Frank & Bernanke 3 rd edition, 2007 Ch. 2: Comparative Advantage: The Basis of Exchange

Why Do People Trade With Each Other? If one person produces bread and another butter, they would be both better off exchanging some of their produce with the other and have a variety in their diet. If one person produces bread and another butter, they would be both better off exchanging some of their produce with the other and have a variety in their diet. If they can both produce bread and butter, they each will have a PPF. If they can both produce bread and butter, they each will have a PPF. The total output of bread and butter would be much higher if each specialized on the product s/he can produce more. The total output of bread and butter would be much higher if each specialized on the product s/he can produce more.

Comparative Advantage

Opportunity Costs What is the implied price of butter for Farmer A? What is the implied price of butter for Farmer A? Each time FA increases her butter production she has to give up 1 bread. Each time FA increases her butter production she has to give up 1 bread. What is the implied price of butter for Farmer B? What is the implied price of butter for Farmer B? Each time FB increases his butter production he has to give up 5/3 breads. Each time FB increases his butter production he has to give up 5/3 breads. OC bt =(Breads given up)/(Butters gained) OC bt =(Breads given up)/(Butters gained)

Combined Production Suppose both are producing only bread. How many breads will be produced? Suppose both are producing only bread. How many breads will be produced? Suppose they decide to reduce bread production by 10 and allocate that effort to butter production. Who should be the one to produce butter? How much butter will be produced? Suppose they decide to reduce bread production by 10 and allocate that effort to butter production. Who should be the one to produce butter? How much butter will be produced?

Opportunity Costs Farmer A can produce either 30 breads or 30 butters. Her opportunity cost is 1br=1bt. Farmer A can produce either 30 breads or 30 butters. Her opportunity cost is 1br=1bt. Farmer B can produce 15 breads or 9 butters. His opportunity cost is 1br=0.6bt. Farmer B can produce 15 breads or 9 butters. His opportunity cost is 1br=0.6bt. As long as different opportunity costs exist, there is room for specialization, trade and improvement of well being. As long as different opportunity costs exist, there is room for specialization, trade and improvement of well being.

Trade If the “world” exchange rate (price) were 1br=0.8bt, FA would be interested in giving up butter to get bread and FB would be interested in giving up bread to get butter. If the “world” exchange rate (price) were 1br=0.8bt, FA would be interested in giving up butter to get bread and FB would be interested in giving up bread to get butter. Start at self-sufficiency for both. Pick a point on the PPF of each to show consumption before specialization and trade. Allow full specialization and exchange some of the production for the production of the other farmer. Show that they are both better off. Start at self-sufficiency for both. Pick a point on the PPF of each to show consumption before specialization and trade. Allow full specialization and exchange some of the production for the production of the other farmer. Show that they are both better off. Specialization expands as the size of the market expands. Specialization expands as the size of the market expands.

PPC for Many-Person Economy PPC is bowed outward. PPC is bowed outward. Principle of Increasing Opportunity Cost is in operation. Principle of Increasing Opportunity Cost is in operation. Opportunity cost of producing product A increases as more A is produced. Opportunity cost of producing product A increases as more A is produced. Different countries will have different PPCs and world prices will determine if a country should be an exporter or importer. Different countries will have different PPCs and world prices will determine if a country should be an exporter or importer.

US Foreign Trade US is more productive than Mexico and China in many products. Yet it engages in trade, freeing resources to be put to use in products where US has a comparative advantage. This way all countries can enjoy a higher standard of living. US is more productive than Mexico and China in many products. Yet it engages in trade, freeing resources to be put to use in products where US has a comparative advantage. This way all countries can enjoy a higher standard of living. Why do some people condemn free trade? Why do some people condemn free trade?

What Shifts the PPC Population increase Population increase Capital increase Capital increase Technology increase Technology increase Knowledge/skill increase (human capital) Knowledge/skill increase (human capital)