1. The Principle of Comparative Advantage Comparative advantage is the ability of a person (or state, region, country) to perform an activity or produce a good or service at a lower opportunity cost than someone else (or some other state, region, or country).

2. Production Possibilities at Tom’s Water-Bottling Plant A Tom’s production point Water (thousands of gallons per hour) Bottles (thousands per hour) 1 10 4 4,000 bottles 1.333 gallons Tom’s opportunity cost: 1 gallon of water costs 3 bottles 1 bottle costs 1/3 gallon of water

3. In summary, for every gallon of water Tom produces, he must give up 3 bottles. For every bottle he produces, he must give up 0.333 gallons of water.

4. Measuring Comparative Opportunity Cost A Water (thousands of gallons per hour) Bottles (thousands per hour) 1 10 4 Tom’s opportunity cost: 1 gallon of water costs 3 bottles 1 bottle costs 1/3 gallon of water Tom’s PPF Nancy’s PPF 4 Nancy’s opportunity cost: 1 gallon of water costs 1/3 bottle of water 1 bottle costs 3 gallons of water Point A is the “pre- specialization” point

5. Notice that for every gallon of water Nancy produces, she must give up 0.333 bottles. Also, to produce 1 bottle, Nancy must sacrifice 3 gallons of water.

6. Who has comparative advantage? Tom has the comparative advantage in bottles since he can produce them at lower opportunity cost than Nancy (1 bottle = 1/3 gallon versus 1 bottle = 3 gallons for Nancy). Nancy has the comparative advantage in water because she can produce a gallon at lower opportunity cost than Tom (1 gallon = 1/3 bottle versus 1 gallon equals 3 bottles for Tom).

7. The Gains from Specialization A Water (thousands of gallons per hour) Bottles (thousands per hour) 1 10 4 Tom’s PPF Nancy’s PPF 4 B B’ Prior to trade and specialization, both Tom and Nancy operated at point A. If they specialize according to comparative advantage, Tom will move to point B and Nancy will move to point B’

8. Pre-specialization Post-specialization Water (Gallons) Bottles (Thousands) Water (Gallons) Bottles (Thousands) Tom1,000 04,000 Nancy1,000 4,0000 Total2,000 4,000 By specializing along line of comparative advantage, Tom and Nancy can double total production of bottles and water Total resources have not changed— but total production has!

9. Terms of Trade Tom would be willing to specialize in bottles if he could purchase 1 gallon of water for less than 3 bottles. Nancy would be willing to specialize in water if she could sell a gallon of water for more than 1/3 of a bottle. Thus there is an opportunity for mutually beneficial exchange

10. The Gains from Specialization A Water (thousands of gallons per hour) Bottles (thousands per hour) 1 10 4 Tom’s PPF Nancy’s PPF Trade line 4 B B’ C Trade occurs along the red function. Both parties move to point C. Notice that point C lies outside their individual PPFs.

11. Complete Practice problem 3.3 on p. 73 Scooters Snowboards 0 Tony’s PPF Patty’s PPF 20 10 2010

12. a.Calculate Tony’s opportunity cost of a snowboard. b.Calculate patty’s opportunity cost of a snowboard. c.Who has the comparative advantage in producing snowboards? d.Who has the comparative advantage in producing scooters? e.If the specialize and trade, how many snowboards and scooters will they produce?