TRADE-OFFS AND TRADE FALL 2013 Comparative Advantage

Production Possibilities for Two Castaways (a) Tom’s Production Possibilities Quantity of coconuts Quantity of fish

Production Possibilities for Two Castaways Hank’s PPF Quantity of coconuts Quantity of fish (a) Hank’s Production Possibilities

Tom and Hank’s Opportunity Costs Tom’s Opportunity Cost Hank’s Opportunity Cost One fish3/4 coconut2 coconuts One coconut4/3 fish1/2 fish

Specialize and Trade  Both castaways are better off when they each specialize in what they are good at and trade.  This is true of countries as well – and it is related to the concept of comparative advantage.

How the Castaways Gain from Trade

Comparative Advantage and Gains from Trade (a) Tom’s Production and Consumption Tom’s consumption without trade 30 Tom's PPF Hank's PPF Quantity of coconuts Quantity of fish Tom’s consumption with trade Tom’s production with trade (b) Hank’s Production and Consumption Hank’s production with trade Hank’s consumption with trade Hank’s consumption without trade

II. Absolute vs. Comparative Advantage  Absolute advantage: Greater total output  Comparative Advantage: Opportunity cost for producing something is lower for one person (or country) than the other.

III. The Circular-Flow Diagram  Model that represents the transactions in an economy by flows around a circle.

The Circular-Flow Diagram Money Factors Goods and services Factors Households Firms Markets for goods and services Factor Markets Goods and services Money