1. Eco 344----Slide 4 After Midterm Exam 3

2. Opportunity Cost (OC) OC of X in terms of Y is the amount of Y you have to give up when producing one unit of X OC is caused by the fact that resource (such as labor) is limited OC of X in term of Y is the inverse of OC of Y in terms of X

3. Production Possibility Frontier (PPF) We can use PPF to illustrate the labor (resource) constraint We determine the maximum amounts of X and Y an economy could produce, and then connect them. The absolute value of slope of PPF equals the OC of X in terms of Y (if we put Y on the vertical axis)

4. No Trade (No Specialization) An economy has to produce both X and Y if there is no trade. No trade is the same as no specialization Because labor is mobile, no specialization occurs only under the condition that wage rate of X industry equals Y industry. Equivalently, the no-specialization condition is that relative price of X in terms of Y equals OC of X in terms of Y, see equation (2). Specialization occurs when (2) fails.

5. Comparative Advantage (CA) Home country has CA in X if OC of X in terms of Y is smaller than that in Foreign country If Home country has CA in X, then Foreign country must have CA in Y. It is impossible that a country has CA in all goods.

6. Trade (Specialization) Trade allows a country to produce a good indirectly Trade is based on CA, not absolute advantage (AA). Suppose Home country has CA in cheese. Then trade allows home country to produce cheese only (specialization), and trade cheese for wine on the market (indirect production of wine).

7. Everyone Can Join Trade Because no country has CA in all goods, every country can participate trade Common misunderstanding: trade is for advanced country only.

8. How Trade Leads to Specialization Because of Arbitrage Arbitrage causes relative prices at Home and Foreign countries to converge (to, say, a final relative price), see equation (4) The final relative price is different from OC, see equation (5) In the end all labor will move to the industry with higher wage rate. To see this notice that equation (5) implies that equation (2) fails.

9. Everyone Can Gain from Trade Suppose Home country has CA in cheese. Trade allows home country to have more wine by producing it indirectly, i.e., by specializing in cheese and trading cheese for wine. Common Misunderstanding: only poor countries like China benefits from trade