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Frank & BernankeFrank & Bernanke4th edition, 20094th edition, 2009

Ch. 2: Comparative Advantage: Ch. 2: Comparative Advantage: The Basis of ExchangeThe Basis of Exchange

http://www.youtube.com/watch?v=2hCotwP-nTI

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Why Do People Trade With Each Why Do People Trade With Each Other?Other?

If one person produces bread and another butter, If one person produces bread and another butter, they would be both better off exchanging some of they would be both better off exchanging some of their produce with the other and have a variety in their produce with the other and have a variety in their diet.their diet.

If they can both produce bread and butter, they If they can both produce bread and butter, they each will have a PPF.each will have a PPF.

The total output of bread and butter would be The total output of bread and butter would be much higher if each specialized on the product much higher if each specialized on the product s/he can produce more.s/he can produce more.

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Comparative AdvantageComparative AdvantageBread Butter

0 3010 2020 1030 0

Bread Butter

0 95 6

10 315 0

Farmer A

0

10

20

30

40

0 5 10 15 20 25 30 35Bread

Bu

tte

r

Farmer B

0

2

4

6

8

10

0 5 10 15 20Bread

Bu

tte

r

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Opportunity CostsOpportunity Costs

What is the implied price of butter for What is the implied price of butter for Farmer A?Farmer A?Each time FA increases her butter Each time FA increases her butter

production she has to give up 1 bread.production she has to give up 1 bread.What is the implied price of butter for What is the implied price of butter for

Farmer B?Farmer B?Each time FB increases his butter Each time FB increases his butter

production he has to give up 5/3 breads.production he has to give up 5/3 breads.OCOCbtbt=(Breads given up)/(Butters gained)=(Breads given up)/(Butters gained)

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Combined ProductionCombined Production

Suppose both are producing only bread. Suppose both are producing only bread. How many breads will be produced? How many breads will be produced?

Suppose they decide to reduce bread Suppose they decide to reduce bread production by 10 and allocate that effort production by 10 and allocate that effort to butter production. Who should be the to butter production. Who should be the one to produce butter? How much one to produce butter? How much butter will be produced?butter will be produced?

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Bread Butter0 395 3610 3315 3020 2525 2030 1535 1040 545 0

PPC

0

10

20

30

40

50

0 10 20 30 40 50Bread

Butte

r

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Opportunity CostsOpportunity Costs

Farmer A can produce either 30 breads Farmer A can produce either 30 breads or 30 butters. Her opportunity cost is or 30 butters. Her opportunity cost is 1br=1bt.1br=1bt.

Farmer B can produce 15 breads or 9 Farmer B can produce 15 breads or 9 butters. His opportunity cost is butters. His opportunity cost is 1br=0.6bt.1br=0.6bt.

As long as different opportunity costs As long as different opportunity costs exist, there is room for specialization, exist, there is room for specialization, trade and improvement of well being.trade and improvement of well being.

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TradeTrade

If the “world” exchange rate (price) were If the “world” exchange rate (price) were 1br=0.8bt, FA would be interested in giving 1br=0.8bt, FA would be interested in giving up butter to get bread and FB would be up butter to get bread and FB would be interested in giving up bread to get butter.interested in giving up bread to get butter.

Start at self-sufficiency for both. Pick a point Start at self-sufficiency for both. Pick a point on the PPF of each to show consumption on the PPF of each to show consumption before specialization and trade. Allow full before specialization and trade. Allow full specialization and exchange some of the specialization and exchange some of the production for the production of the other production for the production of the other farmer. Show that they are both better off.farmer. Show that they are both better off.

Specialization expands as the size of the Specialization expands as the size of the market expands.market expands.

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PPC for Many-Person EconomyPPC for Many-Person Economy

PPC is bowed outward.PPC is bowed outward.Principle of Increasing Opportunity Cost is Principle of Increasing Opportunity Cost is

in operation.in operation.Opportunity cost of producing product A Opportunity cost of producing product A

increases as more A is produced.increases as more A is produced.Different countries will have different PPCs Different countries will have different PPCs

and world prices will determine if a country and world prices will determine if a country should be an exporter or importer.should be an exporter or importer.

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US Foreign TradeUS Foreign Trade

US is more productive than Mexico and US is more productive than Mexico and China in many products. Yet it engages in China in many products. Yet it engages in trade, freeing resources to be put to use in trade, freeing resources to be put to use in products where US has a comparative products where US has a comparative advantage. This way all countries can advantage. This way all countries can enjoy a higher standard of living.enjoy a higher standard of living.

Why do some people condemn free trade?Why do some people condemn free trade?

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What Shifts the PPCWhat Shifts the PPC

Population increasePopulation increaseCapital increaseCapital increaseTechnology increaseTechnology increaseKnowledge/skill increase (human capital)Knowledge/skill increase (human capital)

1313http://www.economist.com/research/articlesBySubject/displaystory.cfm?subjectid=7933596&story_id=15006195