Production Possibilities, Opportunity Cost, and the Gains from Trade ECON 704 Module 2, Part 1

Agenda Define absolute advantage and comparative advantage Understand how comparative advantage gives rise to specialization and gains from trade Apply idea of gains from trade to everyday life and national policy

Specialization and Trade Every Day Around the world – in the first two hours of your day! clock radio from Taiwan; grains from Great Plains; juice from Florida or Brazil; Clothes from China with cotton from Georgia; drive in car with parts from half a dozen countries, using gas from oil from Middle East clock; cereal; juice; clothes; TV; drive to work

We could do many things ourselves, but we specialize and trade – why? Specialization according to opportunity cost makes us better off than if we tried to be self sufficient Works on an individual level which crosses borders, so works for nations too

Self-Sufficient Stewart Without trade: production possibilities frontier (PPF) is the consumption possibilities frontier 4 Rooms Wall-papered 10 Rooms Painted

Can Stewart do Better? Martha is more productive in both activities – she has absolute advantage in both activities Martha’s PPF is everywhere outside Stewart’s PPF What could Stewart possibly offer Martha? She can do everything better WRONG COMPARISON!!

Stewart has something to offer because Martha would find it less expensive in terms of her own labor to trade with him But what to trade? Look at opportunity costs

Computing Opportunity Costs Martha takes 8 hours to wallpaper a room that would mean 8 fewer hours painting in that time she could have done 4 painted rooms, since she can paint a room in only 2 hours Martha’s opportunity cost of wallpapering a room is 4 painted rooms and her op. cost of painting a room is ¼ of a room not wallpapered

Reason for Trade Stewart’s opportunity cost of wallpapering is 2.5 rooms not painted Martha’s opportunity cost of wallpapering is 4 rooms not painted Stewart could offer to wallpaper a room for Martha if she paints 3 rooms for him A price! 1 papered room for 3 painted rooms Martha gets a room papered for 6 hours instead of 8; Stewart gets 3 rooms painted for 10 hours instead of 12. Both save 2 hours!

Comparative Advantage Stewart has lower op. cost of papering (in terms of foregone painting) = comparative advantage in papering Martha has comparative advantage in painting If Martha specializes in painting and Stewart specializes in papering, both can consume outside of their production possibilities frontiers ~ they’re getting more out of their scarce labor resources

Other Points Martha will have a nicer house since she is more productive overall Actual “price” will depend on demand and supply, and bargaining acumen. Gains from trade depend on comparative advantage Overall living standards depend more on absolute advantage

Op. costs and Family Planning Parents choose to have fewer children in more developed countries Related to opportunity cost Raising kids means less time earning wages Wages higher in developed countries; children have higher opportunity cost, so fewer are chosen. Children also have productive potential that cannot be legally realized in developed countries, but can in poor developing countries

The Lawyer and his assistant Suppose a lawyer is better at both legal research and typing than his assistant Lawyer lets assistant do the typing because assistant has lower opportunity cost of typing in terms of lost billable hours

Business Outsourcing and sticking to the “core competencies” are efforts to focus on comparative advantage

International Trade Countries can gain from specialization and trade: exports pay for imports Do countries compete? Trade barriers make the country work harder for less Low-wage foreign competition? Consequence of lower productivity (among other things) Problem of dislocated resources International trade about more than comparative advantage

Next Time: How is the interdependence of billions of people coordinated? Answer: demand, supply, and the price system