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3 (14) - CHAPTER 2 ECONOMIC MODELS TRADE-OFFS AND TRADE 31...

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Unformatted text preview: CHAPTER 2 ECONOMIC MODELS: TRADE-OFFS AND TRADE 31 production possibility frontier in panel (a) of Figure 2-4. which is the same as the pro- duction possibility frontier in Figure 2-1. According to this diagram, Tom could catch 4-0 fish. but only if he gathered no coconuts. and could gather 30 coconuts, but only if he caught no fish. as before. Recall that this means that the slope of his production possibility frontier is -%/4: his opportunity cost of 1 fish is 33/4 of a coconut. Panel (b) of Figure 2-4 shows Hank's production possibilities. Like Tom's. Hank’s production possibility frontier is a straight line, implying a constant opportunity cost of fish in terms of coconuts. His production possibility frontier has a constant slope of —2. Hank is less pro- ductive all around: at most he can produce 10 fish or 20 coconuts. But he is particularly bad at fishing; whereas Tom sacrifices 3/4 of a coconut per fish caught. for Hank the opportunity cost of a fish is 2 whole coconuts. Table 2-1 summarizes the two castaways' opportunity costs of fish and coconuts. Now, Tom and Hank could go their separate ways. each living on his own side of the island, catching his own fish and gathering his own coconuts. Let's suppose that they start out that way and make the consumption choices shown in Figure 2-4: in the absence of trade. Tom consumes 28 fish and 9 coconuts per week. while Hank consumes 6 fish and 8 coconuts. But is this the best they can do? No, it isn’t. Given that the two castaways have different opportunity costs. they can strike a deal that makes both of them better off. Table 2-2 shows how such a deal works: Tom specializes in the production of fish. catching 4-0 per week. and gives 10 to Hank. Meanwhile. Hank specializes in the produc- tion of coconuts, gathering 20 per week. and gives 10 to Tom. The result is shown in Figure 2-5 on the next page. Tom now consumes more of both goods than before: instead of 28 fish and 9 coconuts. he consumes 30 fish and 10 coconuts. And Hank also con- sumes more. going from 6 fish and 8 coconuts to 10 fish and 10 coconuts. As Table 2-2 also shows. both Tom and Hank experience gains from trade: Tom’s consumption of fish increases by two, and his consumption of coconuts increases by one. Hank's consump- tion of fish increases by four. and his consumption of coconut: increases by two. So both castaways are better off when they each specialize in what they are good at and trade. It’s a good idea for Tom to catch the fish for both of them because his opportunity cost of a fish is only 3/4 of a coconut not gathered versus 2 coconuts for Hank. Correspondingly. it’s a good idea for Hank to gather coconuts for both of them. Or we could put it the other way around: Because Tom is so good at catching fish, his opportunity cost of gathering coconuts is high: 4/3 of a fish not caught for every coconut gathered. Because Hank is a pretty poor fisherman, his opportunity cost of gathering coconuts is much less. only 1/2 of a fish per coconut. What we would say in this case is that Tom has a comparative advantage in catch- ing fish and Hank has a comparative advantage in gathering coconuts. An individual has a comparative advantage in producing something if the opportunity cost of that production is lower for that individual than for other people. In other words. Hank has a comparative advantage over Tom in producing a particular good or serv- ice if Hank’s opportunity cost of producing that good or service is lower than Tom's. How the Castaways Gain from Trade Wiflinut Trade With Trade Gains from Tlade Production consumption Production Consumption Fish 28 28 40 30 +2 Coconuts 9 9 [i 10 +1 Fish 6 6 o 10 +4 coconuts 8 8 20 10 +2 An individual has a comparative advantage in producing a good or service iiiha opportunity cost of pro- ducing the good or service is lower for that individual than for other people. Tom’s and Hank's Opportunity Costs of Fish and Cotonuts Tom's Opportuntty Cost Hanks Opportunity toot One fish 3/4 coconut Dne coconut ai/S fish 2 coconuts 1/2 fish ...
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