E201 Chap 3 Notes.doc - ECON 201 CHAPTER 3 INTERDEPENDENCE AND THE GAINS FROM TRADE An Example of Specialization and Trade Assume that in the economy

# E201 Chap 3 Notes.doc - ECON 201 CHAPTER 3 INTERDEPENDENCE...

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ECON 201 CHAPTER 3 – INTERDEPENDENCE AND THE GAINS FROM TRADE An Example of Specialization and Trade Assume that in the economy there are only two goods (meat and potatoes) and two agents (rancher and farmer). They gain from specialization and trade. The Farmer Whenever the farmer spends 1 hour less producing meat and 1 hour more producing potatoes, he reduces his output of meat by 1 ounce and raises his output of potatoes by 4 ounces. Therefore farmer’s opportunity cost of producing 1 ounce of potatoes is ¼ ounce of meat. If he devotes all eight hours of work in a day producing meat, he maximizes the production (and consumption) of meat. His maximum consumption of meat is 8 ounces per day and no potatoes (vertical intercept). Similarly, his maximum consumption of potatoes is 32 ounces and no meat (horizontal intercept). Assuming that the technology is such that the farmer can switch from the production of meat to the production of potatoes at a constant rate, then the frontier is the line between the two intercepts (see Panel b, Figure 1). The Rancher Whenever the rancher spends 1 hour less producing meat and 1 hour more producing potatoes, he reduces his output of meat by 3 ounces and raises his output of potatoes by 6 ounces. Therefore rancher’s opportunity cost of producing 1 ounce of potatoes is ½ ounce of meat. The rancher’s maximum consumption of meat is 24 ounces per day and no potatoes (vertical intercept). Similarly, his maximum consumption of potatoes is 48 ounces and no meat (horizontal intercept). Assuming that the technology is such that the rancher can switch from the production of meat to the production of potatoes at a constant rate, then the frontier is the line between the two intercepts (see Panel c, Figure 1). 1
Absolute and Comparative Advantage The rancher can produce both meat and potatoes using fewer inputs (labor) than the farmer. Therefore, the rancher has an absolute advantage both in producing meat and producing potatoes. However the farmer has a lower opportunity cost of producing potatoes than the rancher (1 ounce of potatoes costs the farmer only ¼ ounce of meat, while it costs the rancher ½ ounce of meat). Symmetrically, the rancher has a lower opportunity cost of producing meat (1 ounce of meat costs the farmer 4 ounces of meat, while it costs the rancher only 2 ounces of potatoes). Comparative advantage represents the ability to produce a good at a lower opportunity cost than another producer. If one producer as a comparative advantage in one good, the other producer will have a comparative advantage in the alternative good. In the example,

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