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Comparative Advantage and TradeUnit 2: The Benefits of TradeI.BridgeOld Idea:Economists compare not only the resource cost of production decisions, but also the opportunity cost.The production possibilities curve shows the opportunity cost of each production decision along the curve.New Idea:Economies should specialize in producing the good on the curve in which they have a lower opportunity cost compared to other economies and then trade for the other good on the curve.II.Absolute Advantage vs. Comparative Advantage ExampleSpecific Assumptions and Analysis:Assume two students, Milton Friedman and Albert Enstein, are both freshmen in college and are in the same economics and physics classes together.Assume they each have only one hour to complete their homework because it is pledge week for their fraternities.Assume each can complete the following amount of problems in that hour:Milton Friedman – 10 economics problems or 5 physics problemsAlbert Einstein – 10 physics problems or 10 economics problemsWho has the absolute and comparative advantages in which good?Production Possibilities ScheduleStudentHour Spent on EconomicsOrHour Spent on PhysicsAbsolute Advantage in Economics ProblemsAbsolute Advantage in Physics ProblemsOpportunity Cost of 1 Economics ProblemOpportunity Cost of 1 Physics ProblemComparative Advantage in Economics ProblemsComparative Advantage in Physics ProblemsMilton Friedman10or5.5 Physics Problems2 Economics ProblemsAlbert Einstein10or101 Physics Problem1 Economics ProblemTotal Problems20or15III.Absolute vs. Comparative Advantage Definitionsabsolute advantage – the ability to produce more of a good compared to someone else using the same resourcescomparative advantage – the ability to produce a good at a lower opportunity cost compared to someone elseIV.Absolute vs. Comparative Advantage Applied to the ExampleExample Explained:Albert has an absolute advantage over Milton in physics (10 problems vs. 5 problems in 1 hour) and they are equal in economics (10 problems vs. 10 problems in 1 hour).Why would Albert have any motivation to specialize in one good and trade for the other with Milton?They each have a comparative advantage in opposite goods.Even though Albert can produce the same amount of economics problems as Milton, it costs Milton less to produce an economics problem compared to Albert He is better at producing economics problems than physics problems compared to Albert.Therefore it also costs Albert less to produce a physics problem than MiltonEven though Albert is just as skilled at producing physics problems than economics problems, he is better at producing physics problems than economics problems compared to MiltonEven though one person can be better at producing both goods compared to the other person, each person can only be better at producing one good compared to the other good compared to the other personV. No Specialization ExampleStudentHalf Hour Spent on EconomicsAndHalf Hour Spent on PhysicsTotal ProblemsMilton Friedman5and2.57.5Albert Einstein5and510Total Problems10and7.517.5VI.Specialization in Comparative Advantage Good ExampleStudentHour Spent on EconomicsOrHour Spent on PhysicsTotal ProblemsMilton Friedman10or010Albert Einstein0or1010Total Problems10or1020VII.Benefits of Specialization Applied to the Examplesif each person specializes in producing the good they have a comparative advantage in, more total problems are produced (20 problems vs. 17.5)VIII.Determining the Ratio (Price) of TradeSince they both Milton and Albert need some of each type of problem, they will come together and trade.What ratio (price) will allow them both to be better off than if they had not specialized and produced both problems themselves?They will set the ratio so that it is between their opportunity cost ratios:Milton: 2:1 (2 economics problems for 1 physics problem)Albert: 1:1 (1 economics problem for 1 physics problem)Trade Ratio: 1.5:1 (1.5 economics problems for 1 physics problem)Milton will give up 1.5 economics problems for 1 physics problemMilton has lowered his opportunity cost per physics problem from 2 to 1.5 economic problemsAlbert will give up 1 physics problem for 1.5 economics problemsAlbert has lowered his opportunity cost per economics problem from 1 to .67 economics problemsAs long as one person is giving up less of the original good to get the same amount of the new good as before, and the other person is getting more of the new good while giving up the same amount of the original good as before, both people are better offIX.Benefits of Trade ExampleMilton FriedmanAlbert EinsteinTotal ProblemsWithout SpecializationEconomics Problems Produced5510Physics Problems Produced2.557.5Total Problems Produced7.51017.5Old Opportunity Cost2 Economics Problems for 1 Physics Problem1 Physics Problem for 1 Economics ProblemWith SpecializationEconomics Problems Produced10010Physics Problems Produced01010Total Problems Produced101020After TradeProblems Lost with Trade4.5 Economics Problems3 Physics ProblemsProblems Gained with Trade3 Physics Problems4.5 Economics ProblemsNew Opportunity Cost1.5 Economics Problems for 1 Physics Problem.67 Physics Problems for 1 Economics ProblemNew Economics Problems Complete5.5 Economics Problems4.5 Economics Problem10New Physics Problems3 Physics Problems7 Physics Problems10New Total Problems8.511.520More total problems are produced in total (20 vs. 17.5)Opportunity costs are lowered for each type of problem:Economics problems were produced by Milton Freidman at a cost of .67 Physics Problems instead of 1 Physics Problem by Albert Einstein Physics Problems were produced at an opportunity cost of 1.5 Economics Problems to Milton Friedmans by Albert Einstein instead of 2 Economics Problems to Milton FriednmanBoth Milton Friedman and Albert Einstein end up with a mix of output that is outside of their production possibilities curve (assume the curves are straight lines for simplicity sakes):A: Milton Friedman’s Mix of Output after Specialization and TradeB: Albert Einstein’s Mix of Output after Specialization and TradeX.Summary of Benefitsmore is produced at a lower opportunity costthe same resources are used more efficiently lowering the opportunity cost ................
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