1. ECON 100 Lecture 6
Wednesday, February 19

2. Announcements
The second problem set is ready and posted on course webpage.

3. Problem session (LABS) information.
Tu B6 Mithat Can Ulubay (SOS B08)
Fr B1 Ahmet Gülek (SOS B08)
Fr B2 Doruk Sırtıoğlu (SOS B07)
Fr B4 Sonkurt Kemal Şen (SOS B08)
KOLT tutors: Cihan Oklap and Sonkurt Kemal Şen
Weblink to Econ 100 tutorial schedules

4. Today’s lecture plan First part: Interdependence and gains from trade
Solution
Theory
Comparative advantage
Absolute advantage

5. Today’s lecture plan
Second part: Something completely different!

6. Poorlander & Richlander; producing and consuming fish and bread
A simple 2x2 model of specialization and trade - 2 individuals/countries and 2 goods
Poorlander & Richlander; producing and consuming fish and bread

7. Resources, technology, and preferences
Each person has a total of 30 hours/per week. The richlander, Mrs. Cecelia Richlander, can produce 1 fish in 1 hour and 1 (loaf of) bread in 1.5 hours. The poorlander, Mrs. Michelle Poorlander, can produce 1 fish in 3 hours and 1 (loaf of) bread in 2 hours. Preferences: Fish and bread are consumed only in fixed proportion sandwiches with 1 fish and 1 loaf of bread.

8. Decisions
What are the production/consumption decisions when each person is self-sufficient?
What are the production/exchange/consumption decisions when they can trade with each other?

9. Answers – self-sufficiency
Everyone wants to eat as many sandwiches as possible.
Richlander:
produces 12 fish and 12 bread, eats 12 sandwiches
Poorlander:
produces 6 fish and 6 bread, eats 6 sandwiches
+___________________
18 sandwiches jj
Everyone has this part correct. Very good!

10. Specialization and Trade
The possibility of trade and specialization complicates things.

11. Specialization and Trade
With specialization these two individuals can produce more than 18 sandwiches. How many more? The optimal specialization will allow them to produce 21 sandwiches. The additional sandwiches (21 – 18 = 3) we call the “gains from trade.”

12. Specialization and Trade
Some practical questions:
Who will specialize in which good?
What will be the degree of specialization?
Complete?
Partial?

13. Comparative advantage (karşılaştırmalı üstünlük)
Question: “Who will specialize in which good?”

14. Comparative advantage (karşılaştırmalı üstünlük)
Answer: “Gains from trade” are created when individuals specialize in the activity in which they have a …

15. Comparative advantage (karşılaştırmalı üstünlük)
Answer: “Gains from trade” are created when individuals specialize in the activity in which they have a COMPARATIVE ADVANTAGE. Mrs. Poorlander specializes in the production of bread, because she has a comparative advantage in bread. Mrs. Richlander specializes in the production of fish, because she has a comparative advantage in fish.

16. Comparative advantage, defined
Mrs. Poorlander has the COMPARATIVE ADVANTAGE in the production of bread … because her opportunity cost of bread is lower than Mrs. Richlander’s.

17. Compute Mrs. Poorlander’s opportunity cost of bread
Mrs. Poorlander (fish in 3 hours, bread in 2 hours) To produce 1 loaf of bread, Mrs. Poorlander needs 2 hours. In 2 hours she can produce ___ units of fish.

18. Compute Mrs. Poorlander’s opportunity cost of bread
Mrs. Poorlander (fish in 3 hours, bread in 2 hours) To produce 1 loaf of bread, Mrs. Poorlander needs 2 hours. In 2 hours she can produce 2/3 units of fish. So, to produce 1 more bread she must give up ___ units of fish.

19. Compute Mrs. Poorlander’s opportunity cost of bread
Mrs. Poorlander (fish in 3 hours, bread in 2 hours) To produce 1 loaf of bread, Mrs. Poorlander needs 2 hours. In 2 hours she can produce 2/3 units of fish. So, to produce 1 more bread she must give up 2/3 units of fish. Mrs. Poorlander’s opportunity cost of bread is ___ units of fish.

