Economies are defined by scarcity. Scarcity forces people to make choices. Choices involve costs. Since we all face different costs, by specializing and trading we can create wealth. Markets form to facilitate trade (formal/informal). Recall

Consider the simplest possible economy. One actor, Robinson Crusoe (R.C.). One resource, time. Since R.C. can only work eight hours in a day, he is faced with scarcity. Scarcity forces R.C. to make choices. Comparative Advantage & the Tale of Robinson Crusoe

R.C.’s Choices (The number of hours to get 1 unit) FishPalms R.C.1/2hr1/4hr

It takes R.C. 1/2 hour (30m) to catch 1 fish and it takes him 1/4 hour (15m) to cut 1 palm. So, each fish he catches requires giving up 2 palms (1/2 hour (30m) not spent palming). It takes R.C. 1/4 hour (15m) to cut 1 palm and it takes him 1/2 hour (30m) to catch 1 fish. So, each palm he cuts requires giving up 1/2 fish (1/4 hour (15m) not spent fishing). R.C.’s Opportunity Costs FishPalms 1/2hr1/4hr

1 fish costs 2 palms. The opportunity cost of 1 fish is 2 palms. 1 palm costs 1/2 fish. The opportunity cost of 1 palm is 1/2 fish. Let’s put it in a table. R.C.’s Opportunity Costs

R.C.’s Choices/Opportunity Costs FishPalms 1/2hr1/4hr FishPalms 2P1/2F The number of hours to get 1 unit What he gives up for 1 unit FishPalms 16F32P What is possible in eight hours?

R.C.’s Possibilities R.C. likes an even mix in his consumption so he spends half his time fishing and half palming. FishPalms 16F32P ■ F P R.C.’s PPF A Slope = 1/2 = Opp. Cost of 1P

Meanwhile on the other side of the island Friday plans his workday… (The number of hours to get 1 unit) FishPalms Friday1/2hr1/8hr

It takes Friday 1/2 hour (30m) to catch 1 fish and it takes him 1/8 hour (7.5m) to cut 1 palm. So, each fish he catches requires giving up 4 palms (1/2 hour (30m) not spent palming). It takes Friday 1/8 hour (7.5m) to cut 1 palm and it takes him 1/2 hour (30m) to catch 1 fish. So, each palm he cuts requires giving up 1/4 fish (1/8 hour (7.5m) not spent fishing). Friday’s Opportunity Costs FishPalms 1/2hr1/8hr

1 fish costs 4 palms. The opportunity cost of 1 fish is 4 palms. 1 palm costs 1/4 fish. The opportunity cost of 1 palm is 1/4 fish. Let’s put it in a table. Friday’s Opportunity Costs

Friday’s Choices/Opportunity Costs FishPalms 1/2hr1/8hr FishPalms 4P1/4F The number of hours to get 1 unit What he gives up for 1 unit FishPalms 16F64P What is possible in eight hours?

Friday’s Possibilities Like R.C., Friday likes an even mix of consumption so he spend half his time fishing and half palming. FishPalms 16F64P Slope = 1/4 = Opp. Cost of 1P ■ F P Friday’s PPF A

Opportunity Costs: Summing Up Although R.C. and Friday have similar resources, they face different costs. R.C. is the low cost producer of Fish. Friday is the low cost producer of Palms. ◦Remember, cost is always measured in terms of Opp. Costs. FishPalms R.C.2P1/2F Friday4P1/4F Friday is a better palmer because of a superior tree climbing ability. Opportunity Costs

Comparative Advantage We say someone has a “Comparative Advantage” if they can produce a good at a lower relative cost compared to someone else. FishPalms R.C.2P1/2F Friday4P1/4F

Can life improve for both R.C. & Friday? ■ F P Friday’s PPF A ■ F P R.C’s PPF A

Taking the (comparative) Advantage Exchange rate (fish for palms): 1F for 3P Will R.C. trade? Will Friday trade? And if so…how will they do it? FishPalms R.C.2P1/2F Friday4P1/4F

The Deal Goes Down What effect does this trade have on R.C.’s and Friday’s level of consumption? RobFriday Brings16F 0P0F 64P Gives-8F -24P Gets 24P8F Leaves8F 24P8F 40P

BOTH R.C. and Friday are OUTSIDE their PPF. Gains From Trade F P ■ Friday’s PPF ■ A B 8 F P ■ Robinson’s PPF B A ■

When people specialize in their comparative advantage, and trade in markets for other goods, wealth increases. Notice that no extra resources are used. Using the Low-Cost Producer conserves scarce resources. Specialization and trade REDUCES scarcity! Gains From Trade

Specialization and trade creates wealth. With trade we get more goods from fewer resources. Trade (in aggregate) makes societies better off. Trade improves welfare even if one party is bigger, smarter, or more productive than another. The Big Picture