Dr. David P Echevarria1All Rights Reserved LECTURE #2: MICROECONOMICS CHAPTER 3 Specialization Comparative Advantage Opportunity Costs

All Rights ReservedDr. David P Echevarria2 Interdependence and the Gains from Trade  In the following slides, we examine a special case. We assume the world to consist of two products; meat and potatoes.  There are two producers: A Farmer and A Rancher  Each producer has a production possibility frontier: How much of each good can they produce in an 8-hour day.  The key to understanding the motivation for trade is defining the difference between absolute advantage and comparative advantage. The latter forms the basis for trade.  The objective of trade is to improve the standard of living for both producers (consumers).

All Rights ReservedDr. David P Echevarria3 Trade, Specialization, and Comparative Advantage Production Possibility Frontier: 2 Producers- 8 hours of labor each yields Farmer: 8oz meat or 32 oz potatoes Rancher: 24 oz meat or 48 oz potatoes If both split their time equally between neat and potatoes: Farmer produces 4 oz of meat and 16 oz of potatoes Rancher produces 12 oz of meat and 24 oz of potatoes

G. Mankiw4 The Production Possibilities Frontier (a) (a) Production Opportunities Minutes needed to Make 1 ounce of: Amount produced in 8 hours MeatPotatoesMeatPotatoes Farmer Rancher 60 min/oz 20 min/oz 15 min/oz 10 min/oz 8 oz 24 oz 32 oz 48 oz Panel (a) shows the production opportunities available to the farmer and the rancher.

G. Mankiw5 Production Possibilities Frontier (b, c) (b) The farmer’s production possibilities frontier Panel (b): Combinations of meat and potatoes the farmer can produce. Panel (c): Combinations of meat and potatoes the rancher can produce. Both PPF are derived assuming that the farmer and rancher each work 8 hours per day. If there is no trade, each person’s production possibilities frontier is also his or her consumption possibilities frontier (c) The rancher’s production possibilities frontier Meat (oz) Potatoes (oz) 1632 A If there is no trade, the farmer chooses this production and consumption. Meat (oz) Potatoes (oz) 2448 B If there is no trade, the rancher chooses this production and consumption.

All Rights ReservedDr. David P Echevarria6 Trade, Specialization, and Comparative Advantage How can the two improve their total [consumption] via trade? The rancher can produce 3x as much meat in 8 hours as the farmer, but only 50% more potatoes in the 8 hours. The rancher has a definite absolute advantage in meat and potato production. The farmer (less obvious) has a small comparative advantage in growing potatoes Consider the Opportunity Costs: Farmer: 4 oz potatoes per 1 oz meat or 1 oz P = ¼ oz M Rancher: 2 oz potatoes per 1 oz of meat or 1 oz P = ½ oz M For the rancher – potatoes are more expensive relative to meat For the Farmer – meat is more expensive relative to potatoes The difference motivates the basis for trade

All Rights ReservedDr. David P Echevarria7 Trade, Specialization, and Comparative Advantage The Rancher's Offer to Farmer: Spend all 8 hours producing potatoes and I’ll trade 5 oz of meat for 15 oz of your potatoes. The rancher establishes values in trade: 1 oz meat = 3 oz of potatoes The rancher trades 1 oz meat for 3 oz potatoes from farmer. (+ 1 oz P) The farmer trades 3 oz potatoes for 1 oz meat from rancher. (+ 1 oz P) The farmer spends 8 hours growing 32 oz of potatoes and trades 15 oz of Potatoes for 5 oz of meat. Net Gain: 1 oz M, 1 oz P for a total consumption of 5 oz M, 17 oz P The rancher spends 6 hours producing meat (18 oz) and 2 hours producing potatoes (12 oz) and trades 5 oz M for 15 oz P. Net Gain: 1 oz M, 3 oz P for a total consumption of 13 oz M, 27 oz P

G. Mankiw8 Trade Expands the set of consumption opportunities (a, b) (a) The farmer’s production and consumption Proposed trade between farmer and rancher offers each of them a combination of meat and potatoes impossible without trade. Panel (a): farmer consumes at point A* rather than point A. Panel (b): rancher consumes at point B* rather than point B. Trade allows each to consume more meat and more potatoes. (b) The rancher’s production and consumption Meat (oz) Potatoes (oz) 1632 A Farmer's production and consumption without trade Meat (oz) Potatoes (oz) 2448 B Rancher’s production and consumption without trade Farmer's production with trade 5 17 A* Farmer's consumption with trade B* Rancher’s consumption with trade Rancher’s production with trade

All Rights ReservedDr. David P Echevarria9 BREAK TIME

G. Mankiw10 Comparative Advantage Comparative advantage Produce a good with lower opportunity cost than another producer Reflects - relative opportunity cost Principle of comparative advantage Each good - produced by the individual that has the smaller opportunity cost of producing that good

G. Mankiw11 Comparative Advantage One person Can have absolute advantage in both goods Cannot have comparative advantage in both goods For different opportunity costs One person - comparative advantage in one good The other person - comparative advantage in the other good

G. Mankiw12 Comparative Advantage Opportunity cost of one good Inverse of the opportunity cost of the other Gains from specialization and trade Based on comparative advantage Total production in economy rises Increase in the size of the economic pie Everyone – better off

G. Mankiw13 Comparative Advantage Trade can benefit everyone in society Allows people to specialize in activities Have a comparative advantage The price of trade Must lie between the two opportunity costs Principle of Comparative Advantage explains: Interdependence Gains from trade

G. Mankiw14 Comparative Advantage Should Tiger Woods mow his own lawn? Woods Mow his lawn in 2 hours Film a TV commercial and earn $10,000 (2 hours) Forrest Gump Mow Woods’s lawn in 4 hours Work at McDonald’s and earn $20 (4 hours)

G. Mankiw15 Comparative Advantage Should the U.S. trade with other countries? Imports: Goods produced abroad and sold domestically Exports: Goods produced domestically and sold abroad Principle of comparative advantage Each good – produced by the country with smaller opportunity cost of producing that good Specialization and trade All countries – greater prosperity

All Rights ReservedDr. David P Echevarria16 Trade, Specialization, and Comparative Advantage Two Important Economists' Contributions Adam Smith: The economic benefits of specialization David Ricardo: The economic benefits of comparative advantage and free trade Homework: Chapter 3 Questions for Review: 1, 4, 5 Problems and Applications: 1, 2 (parts a, b, c), 9