20. Compute Mrs. Poorlander’s opportunity cost of bread
Mrs. Poorlander (fish in 3 hours, bread in 2 hours) To produce 1 loaf of bread, Mrs. Poorlander needs 2 hours. In 2 hours she can produce 2/3 units of fish. So, to produce 1 more bread she must give up 2/3 units of fish. Mrs. Poorlander’s opportunity cost of bread is 2/3 units of fish. =

21. Now, the same computations for Mrs. Richlander, but faster

22. Compute Mrs. Richlander’s opportunity cost of bread
Mrs. Richlander (fish in 1 hours, bread in 1.5 hours)
To produce 1 more bread Mrs. Richlander needs 1.5 hours.
In 1.5 hours she can produce 1.5 units of fish.
Mrs. Richlander’s opportunity cost of bread is 1.5 fish =

23. Opportunity cost of bread
Mrs. Poorlander’s oppotunity cost of bread is 2/3 units of fish.
Mrs. Richlander’s opportunity cost of bread is 1.5 fish = =

24. Summary
Mrs. Poorlander’s opportunity cost of 1 unit of bread is 2/3 fish. Mrs. Richlander’s opportunity cost of 1 unit of bread is 1.5 units of fish Mrs. Poorlander has a COMPARATIVE ADVANTAGE in the production of bread because her opportunity cost of bread is lower than Mrs. Richlander’s.

25. So,
Mrs. Poorlander specializes in bread and Mrs. Richlander specializes in fish. That means; Mrs. P will produce bread for her own consumption and also to sell to Mrs. R (in exchange of fish) Mrs. R will produce fish for her own consumption and also to sell to Mrs. P (in exchange of bread)

26. Specialization: How much? Partial or complete?
Complete specialization by both is not optimal. Mrs. Richlander produces 30 fish, Mrs. Poorlander produces 15 loaves of bread. This is not a good resource allocation if your goal is to eat maximum number of sandwiches.
Mrs. Richlander: 1 fish in 1 hour and 1 bread in 1.5 hours.
Mts. Poorlander: 1 fish in 3 hours and 1 bread in 2 hours.

27. Specialization: Use this method
Let P produce bread and R produce fish one unit at a time, so that at each step the number of breads equals the number of fish, until one of them uses up all her 30 hours. This will be P, at that point you have 15 units of bread and 15 units of fish. R has still 15 hours free time. Let R produce 1 fish and 1 bread until she uses up all her remaining 15 hours. You will have an additional 15/2.5 = 6 fish and bread.
Mrs. Richlander: 1 fish in 1 hour and 1 bread in 1.5 hours.
Mts. Poorlander: 1 fish in 3 hours and 1 bread in 2 hours.

28. Specialization
The “best” resource allocation with specialization: Mrs. Poorlander completely specializes in bread: She produces 15 breads. Mrs. Richlander mostly produces fish: 21 fish (in 21 hours), and also some bread: 6 loaves of bread (in 9 hours). This is partial specialization. They have 21 loaves of bread and 21 fish.

29. Dividing the gains from trade
Specialization and division of labor gives them 3 more sandwiches. How will they divide up the gains from trade? After trade each individual should have at least the consumption level she could have without trade. Otherwise the individual who has fewer sandwiches with trade than with self-sufficiency will not agree to specialization and trade.

30. Dividing the gains from trade
I didn’t explain that part very well on Monday. Therefore, many people gave 11 of these 21 sandwiches to one individual and the remaining 10 to the other. (equality, fairness) This is certainly great for Mrs. P. but not acceptable to Mrs. R. She wants at least 12 sandwiches to agree to specialization. But this point is less important. The important point is that with specialization and division of labor we “create” 3 extra sandwiches even though Mrs. P. and Mrs. R. work the same total number of hours and the technology they use is the same old technology!

31. Dividing the gains from trade
Equal sharing of gains from trade Mrs. Poorlander “sells” 7.5 units of bread to Mrs. Richlander and “buys” 7.5 units of fish, so that she can make 7.5 sandwiches. This is 1.5 more than she had in the no trade situation. Mrs. Richlander “sells” 7.5 fish to Mrs. Poorlander and “buys” 7.5 units of bread from her. After trade, Mrs. Richlander can make 13.5 sandwiches. This is 1.5 more than the no trade situation.

32. Poorland, Production Possibilities (She has 30 hours, can produce 1 fish in 3 hours and 1 bread in 2 hours)
Bread 15 D
7.5 A 6
7.5
Fish 6 10

33. Richland, Production Possibilities (She has 30 hours, can produce 1 fish in 1 hour and 1 bread in 1.5 hours)
Bread 20 D
13.5 A 12 12
13,5
Fish 30

34. Dividing the gains from trade
Specialization and division of labor “creates” 3 more sandwiches. All gains go to Poorlander Mrs. Poorlander “sells” 6 units of bread to Mrs. Richlander and “buys” 9 units of fish. After this trade, Mrs. Poorlander can make 9 sandwiches. This is 3 more than she had in the no trade situation. Mrs. Richlander “sells” 9 units of fish to Mrs. Poorlander and “buys” 6 units of bread from her. After this trade, Mrs. Richlander can make 12 sandwiches. This is the same as the no trade situation.

