advantage in an activity if he or in an activity if he or she can do it better than other people. Having an absolute she can do it better than other people. Having an absolute advantage is not the same thing as having a comparative advantage is not the same thing as having a comparative advantage.advantage.



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Tom vs. Hank – Absolute vs. ComparativeTom vs. Hank – Absolute vs. Comparative

• Tom has an absolute advantage in both activities: he can Tom has an absolute advantage in both activities: he can produce more output with a given amount of input (in this case, produce more output with a given amount of input (in this case, his time) than Hank.his time) than Hank.

• But we’ve just seen that Tom can indeed benefit from a deal But we’ve just seen that Tom can indeed benefit from a deal with Hank because with Hank because comparativecomparative, not , not absoluteabsolute, advantage is the , advantage is the basis for mutual gain.basis for mutual gain.

• So Hank, despite his absolute disadvantage, even in coconuts, So Hank, despite his absolute disadvantage, even in coconuts, has a comparative advantage in coconut gathering.has a comparative advantage in coconut gathering.

• Meanwhile Tom, who can use his time better by catching fish, Meanwhile Tom, who can use his time better by catching fish, has a comparative has a comparative disdisadvantage in coconut-gathering.advantage in coconut-gathering.



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Question: Consider the individual Question: Consider the individual consumption and individual production consumption and individual production possibilities for the U.S. and Canada on these two slides. Determine trade to possibilities for the U.S. and Canada on these two slides. Determine trade to make production efficient, and make both countries better off. make production efficient, and make both countries better off.

0

1,500

1,000

Quantity of pork (millions of tons)

Quantity of

aircraft

(a) The U.S. Production Possibilities Frontier

321 0

3,000

2,000

10.5 1.5

U.S.PPF

CanadianPPF

Quantity of pork (millions of tons)

Quantity of

aircraft

(b) Canadian Production Possibilities Frontier

U.S. consumption without trade

U.S. production with trade

Canadian production with trade

Canadian consumption without trade


International TradeInternational Trade

14 14

Answer: Opportunity Costs Answer: Opportunity Costs determine efficient trade and determine efficient trade and mutually-beneficial trade.mutually-beneficial trade.


U.S.'s Opportunity

Cost

Canada's Opportunity

Cost

One Pork 500 aircraft 2000 aircraft

One Aircraft 1/500 pork 1/2000 pork


15 15

• Production becomes efficient and both countries are better off Production becomes efficient and both countries are better off when they each specialize in what they are good at and trade. when they each specialize in what they are good at and trade.

• It’s efficient for U.S. to produce pork for both of them, because It’s efficient for U.S. to produce pork for both of them, because U.S. opportunity cost of pork in terms of aircraft is only 500 U.S. opportunity cost of pork in terms of aircraft is only 500 aircraft, versus 2000 aircraft for Canada. If U.S. specializes, it aircraft, versus 2000 aircraft for Canada. If U.S. specializes, it can produce 3 pork total.can produce 3 pork total.

• It’s efficient for Canada to produce aircraft for the both of It’s efficient for Canada to produce aircraft for the both of them. If Canada specializes, it can produce 3000 aircraft total.them. If Canada specializes, it can produce 3000 aircraft total.

• Without trade, total production is 1+.5=1.5 pork and Without trade, total production is 1+.5=1.5 pork and 1000+2000=3000 aircraft. So, specialization increases 1000+2000=3000 aircraft. So, specialization increases production by 1.5 pork, without any reduction in aircraft. production by 1.5 pork, without any reduction in aircraft.

• If the gains from increased production are split 50-50, both If the gains from increased production are split 50-50, both U.S. and Canada can have 0.75 more pork. U.S. and Canada can have 0.75 more pork.



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Efficient MarketsEfficient Markets


Comment:Comment: The previous examples of efficient and mutually- The previous examples of efficient and mutually-beneficial trade guided by comparative advantage evenly split the beneficial trade guided by comparative advantage evenly split the gains from increased production among two individual people or gains from increased production among two individual people or countries. Now consider richer examples of efficient trade:countries. Now consider richer examples of efficient trade: There are three individuals.There are three individuals. With efficient trade, one of the individuals does not specializeWith efficient trade, one of the individuals does not specialize his production.his production. The trade of production among the three individuals is guidedThe trade of production among the three individuals is guided by prices in the marketplace.by prices in the marketplace.

