LECTURE #2: MICROECONOMICS
CHAPTER 3
Specialization
Comparative Advantage
Opportunity Costs
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Dr. David P Echevarria
1
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).
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Dr. David P Echevarria
2
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
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Dr. David P Echevarria
3
The Production Possibilities Frontier (a)
(a) Production Opportunities
Minutes needed to
Make 1 ounce of:
Farmer
Rancher
Amount produced
in
8 hours
Meat
Potatoes
Meat
Potatoes
60
min/oz
20
min/oz
15
min/oz
10
min/oz
8 oz
32 oz
24 oz
48 oz
Panel (a) shows the production opportunities available to the
farmer and the rancher.
G. Mankiw
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Production Possibilities Frontier (b, c)
(b) The farmer’s production
possibilities frontier
Meat (oz)
(c) The rancher’s production
possibilities frontier
Meat (oz)
If there is no trade, the farmer
chooses this production and
consumption.
24
8
12
If there is no trade, the
rancher chooses this
production and consumption.
B
A
4
0
16
Potatoes (oz)
32
0
24
48
Potatoes (oz)
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
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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
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Dr. David P Echevarria
6
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
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Dr. David P Echevarria
7
Trade Expands the set of consumption opportunities (a, b)
(a) The farmer’s production
and consumption
Meat (oz)
Farmer's
production and
consumption
without trade
8
A*
5
4
A
0
16 17
(b) The rancher’s production
and consumption
Meat (oz)
24
Farmer's
consumption
with trade
Farmer's
production
with trade
32
18
B*
13
12
0
Rancher’s
production and
consumption
without trade
Rancher’s
production
with trade
B
12
24 27
Rancher’s
consumption
with trade
48
Potatoes (oz)
Potatoes (oz)
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.
G. Mankiw
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BREAK TIME
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Dr. David P Echevarria
9
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
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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
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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
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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
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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)
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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
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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
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Dr. David P Echevarria
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