35. Which agreement is most likely?
Equal division of the gains from trade? All gains go to Mrs. P? All gains go to Mrs. R?

36. There is also something called…

37. Absolute advantage
The individual who can produce one unit of a good with less resources has an absolute advantage in producing that good. or, we can also say that … The producer who can produce more of a good with a given amount of resources has an absolute advantage in producing that good.

38. Who has an absolute advantage in what?
Mrs. Richlander needs 1 hour to catch one fish. Mrs. Poorlander needs 3 hours to catch one fish. Who has an absolute advantage in the production of fish? Mrs. Richlander

39. Who has an absolute advantage in what?
Mrs. Richlander needs 1.5 hours to produce one (loaf of) bread. Mrs. Poorlander needs 2 hours to produce one (loaf of) bread. Who has an absolute advantage in the production of bread? Mrs. Richlander

40. Adam Smith thought that …
Absolute advantage is the explanation for division of labor, specialization, and gains from trade. But then Adam Smith was wrong! Absolute advantage cannot explain why people specialize and why there are gains from trade. Gains from trade exist even if one individual has the absolute advantage in everything.

41. In class activity

43. There are two individuals, A and B, who produce two goods: tiki and taka. A needs 2 hours to produce one unit of taka and 2 hours for one unit of tiki. B needs 6 hours to produce one unit of taka and 3 hours for one unit of tiki. A’s opportunity cost of taka is ________units of tiki. B’s opportunity cost of taka is ________ units of tiki. Who has the comparative advantage in taka?

44. Now for something completely different!!!
Second part:
Now for something completely different!!!

45. The standard assumption in economics is that individuals are entirely self-interested in a very narrow sense: they care about their own material benefits. The “selfishness axiom” People try to maximize their own material gains in their interactions and expect others to do the same.

46. In the first part of the lecture we saw how two individuals can successfully cooperate and improve their welfare. They cooperate because cooperation increases their own material benefits. (more sandwiches) Now let us focus more on the “dividing the gains/surplus” part: This is a situation with some conflict of interest.

47. INSTRUCTIONS
There is 50 TL to split between a proposer and a responder.

48. Proposer

49. Responder

51. INSTRUCTIONS
There is 50 TL to split between a proposer and a responder.
The proposer proposes how much of 50 TL to keep for himself/herself and give the remaining to the responder.
The proposer sheets will then be collected and shuffled.
One of the sheets will be given to each responder, who must either accept or reject.
If the responder accepts, then the proposal is enacted. If the responder rejects, then each person, proposer and responder, will earn nothing.

52. Proposer Number: _____ (Write down this number) I propose to keep ______ TL for myself and give ______ TL to the responder. Responder Number: _____ (Same as Proposer number) _______ I accept, and earnings will be determined by the proposal. _______ I reject, and both of us will earn nothing.

53. Very important: Proposer number must be unique
Very important: Proposer number must be unique is not a good Proposer number! Write it down, don’t lose it! Same for the respondent. Write the number down, don’t lose it.
Proposer Number: _____ (Write down this number) I propose to keep ______ TL for myself and give ______ TL to the responder. Responder Number: _____ (Same as Proposer number) _______ I accept, and earnings will be determined by the proposal. _______ I reject, and both of us will earn nothing.

54. EXAMPLE
Proposer Number: (Write down this number) I propose to keep 50 TL for myself and give 0 TL to the responder. Responder Number: (Same as Proposer number) _______ I accept, and earnings will be determined by the proposal. __XXX___ I reject, and both of us will earn nothing.

55. Those in the front rows will be proposers, and those in the back rows will be respondents.
I will collect the sheets and randomly select one of them.
The earnings (if any) determined by the decisions on that sheet will be paid at the beginning of the next lecture (on Monday) to the proposer and responder who made those decisions.

56. To receive the payment you need to remember your proposer number

57. Proposer Number: _____ (Write down this number) I propose to keep ______ TL for myself and give ______ TL to the responder. Responder Number: _____ (Same as Proposer number) _______ I accept, and earnings will be determined by the proposal. _______ I reject, and both of us will earn nothing.

58. End of the lecture