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• Two goods: Corn and Wheat
• Two counties: U.S.A. and Canada
• If U.S.A produces only corn and Canada produces only wheat
– both gain from trade
• If both U.S.A. and Canada produce both corn and wheat
– they still gain from specialization and trade copyright © michael .roberson@eStudy.us 2010, All rights reserved

Wheat
50 eStudy.us
U.S.A. production possibilities frontier
If there is no trade, then
U.S.A. produces and consumes.
Production Possibilities Frontier
Canada production possibilities frontier
Wheat
If there is no trade, then
Canada produces and consumes.
40
20
A
B
10
0 60
100 Corn
0
30 40 Corn
The left graph shows the combinations of corn and wheat that can be produced in the U.S.A. The right graph shows the combinations of corn and wheat that the can be produced in Canada. If there is no trade, each country’s production possibilities frontier is also the consumption possibilities frontier.
copyright © michael .roberson@eStudy.us 2010, All rights reserved

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– U.S.A specializes in growing corn
• more land growing corn
• less land raising wheat
– Canada specializes in growing wheat
• more land growing wheat
• less land growing corn copyright © michael .roberson@eStudy.us 2010, All rights reserved

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• Absolute advantage
– Produce a good using fewer inputs than another producer
• Opportunity cost
– Whatever must be given up to obtain some item
– Measures the trade-off between the two goods that each producer faces
The opportunity cost of corn and wheat
U.S.A.: 100 / 50 = 2 (opportunity cost of one bushel of wheat is two bushels of corn in the U.S.A.)
Canada: 40 / 40 = 1 (opportunity cost of one bushel of wheat is one bushel of corn in Canada) copyright © michael .roberson@eStudy.us 2010, All rights reserved

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Gains from trade (expands consumption opportunities)
Would without Trade
U.S.A.
Canada
Corn Wheat
60 20
30 10
World 90 30
Would with Trade
U.S.A.
Corn Wheat
100 0
Canada
World
0
100
40
40
With specialization and trade the world adds 10 corn and 10 wheat that can not be produced otherwise copyright © michael .roberson@eStudy.us 2010, All rights reserved

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• A country has a comparative advantage if opportunity cost is less than in other countries for a product
• A country
– can have absolute advantage in both goods
– can’t have comparative advantage in both goods
• 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 copyright © michael .roberson@eStudy.us 2010, All rights reserved

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• Trade can benefit everyone in society
– Allows people to specialize in activities
• The price of trade
– Must lie between the two opportunity costs
• Principle of comparative advantage explains:
– Interdependence
– Gains from trade copyright © michael .roberson@eStudy.us 2010, All rights reserved

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• Should Tiger Woods mow his own lawn?
Tiger Woods or Forrest Gump
– Tiger Woods (Mow his lawn in 2 hours)
– Forrest Gump (Mow Woods’s lawn in 4 hours)
– Film a TV commercial and earn $10,000 (2 hours)
– Work at McDonald’s and earn $36 (4 hours)
• Tiger Woods has the absolute advantage, but Forrest Gump has the comparative advantage.
• Forrest Gump should mow Tiger’s yard copyright © michael .roberson@eStudy.us 2010, All rights reserved

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• 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 copyright © michael .roberson@eStudy.us 2010, All rights reserved

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Currency Values and Trade
• The U.S.A. produces a Corvette valued at $100,000
• Germany products a Porsche valued at €100,000
Suppose one dollar can purchase 1.25 euros or it cost 80 cents to purchase one euro 0.80 = ($1/ €1.25)
In the U.S.A.
A Corvette would cost $100,000
Only cost 80 cents to buy a euro
A Porsche would cost only €100,000 (0.80) = $80,000
In Germany
A dollar cost 1.25 euros
A Corvette would cost $100,000(1.25) = €125,000
A Porsche would cost €100,000
Both German and U.S.A. citizens will purchase Porsche cars.
copyright © michael .roberson@eStudy.us 2010, All rights reserved

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Currency Values and Trade
• The U.S.A. produces a Corvette valued at $100,000
• Germany products a Porsche valued at €100,000
Now suppose one dollar can purchase 4/5 of a euro then one euro can purchase 1.25 dollars 1.25 = ($1/ €0.80)
In the U.S.A.
A Corvette would cost $100,000
Cost 1.25 dollars to buy a euro
A Porsche would cost only €100,000 (1.25) = $125,000
In Germany
A dollar cost 0.80 euros
A Corvette would cost $100,000(0.80) = €80,000
A Porsche would cost €100,000
Both German and U.S.A. citizens will purchase Corvettes.
copyright © michael .roberson@eStudy.us 2010, All rights reserved