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AdsComposed

AdsTelevised

Tom 2 composed 2 televised

Jeffery 1 composed 2 televised

Hank 6 composed 3 televised



Question:Question: Consider the following linear production possibilities Consider the following linear production possibilities from Tom, Jeffery, and Hank. To be useful, an ad must be both from Tom, Jeffery, and Hank. To be useful, an ad must be both composed and composed and televised.televised.

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AdsComposed

AdsTelevised




For example, Tom can compose For example, Tom can compose 2 ads if he specializes in 2 ads if he specializes in composing; or televise 2 composing; or televise 2 previously composed ads if previously composed ads if he specializes in televising; orhe specializes in televising; orcomplete an ad (compose andcomplete an ad (compose andtelevise) if he spends half his time composing and half his time televise) if he spends half his time composing and half his time televising. televising.


Part a.Part a. How many ads can be How many ads can becompleted if Tom, Jeffery, and completed if Tom, Jeffery, and Hank work separately? That is,Hank work separately? That is,each composes and televises hiseach composes and televises hisown ads. (As usual, fractionsown ads. (As usual, fractionsare allowed.) are allowed.)


AdsComposed

AdsTelevised





Answer to Part a:Answer to Part a: First consider Tom. On one hand, if he spent all First consider Tom. On one hand, if he spent all day composing, he would compose 2 ads and televise 0 ads and, day composing, he would compose 2 ads and televise 0 ads and, thereby, complete 0 ads. On the other hand, if he spent all day thereby, complete 0 ads. On the other hand, if he spent all day trying to televise, he would compose 0 ads and try to televise 2 trying to televise, he would compose 0 ads and try to televise 2 ads and, thereby, complete 0 ads. Obviously, to complete the ads and, thereby, complete 0 ads. Obviously, to complete the maximum number of ads he would split his day evenly: spending maximum number of ads he would split his day evenly: spending half his day composing and the other half his day televising, he half his day composing and the other half his day televising, he would compose 1 ad and televise 1 ad and, thereby, would compose 1 ad and televise 1 ad and, thereby, complete 1 complete 1 adad..

AdsComposed

AdsTelevised






Next consider Jeffery. Like Tom, to complete the maximum number of ads he Next consider Jeffery. Like Tom, to complete the maximum number of ads he splits his day between composing and televising. Let’s find that split with splits his day between composing and televising. Let’s find that split with algebra. Let c be the fraction of his day spent composing; that leaves the algebra. Let c be the fraction of his day spent composing; that leaves the fraction 1−c for televising. Spending c of his day composing and 1−c of his fraction 1−c for televising. Spending c of his day composing and 1−c of his day televising, he would compose c letters and televise 2(1−c) letters. If c < day televising, he would compose c letters and televise 2(1−c) letters. If c < 2(1−c), then some televising exceeds composing, which is wasted effort. 2(1−c), then some televising exceeds composing, which is wasted effort. Likewise, c > 2(1−c) has some composing exceeding televising, which is also Likewise, c > 2(1−c) has some composing exceeding televising, which is also wasted effort. Therefore, to complete the maximum number of ads he would wasted effort. Therefore, to complete the maximum number of ads he would set c = 2(1 − c), which implies 3c = 2 and c = 2/3. That is, Jeffery spends 2/3 set c = 2(1 − c), which implies 3c = 2 and c = 2/3. That is, Jeffery spends 2/3 of his day composing and 1/3 of his day televising and, thereby, composes, of his day composing and 1/3 of his day televising and, thereby, composes, televises, and televises, and completes 2/3 adscompletes 2/3 ads, which is approximately .66 ads., which is approximately .66 ads.

