Dr. David P Echevarria1All Rights Reserved LECTURE #2: MICROECONOMICS CHAPTER 3 Specialization Comparative Advantage Opportunity Costs

Dr. David P Echevarria 1All Rights Reserved

LECTURE #2: MICROECONOMICSCHAPTER 3

Specialization

Comparative Advantage

Opportunity Costs

All Rights Reserved Dr. David P Echevarria 2

Interdependence and the Gains from Trade

In the following slides, we examine a special case. We assume the world to consist of two products; meat and potatoes.

There are two producers: A Farmer and A RancherEach producer has a production possibility

frontier: How much of each good can they produce in an 8-hour day.

The key to understanding the motivation for trade is defining the difference between absolute advantage and comparative advantage. The latter forms the basis for trade.

The objective of trade is to improve the standard of living for both producers (consumers).


Trade, Specialization, and Comparative Advantage

Production Possibility Frontier: 2 Producers- 8 hours of labor each yieldsFarmer: 8oz meat or 32 oz potatoesRancher: 24 oz meat or 48 oz potatoes

If both split their time equally between neat and potatoes:Farmer produces 4 oz of meat and 16 oz of

potatoesRancher produces 12 oz of meat and 24 oz of

potatoes

G. Mankiw 4

The Production Possibilities Frontier (a)

(a) Production Opportunities

Minutes needed toMake 1 ounce of:

Amount produced in

8 hours

Meat Potatoes

Meat Potatoes

Farmer

Rancher

60 min/oz

20 min/oz

15 min/oz

10 min/oz

8 oz

24 oz

32 oz

48 oz

Panel (a) shows the production opportunities available to the farmer and the rancher.

G. Mankiw 5

Production Possibilities Frontier (b, c)

(b) The farmer’s production possibilities frontier

Panel (b): Combinations of meat and potatoes the farmer can produce. Panel (c): Combinations of meat and potatoes the rancher can produce. Both PPF are derived assuming that the farmer and rancher each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier

(c) The rancher’s production possibilities frontier

Meat (oz)

0

4

8

Potatoes (oz)

16 32

A

If there is no trade, the farmer chooses this production and consumption.

Meat (oz)

0

12

24

Potatoes (oz)

24 48

B

If there is no trade, the rancher chooses this production and consumption.



How can the two improve their total [consumption] via trade?The rancher can produce 3x as much meat in 8 hours as the

farmer, but only 50% more potatoes in the 8 hours. The rancher has a definite absolute advantage in meat and

potato production.The farmer (less obvious) has a small comparative advantage in

growing potatoes Consider the Opportunity Costs:

Farmer: 4 oz potatoes per 1 oz meat or 1 oz P = ¼ oz MRancher: 2 oz potatoes per 1 oz of meat or 1 oz P = ½ oz M

For the rancher – potatoes are more expensive relative to meat

For the Farmer – meat is more expensive relative to potatoes

The difference motivates the basis for trade



The Rancher's Offer to Farmer: Spend all 8 hours producing potatoes and I’ll trade 5 oz of meat for 15 oz of your potatoes.The rancher establishes values in trade: 1 oz meat = 3 oz of potatoes

The rancher trades 1 oz meat for 3 oz potatoes from farmer. (+ 1 oz P)

The farmer trades 3 oz potatoes for 1 oz meat from rancher. (+ 1 oz P)

The farmer spends 8 hours growing 32 oz of potatoes and trades 15 oz of Potatoes for 5 oz of meat.Net Gain: 1 oz M, 1 oz P for a total consumption of 5 oz M, 17 oz P

The rancher spends 6 hours producing meat (18 oz) and 2 hours producing potatoes (12 oz) and trades 5 oz M for 15 oz P.Net Gain: 1 oz M, 3 oz P for a total consumption of 13 oz M, 27 oz P

G. Mankiw 8

Trade Expands the set of consumption opportunities (a, b)

(a) The farmer’s production and consumption

Proposed trade between farmer and rancher offers each of them a combination of meat and potatoes impossible without trade. Panel (a): farmer consumes at point A* rather than point A. Panel (b): rancher consumes at point B* rather than point B. Trade allows each to consume more meat and more potatoes.

(b) The rancher’s production and consumption

Meat (oz)

0

4

8

Potatoes (oz)

16 32

A

Farmer'sproduction andconsumptionwithout trade

Meat (oz)

0

12

24

Potatoes (oz)

24 48

B

Rancher’s production and consumption without trade

Farmer'sproductionwith trade

5

17

A*

Farmer'sconsumptionwith trade 13

18

12 27

B*Rancher’s consumption with trade

Rancher’s production with trade


BREAK TIME

G. Mankiw 10


Comparative advantageProduce a good with lower

opportunity cost than another producer

Reflects - relative opportunity cost

Principle of comparative advantageEach good - produced by the

individual that has the smaller opportunity cost of producing that good

G. Mankiw 11


One personCan have absolute advantage in both

goodsCannot have comparative advantage

in both goods

For different opportunity costsOne person - comparative advantage

in one goodThe other person - comparative

advantage in the other good

G. Mankiw 12


Opportunity cost of one goodInverse of the opportunity cost of the

other

Gains from specialization and tradeBased on comparative advantageTotal production in economy rises

Increase in the size of the economic pie

Everyone – better off

G. Mankiw 13


Trade can benefit everyone in societyAllows people to specialize in activitiesHave a comparative advantage

The price of tradeMust lie between the two opportunity costs

Principle of Comparative Advantage explains:

InterdependenceGains from trade

G. Mankiw 14


Should Tiger Woods mow his own lawn?Woods

Mow his lawn in 2 hoursFilm a TV commercial and earn $10,000 (2 hours)

Forrest GumpMow Woods’s lawn in 4 hoursWork at McDonald’s and earn $20 (4 hours)

G. Mankiw 15


Should the U.S. trade with other countries?Imports: Goods produced abroad and sold

domesticallyExports: Goods produced domestically and

sold abroad

Principle of comparative advantageEach good – produced by the country with

smaller opportunity cost of producing that good

Specialization and tradeAll countries – greater prosperity



Two Important Economists' Contributions

Adam Smith: The economic benefits of specialization

David Ricardo: The economic benefits of comparative advantage and free trade

Homework: Chapter 3Questions for Review: 1, 4, 5Problems and Applications: 1, 2 (parts a, b, c), 9

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Dr. David P Echevarria1All Rights Reserved LECTURE #2: MICROECONOMICS CHAPTER 3 Specialization Comparative Advantage Opportunity Costs