Comparative advantage as a basis for exchange 1. Production possibility frontier 1. Production possibility frontier –Choices & opportunity costs 2. Specialisation and production 2. Specialisation and production 3. Comparative advantage & trade 3. Comparative advantage & trade –Exchange & opportunity costs

1. Production possibility frontier Definition Definition –A curve showing all the possible combinations of two goods that a country can produce in a specified time period with all of its resources fully and efficiently employed. Simplification – (a) two types of goods & (b) one type of each good. Simplification – (a) two types of goods & (b) one type of each good.

Units of food Units of clothing 8m 0.0 8m 0.0 7m 2.2m 7m 2.2m 6m 4.0m 6m 4.0m 5m 5.0m 5m 5.0m 4m 5.6m 4m 5.6m 3m 6.0m 3m 6.0m 2m 6.4m 2m 6.4m 1m 6.7m 1m 6.7m 0 7.0m 0 7.0m Units of food (millions) A production possibility curve Units of clothing (millions)

Choice & opportunity cost Downward sloping PPC Downward sloping PPC –Choice – e.g. sacrifice food for more clothes –Opportunity cost –Increasing opportunity costs Producing more of one good, sacrifice ever increasing amounts of the other good. Producing more of one good, sacrifice ever increasing amounts of the other good. Why? Why? –See figures

x Units of clothing (millions) Units of food (millions) Increasing opportunity costs

2. Specialisation & production Why go countries trade? What do they gain? Why go countries trade? What do they gain? –If firms specialise in production Economies of scale Economies of scale Exploit location Exploit location Ownership of specific natural resources Ownership of specific natural resources –Trade with other firms – inputs –National level: produce certain goods, export surplus, import other goods –Examples?

3. Comparative advantage & trade In which goods & services should a country specialise? Which should it export? In which goods & services should a country specialise? Which should it export? The law of comparative advantage The law of comparative advantage –Factor endowments vary & persist –Ability to supply different goods varies –Relative costs of production therefore vary –Example? –Absolute versus comparative advantage

Absolute versus comparative advantage Definitions Definitions –Absolute: if a country can produce a good with less resources than another country –Comparative: a country has a comparative advantage in production if it can produce at a lower opportunity cost See example See example

Production possibilities for two countries To gain from trade, export those goods in which the country has a CA!

The law of comparative advantage Definition Definition –Provided opportunity costs of various goods differ in two countries, both can gain from mutual trade if they specialise in producing (and exporting) those goods (and services) that have a relatively low opportunity costs compared with other countries. –What do they gain?

Cloth (metres m) Wheat (kilos m) a b c d e f Cloth (metres m) Less developed country Developed country

Cloth (metres m) Wheat (kilos m) Cloth (metres m) Less developed country Developed country Imports Exports 600 Exports 600 Imports 600 x y Effect of trade on consumption possibilities

Conclusion Comparative advantage is a basis for Comparative advantage is a basis for –Specialisation Countries Countries Firms Firms Workers Workers –Exchange –Trade Opportunity costs Opportunity costs