AdsComposed

AdsTelevised






Finally consider Hank. Let c be the fraction of his day spent Finally consider Hank. Let c be the fraction of his day spent composing; that leaves the fraction 1−c for televising. Spending c composing; that leaves the fraction 1−c for televising. Spending c of his day composing and 1−c of his day televising, he would of his day composing and 1−c of his day televising, he would compose 6c letters and televise 3(1−c) letters. To complete the compose 6c letters and televise 3(1−c) letters. To complete the maximum number of ads he would set 6c = 3(1 − c), which maximum number of ads he would set 6c = 3(1 − c), which implies 9c = 3 and c = 1/3. That is, Jeffery spends 1/3 of his day implies 9c = 3 and c = 1/3. That is, Jeffery spends 1/3 of his day composing and 2/3 of his day televising and, thereby, composes, composing and 2/3 of his day televising and, thereby, composes, televises, and televises, and completes 2 adscompletes 2 ads..Altogether, the three Altogether, the three complete 3.66 adscomplete 3.66 ads when working separately. when working separately.

AdsComposed

AdsTelevised






Part b.Part b. Who has the absolute Who has the absoluteadvantage in televising ads?advantage in televising ads?who is next? On the basis of who is next? On the basis of absolute advantage in televisingabsolute advantage in televisingads, how would production be ads, how would production be organized? What is the total organized? What is the total output of ads per day?output of ads per day?


AdsComposed

AdsTelevised





Answer to Part b:Answer to Part b: Hank has the absolute advantage in televising, Hank has the absolute advantage in televising, so consider this trial solution: Hank spends all day televising and, so consider this trial solution: Hank spends all day televising and, thereby, televises 3 ads. Both Tom and Jeffery spend all day thereby, televises 3 ads. Both Tom and Jeffery spend all day composing and, thereby, compose 3 ads. Since the number composing and, thereby, compose 3 ads. Since the number televised equals the number composed, that is the absolute-televised equals the number composed, that is the absolute-advantage solution. In particular, total output is 3 completed ads advantage solution. In particular, total output is 3 completed ads per day.per day.

Comment: That output is Comment: That output is lessless than when they worked separately. than when they worked separately.


AdsComposed

AdsTelevised





Part c.Part c. How How shouldshould production be production be organized? What is the total organized? What is the total output of ads per day?output of ads per day?


AdsComposed

AdsTelevised






AdsComposed

AdsTelevised

OpportunityCost of

Televising

Tom 2 composed 2 televised 2/2 composed

Jeffery 1 composed 2 televised 1/2 composed

Hank 6 composed 3 televised 6/3 composed

Answer to Part c:Answer to Part c: To find efficient production, compute the To find efficient production, compute the opportunity cost of televising ads. For Larry, each ad televised opportunity cost of televising ads. For Larry, each ad televised takes 1/2 of a day (since in one day he can televise 2 letters), and takes 1/2 of a day (since in one day he can televise 2 letters), and in that 1/2 of a day he could have composed 1 letter (since in one in that 1/2 of a day he could have composed 1 letter (since in one day he can compose 2 ads). Hence, Tom’s opportunity cost of day he can compose 2 ads). Hence, Tom’s opportunity cost of televising a letter is 1 composed letter. televising a letter is 1 composed letter.



AdsComposed

AdsTelevised

OpportunityCost of

Televising




For Jeffery, each ad televised takes 1/2 of a day, and in that 1/2 For Jeffery, each ad televised takes 1/2 of a day, and in that 1/2 of a day he could have composed 1/2 letter. Hence, Jeffery’s of a day he could have composed 1/2 letter. Hence, Jeffery’s opportunity cost of televising a letter is 1/2 composed letter. opportunity cost of televising a letter is 1/2 composed letter. Likewise, Hence, Hank’s opportunity cost of televising a letter is Likewise, Hence, Hank’s opportunity cost of televising a letter is 6/3 composed letter (the ratio of maximum composing output to 6/3 composed letter (the ratio of maximum composing output to maximum televising output). maximum televising output).



AdsComposed

AdsTelevised

OpportunityCost of

Televising




Jeffery has the comparative advantage in televising (he gives up Jeffery has the comparative advantage in televising (he gives up the fewest composed letters), so consider this trial solution: the fewest composed letters), so consider this trial solution: Jeffery spends all day televising and, thereby, televises 2 ads. Jeffery spends all day televising and, thereby, televises 2 ads. Both Tom and Hank spend all day composing and, thereby, Both Tom and Hank spend all day composing and, thereby, compose 8 letters. Since the number televised is less than the compose 8 letters. Since the number televised is less than the number composed, we need another televiser and, so, must number composed, we need another televiser and, so, must consider another trial solution:consider another trial solution:



