Week 1 Quick Review
1
The opportunity cost of meat and potatoes
Opportunity cost of:
Farmer
Rancher
1 oz of Meat
1 oz of Potatoes
4 oz potatoes
2 oz potatoes
¼ oz meat
½ oz meat
2
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
2
Greg’s Final Solution (text)
(a) The farmer’s production
Meat (oz) and consumption
Farmer's
production and
consumption
without trade
8
Farmer's
consumption
with trade
0
A
16 17
Farmer's
production
with trade
32
18
B*
13
12
0
Rancher’s
production and
consumption
without trade
Rancher’s
production
with trade
24
A*
5
4
(b) The rancher’s production
Meat (oz) and consumption
Rancher’s
consumption
with trade
B
12
27
24
48
Potatoes (oz)
Potatoes (oz)
Farmer and Rancher agree to trade 5 oz of Meat for 15 oz of Potatoes (3:1)
Start at corners (specialization)
4
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