Week 1 Quick Review

The opportunity cost of meat and potatoes 1 2 Opportunity cost of: 1 oz of Meat1 oz of Potatoes Farmer Rancher 4 oz potatoes 2 oz potatoes ¼ oz meat ½ oz meat

A Parable for the Modern Economy Specialization and trade Farmer – specialize in growing potatoes More time growing potatoes Less time raising cattle Rancher – specialize in raising cattle More time raising cattle Less time growing potatoes Trade Willing to trade: 3 oz of meat for 1 oz potatoes Final trade -5 oz of meat for 15 oz of potatoes Both gain from specialization and trade 3

Greg’s Final Solution (text) 2 4 (a) The farmer’s production and consumption Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1) Start at corners (specialization) (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

Comparative Advantage Comparative advantage Produce a good - 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 5

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 6

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 (between 4P:1M and 2P:1M) Principle of comparative advantage explains: Interdependence Gains from trade 7

Applications of 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 Smaller opportunity cost of producing that good Specialization and trade All countries – greater prosperity 8