1. Production Possibilities, Opportunity Cost, and the Gains from Trade
ECON 704
Module 2, Part 1

2. Agenda Define absolute advantage and comparative advantage
Understand how comparative advantage gives rise to specialization and gains from trade
Apply idea of gains from trade to everyday life and national policy

3. Specialization and Trade Every Day
Around the world – in the first two hours of your day!
clock radio from Taiwan; grains from Great Plains; juice from Florida or Brazil; Clothes from China with cotton from Georgia; drive in car with parts from half a dozen countries, using gas from oil from Middle East
clock; cereal; juice; clothes; TV; drive to work

4. We could do many things ourselves, but we specialize and trade – why?
Specialization according to opportunity cost makes us better off than if we tried to be self sufficient
Works on an individual level which crosses borders, so works for nations too

5. Self-Sufficient Stewart
Without trade: production possibilities frontier (PPF) is the consumption possibilities frontier 4
Rooms
Wall-papered 10
Rooms Painted

6. Can Stewart do Better?
Martha is more productive in both activities – she has absolute advantage in both activities
Martha’s PPF is everywhere outside Stewart’s PPF
What could Stewart possibly offer Martha? She can do everything better
WRONG COMPARISON!!

7. Stewart has something to offer because Martha would find it less expensive in terms of her own labor to trade with him
But what to trade?
Look at opportunity costs

8. Computing Opportunity Costs
Martha takes 8 hours to wallpaper a room
that would mean 8 fewer hours painting
in that time she could have done 4 painted rooms, since she can paint a room in only 2 hours
Martha’s opportunity cost of wallpapering a room is 4 painted rooms
and her op. cost of painting a room is ¼ of a room not wallpapered

9. Reason for Trade
Stewart’s opportunity cost of wallpapering is 2.5 rooms not painted
Martha’s opportunity cost of wallpapering is 4 rooms not painted
Stewart could offer to wallpaper a room for Martha if she paints 3 rooms for him
A price! 1 papered room for 3 painted rooms
Martha gets a room papered for 6 hours instead of 8; Stewart gets 3 rooms painted for 10 hours instead of 12. Both save 2 hours!

10. Comparative Advantage
Stewart has lower op. cost of papering (in terms of foregone painting) = comparative advantage in papering
Martha has comparative advantage in painting
If Martha specializes in painting and Stewart specializes in papering, both can consume outside of their production possibilities frontiers ~ they’re getting more out of their scarce labor resources

11. Other Points
Martha will have a nicer house since she is more productive overall
Actual “price” will depend on demand and supply, and bargaining acumen.
Gains from trade depend on comparative advantage
Overall living standards depend more on absolute advantage

12. Op. costs and Family Planning
Parents choose to have fewer children in more developed countries
Related to opportunity cost
Raising kids means less time earning wages
Wages higher in developed countries; children have higher opportunity cost, so fewer are chosen.
Children also have productive potential that cannot be legally realized in developed countries, but can in poor developing countries

13. The Lawyer and his assistant
Suppose a lawyer is better at both legal research and typing than his assistant
Lawyer lets assistant do the typing because assistant has lower opportunity cost of typing in terms of lost billable hours

14. Business
Outsourcing and sticking to the “core competencies” are efforts to focus on comparative advantage

15. International Trade
Countries can gain from specialization and trade: exports pay for imports
Do countries compete?
Trade barriers make the country work harder for less
Low-wage foreign competition? Consequence of lower productivity (among other things)
Problem of dislocated resources
International trade about more than comparative advantage

16. Next Time:
How is the interdependence of billions of people coordinated?
Answer: demand, supply, and the price system