AdsComposed

AdsTelevised

OpportunityCost of

Televising




After Jeffery, Tom has the comparative advantage in televising, After Jeffery, Tom has the comparative advantage in televising, so consider this trial solution: Jeffery and Tom spend all day so consider this trial solution: Jeffery and Tom spend all day televising and, thereby, televise 4 ads. Hank spends all day televising and, thereby, televise 4 ads. Hank spends all day composing and, thereby, composes 6 ads. Since the number composing and, thereby, composes 6 ads. Since the number televised is less than the number composed, we need anothertelevised is less than the number composed, we need anotherteleviser (at least part time) and must consider another trial televiser (at least part time) and must consider another trial solution:solution:



AdsComposed

AdsTelevised

OpportunityCost of

Televising




Clearly, if Hank joins Jeffery and Tom to spend all day televising, then the Clearly, if Hank joins Jeffery and Tom to spend all day televising, then the number televised is greater than the number composed. Hence, Hank splits his number televised is greater than the number composed. Hence, Hank splits his time between composing and televising, spending the fraction c composing time between composing and televising, spending the fraction c composing and the fraction 1−c televising and, thereby, composing 6c and televising and the fraction 1−c televising and, thereby, composing 6c and televising 3(1−c). As before, Jeffery and Tom spend all day televising and, thereby, 3(1−c). As before, Jeffery and Tom spend all day televising and, thereby, televise 4 ads total. All together, the three compose 6c and televise 4+3(1−c). televise 4 ads total. All together, the three compose 6c and televise 4+3(1−c). To complete the maximum number of ads, set 6c = 4 + 3(1 − c), which implies To complete the maximum number of ads, set 6c = 4 + 3(1 − c), which implies 9c = 7 and c = 7/9. That is, Hank spends 7/9 of his day composing and 2/9 of9c = 7 and c = 7/9. That is, Hank spends 7/9 of his day composing and 2/9 ofhis day televising and, thereby, the three compose, televise, and completehis day televising and, thereby, the three compose, televise, and complete6(7/9) = 4 + 3(2/9) = 14/3 ads, which is approximately 4.66 ads.6(7/9) = 4 + 3(2/9) = 14/3 ads, which is approximately 4.66 ads.

That is the maximum number of ads that can be completed per day.That is the maximum number of ads that can be completed per day.


Part d.Part d. Show how the market Show how the marketcan organize production can organize production efficiently. Specifically, supposeefficiently. Specifically, supposethe market price per unit for the market price per unit for televising ads is $100. Find televising ads is $100. Find the price Pthe price PCC per unit for per unit for

composing ads so that, when the output of completed ads is composing ads so that, when the output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income.work that maximizes their income.


AdsComposed

AdsTelevised





Answer to Part d:Answer to Part d: When the output of completed ads is When the output of completed ads is maximized, Hank spends part of his day composing and part of maximized, Hank spends part of his day composing and part of his day televising, so his daily income must equal from the two his day televising, so his daily income must equal from the two jobs, 6Pjobs, 6PCC = 300, or P = 300, or PCC = 50. And Tom and Jeffery each specialize = 50. And Tom and Jeffery each specialize

in televising, so at Pin televising, so at PCC = 50 their daily incomes from composing = 50 their daily incomes from composing

must lower than from televising, 100 < 200 and 50 < 200. must lower than from televising, 100 < 200 and 50 < 200.

So, So, at the price Pat the price PCC = 50 per unit for composing ads = 50 per unit for composing ads, when the , when the

output of completed ads is maximized, then Tom, Jeffery and output of completed ads is maximized, then Tom, Jeffery and Hank are each choosing the work that maximizes their income.Hank are each choosing the work that maximizes their income.


AdsComposed

AdsTelevised

Income atPrices

PC and PT=100

Tom 2 composed 2 televised 2PC or 200

Jeffery 1 composed 2 televised PC or 200

Hank 6 composed 3 televised 6PC or 300

33 33

Controversy: Sweatshop LaborControversy: Sweatshop Labor




A sweatshop A sweatshop is a working environment with unhealthy conditions is a working environment with unhealthy conditions that are considered by many people of industrialized nations to be that are considered by many people of industrialized nations to be difficult or dangerous, usually where the workers have few difficult or dangerous, usually where the workers have few opportunities to address their situation. This can include exposure opportunities to address their situation. This can include exposure to harmful materials, hazardous situations, extreme temperatures, to harmful materials, hazardous situations, extreme temperatures, or abuse from employers. Sweatshop workers often work long or abuse from employers. Sweatshop workers often work long hours for little pay, regardless of any laws mandating overtime hours for little pay, regardless of any laws mandating overtime pay or a minimum wage. Child labor laws may also be violated.pay or a minimum wage. Child labor laws may also be violated.



Defenders of sweatshopsDefenders of sweatshops, such as Paul Krugman, claim that , such as Paul Krugman, claim that people choose to work in sweatshops because the sweatshops people choose to work in sweatshops because the sweatshops offer them substantially higher wages and better working offer them substantially higher wages and better working conditions compared to their previous jobs of manual farm labor, conditions compared to their previous jobs of manual farm labor, and that sweatshops are an early step in the process of and that sweatshops are an early step in the process of technological and economic development whereby a poor technological and economic development whereby a poor country turns itself into a rich country. Economists are focused country turns itself into a rich country. Economists are focused on “trade offs” and when it comes to sweatshops, they ask on “trade offs” and when it comes to sweatshops, they ask whether the alternative of unemployment or even worse whether the alternative of unemployment or even worse employment is better. In addition, sometimes when anti-employment is better. In addition, sometimes when anti-sweatshop activists were successful in getting sweatshops to sweatshop activists were successful in getting sweatshops to close, some of the employees who had been working in the close, some of the employees who had been working in the sweatshops ended up starving to death, while others ended up sweatshops ended up starving to death, while others ended up turning to prostitution.turning to prostitution.



In 1996, the National Labor Committee, a human rights group, In 1996, the National Labor Committee, a human rights group, reported that sweatshop labor in Honduras was used to make reported that sweatshop labor in Honduras was used to make clothes for the Kathie Lee line, sold at Wal-Mart. The biggest clothes for the Kathie Lee line, sold at Wal-Mart. The biggest consumer import into Honduras are processed foods. Consider consumer import into Honduras are processed foods. Consider how Hondurans benefit by exporting clothes to the U.S. and how Hondurans benefit by exporting clothes to the U.S. and importing cars.importing cars.


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Dresses Food

U.S. 40 dresses 40 cans

Honduras 8 dresses 4 cans


Question:Question: Consider the following linear production possibilities Consider the following linear production possibilities from the U.S. and Honduras. Production number are average from the U.S. and Honduras. Production number are average monthly production per worker. Describe trade that can make monthly production per worker. Describe trade that can make both countries better off if, currently, both countries do not trade, both countries better off if, currently, both countries do not trade, the U.S. makes 20 dresses and 20 cans of processed food, and the U.S. makes 20 dresses and 20 cans of processed food, and Honduras makes 4 dresses and 2 cans. What would happen if the Honduras makes 4 dresses and 2 cans. What would happen if the National Labor Committee shut down such trade? National Labor Committee shut down such trade?



U.S.'s Opportunity

Cost

Honduras's Opportunity

Cost

One Dress 1 Can 1/2 Can

One Can 1 Dress 2 Dresses

Answer: Compute and compare Answer: Compute and compare opportunity costs.opportunity costs. U.S. has the U.S. has theabsolute advantage in both absolute advantage in both goods, but Honduras has the goods, but Honduras has the comparative advantage incomparative advantage indresses. Hence trade that can make both countries better off is dresses. Hence trade that can make both countries better off is U.S. making more food and Honduras making more dresses. U.S. making more food and Honduras making more dresses. Specifically, suppose the U.S. makes one more can of processed Specifically, suppose the U.S. makes one more can of processed food and Honduras makes one less can of processed food. The food and Honduras makes one less can of processed food. The U.S. then has to sacrifice 1 dress but Honduras can make 2 more U.S. then has to sacrifice 1 dress but Honduras can make 2 more dresses. If the gain of 1 dress is split evenly each month, the U.S. dresses. If the gain of 1 dress is split evenly each month, the U.S. can trade the extra can of food for 1.5 dresses (thus gaining 0.5 can trade the extra can of food for 1.5 dresses (thus gaining 0.5 dresses), and Honduras can trade 1.5 dresses for the 1 can of food dresses), and Honduras can trade 1.5 dresses for the 1 can of food (thus gaining 0.5 dresses). (thus gaining 0.5 dresses). If the National Labor Committee shut If the National Labor Committee shut down such trade, then Honduras looses their gain from trade. down such trade, then Honduras looses their gain from trade.


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SummarySummary

1.1. Almost all economics is based on models and assumptions in Almost all economics is based on models and assumptions in those models. those models.

2.2. One important economic model is the production possibilityOne important economic model is the production possibility frontier. It illustrates frontier. It illustrates opportunity costopportunity cost, , efficiencyefficiency, , andand economic growtheconomic growth. There are two basic sources of growth: an. There are two basic sources of growth: an increase in factors of production, resources such as land,increase in factors of production, resources such as land, labor, capital, and human capital, inputs that are not usedlabor, capital, and human capital, inputs that are not used up up in production, and improved technology.in production, and improved technology.

3.3. One important conclusion is cOne important conclusion is comparative advantageomparative advantage explains explains the gains from trade betweenthe gains from trade between individuals and countries.individuals and countries. Everyone has a comparativeEveryone has a comparative advantage in somethinadvantage in somethingg. . ThisThis is is often confused with absolute advantage,often confused with absolute advantage, an ability to produce an ability to produce a particular good bettera particular good better than anyone else.than anyone else.


SummarySummary

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SummarySummary

4.4. The efficient trade of production can be guided by either a The efficient trade of production can be guided by either a comparison of opportunity costs, or by prices in the comparison of opportunity costs, or by prices in the marketplace.marketplace.


SummarySummary

41 41

Review QuestionsReview Questions


Review QuestionsReview Questions You should try to answer some of the following questions You should try to answer some of the following questions before the next class. before the next class. You will not turn in your answers, but students may request You will not turn in your answers, but students may request to discuss their answers to begin the next class. to discuss their answers to begin the next class. Your upcoming Exam 1 and cumulative Final Exam will Your upcoming Exam 1 and cumulative Final Exam will contain some similar questions, so you should eventually contain some similar questions, so you should eventually consider every review question before taking your exams.consider every review question before taking your exams.

42 42

ArmyOutput

CivilianOutput

D 2 missions 1 program

H 4 missions 4 programs

C 6 missions 9 programs


Question:Question: Consider the following linear production possibilities Consider the following linear production possibilities of Army missions and computer programs from 1 high school of Army missions and computer programs from 1 high school dropout (D), 1 high dropout (D), 1 high school graduate with school graduate with no college degree (H), no college degree (H), and 1 college and 1 college graduate (C).graduate (C).


43 43

ArmyOutput

CivilianOutput





Part a.Part a. If you need 2.5 missions per month If you need 2.5 missions per month (for example, 5 every 2 months)(for example, 5 every 2 months)and if the market price (or wage)and if the market price (or wage)for producing a computer for producing a computer program is 6 pesos each, thenprogram is 6 pesos each, thenwhat what shouldshould be the unit price be the unit price paid per mission? paid per mission?


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Answer to Part a: Answer to Part a: Step 1. Find whomStep 1. Find whomto draft. That is, who has the to draft. That is, who has the comparative advantage. For D, comparative advantage. For D, each mission takes up 1/2 of his each mission takes up 1/2 of his month, during which time hemonth, during which time hecould complete ½ × 1 = ½ could complete ½ × 1 = ½ program. For H, each mission takes up ¼ of his month, during program. For H, each mission takes up ¼ of his month, during which time he could complete ¼ × 4 = 1 program. For C, each which time he could complete ¼ × 4 = 1 program. For C, each mission takes up 1/6 of his month, during which time he could mission takes up 1/6 of his month, during which time he could complete 1/6 × 9 = 3/2 programs.complete 1/6 × 9 = 3/2 programs.Conclusion: Despite his absolute disadvantage, it’s comparativelyConclusion: Despite his absolute disadvantage, it’s comparativelycheaper for D to serve first. Then H, then C. So, for 2.5 missions, cheaper for D to serve first. Then H, then C. So, for 2.5 missions, start with D in the military full time, for 2 missions. That start with D in the military full time, for 2 missions. That leaves .5 missions, to be completed by H serving part time.leaves .5 missions, to be completed by H serving part time.


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Step 2. Find the price PStep 2. Find the price PMM per per

mission. Given that classes pay mission. Given that classes pay 6 pesos each, here is what that 6 pesos each, here is what that price Pprice PMM must satisfy to get the must satisfy to get the

solution above: solution above: For D to choose the military For D to choose the military full-time, potential income from the military 2 Pfull-time, potential income from the military 2 PMM must be no less must be no less

than potential income from writing computer programs, 1 × 6 = than potential income from writing computer programs, 1 × 6 = 6. Conclusion: 2 P6. Conclusion: 2 PMM >> 6, or P 6, or PMM >> 3. 3.

For type H to choose the military part-time, potential income For type H to choose the military part-time, potential income from the military 4 Pfrom the military 4 PMM must be the same as potential income from must be the same as potential income from

writing programs 4 × 6 = 24. Conclusion: 4 Pwriting programs 4 × 6 = 24. Conclusion: 4 PMM = 24, or P = 24, or PMM = 6. = 6.


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For C to choose programmingFor C to choose programmingfull-time, potential income from the military 6 Pfull-time, potential income from the military 6 PMM must be no must be no

greater than potential income from writing computer programs, 9 greater than potential income from writing computer programs, 9 × 6 = 54. Conclusion: 6 P× 6 = 54. Conclusion: 6 PMM << 54, or P 54, or PMM << 9. 9.

Putting it all together, the price should be PPutting it all together, the price should be PMM = 6 pesos per = 6 pesos per

mission.mission.

(See how the non-specialist determines price, and that the (See how the non-specialist determines price, and that the specialists inequalities are satisfied at that price.)specialists inequalities are satisfied at that price.)


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Part b.Part b. Now suppose you Now suppose you need 7 missions per month.need 7 missions per month.What should be the unit price What should be the unit price paid per mission? paid per mission?


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Answer to Part b: Answer to Part b: The production The production possibilities have not changed, possibilities have not changed, so it is still comparatively so it is still comparatively cheaper for D to serve first; cheaper for D to serve first; then H; then C. So, for then H; then C. So, for 7 missions, start with D in the 7 missions, start with D in the military full time, for 2 missions; then H, for 4 missions. That military full time, for 2 missions; then H, for 4 missions. That leaves 1 mission, to be completed by C serving part time.leaves 1 mission, to be completed by C serving part time.

For type C to choose the military part-time, potential income For type C to choose the military part-time, potential income from the military 6 Pfrom the military 6 PMM must be the same as potential income from must be the same as potential income from

writing programs 9 × 6 = 54. Conclusion: 6 Pwriting programs 9 × 6 = 54. Conclusion: 6 PMM = 54, or P = 54, or PMM = 9. = 9.

(As always, the non-specialist determines price, and the (As always, the non-specialist determines price, and the specialists choose the right specialties at that price.)specialists choose the right specialties at that price.)


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Follow the linkFollow the linkhttp://faculty.pepperdine.edu/jburke2/ba210/PowerP1/Set2Answers.pdffor review questions for Lesson I.3 that practices these skills: for review questions for Lesson I.3 that practices these skills: Draw a linear production possibilities frontier.Draw a linear production possibilities frontier. Draw a bowed production possibilities frontier.Draw a bowed production possibilities frontier. Compute opportunity costs from a production possibilities frontier.Compute opportunity costs from a production possibilities frontier.Identify feasible and infeasible and efficient and inefficient points from a Identify feasible and infeasible and efficient and inefficient points from a production possibilities frontier.production possibilities frontier.Identify comparative and absolute advantage from a production possibilities Identify comparative and absolute advantage from a production possibilities frontier.frontier. Describe trade based on comparative advantage.Describe trade based on comparative advantage. Identify positive and normative statements. Identify positive and normative statements.

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End of Lesson I.3End of Lesson I.3


BA 210 Introduction to BA 210 Introduction to MicroeconomicsMicroeconomics

Documents

1 1 Lesson Overview BA 210 Lesson I.3 Trade Chapter 2 Trade Production Possibility Frontier Opportunity Cost Specialization and Trade Comparative vs. Absolute