Economies are defined by scarcity.

Scarcity forces people to make choices.

Choices involve costs.

Since we all face different costs, by specializing and trading we can create wealth.

Markets form to facilitate trade (formal/informal).

Recall

Consider the simplest possible economy.

One actor, Robinson Crusoe (R.C.).

One resource, time.

Since R.C. can only work eight hours in a day, he is faced with scarcity.

Scarcity forces R.C. to make choices.

Comparative Advantage & the Tale of Robinson Crusoe

R.C.’s Choices(The number of hours to get 1 unit)

Fish Palms

R.C. 1/2hr 1/4hr

It takes R.C. 1/2 hour (30m) to catch 1 fish and it takes him 1/4 hour (15m) to cut 1 palm.

So, each fish he catches requires giving up 2 palms (1/2 hour (30m) not spent palming).

It takes R.C. 1/4 hour (15m) to cut 1 palm and it takes him 1/2 hour (30m) to catch 1 fish.

So, each palm he cuts requires giving up 1/2 fish (1/4 hour (15m) not spent fishing).

R.C.’s Opportunity Costs Fish Palms

1/2hr 1/4hr

1 fish costs 2 palms.The opportunity cost of 1 fish is 2 palms.

1 palm costs 1/2 fish.The opportunity cost of 1 palm is 1/2 fish.

Let’s put it in a table.

R.C.’s Opportunity Costs

R.C.’s Choices/Opportunity Costs

Fish Palms

1/2hr 1/4hr

Fish Palms

2P 1/2F

The number of hours to get 1 unit

What he gives up for 1 unit

Fish Palms

16F 32P

What is possible in eight hours?

R.C.’s Possibilities

R.C. likes an even mix in his consumption so he spends half his time fishing and half palming.

Fish Palms

16F 32P

■

F

P

16

32

8

16

R.C.’s PPF

A

Slope = 1/2 = Opp. Cost of 1P

Meanwhile on the other side of the island Friday plans his workday…

(The number of hours to get 1 unit)

Fish Palms

Friday 1/2hr 1/8hr

It takes Friday 1/2 hour (30m) to catch 1 fish and it takes him 1/8 hour (7.5m) to cut 1 palm.

So, each fish he catches requires giving up 4 palms (1/2 hour (30m) not spent palming).

It takes Friday 1/8 hour (7.5m) to cut 1 palm and it takes him 1/2 hour (30m) to catch 1 fish.

So, each palm he cuts requires giving up 1/4 fish (1/8 hour (7.5m) not spent fishing).

Friday’s Opportunity Costs Fish Palms

1/2hr 1/8hr

1 fish costs 4 palms.The opportunity cost of 1 fish is 4 palms.

1 palm costs 1/4 fish.The opportunity cost of 1 palm is 1/4 fish.

Let’s put it in a table.

Friday’s Opportunity Costs

Friday’s Choices/Opportunity Costs

Fish Palms

1/2hr 1/8hr

Fish Palms

4P 1/4F

The number of hours to get 1 unit

What he gives up for 1 unit

Fish Palms

16F 64P

What is possible in eight hours?

Friday’s Possibilities

Like R.C., Friday likes an even mix of consumption so he spend half his time fishing and half palming.

Fish Palms

16F 64PSlope = 1/4 = Opp. Cost of 1P

■

F

P

16

64

8

32

Friday’s PPF

A

Opportunity Costs: Summing Up

Although R.C. and Friday have similar resources, they face different costs.

R.C. is the low cost producer of Fish.Friday is the low cost producer of Palms.◦ Remember, cost is always measured in terms of Opp. Costs.

Fish Palms

R.C. 2P 1/2F

Friday 4P 1/4F

Friday is a better palmer because of a superior tree climbing ability.

Opportunity Costs

Comparative Advantage

We say someone has a “Comparative Advantage” if they can produce a good at a lower relative cost compared to someone else.

Fish Palms

R.C. 2P 1/2F

Friday 4P 1/4F

Can life improve for both R.C. & Friday?

■

F

P

16

64

8

32

Friday’s PPF

A■

F

P

16

32

8

16

R.C’s PPF

A

Taking the (comparative) Advantage

Exchange rate (fish for palms): 1F for 3P

Will R.C. trade?Will Friday trade?And if so…how will they do it?

Fish Palms

R.C. 2P 1/2F

Friday 4P 1/4F

The Deal Goes Down

What effect does this trade have on R.C.’s and Friday’s level of consumption?

Rob Friday

Brings 16F 0P 0F 64P

Gives -8F -24P

Gets 24P 8F

Leaves 8F 24P 8F 40P

BOTH R.C. and Friday are OUTSIDE their PPF.

Gains From Trade

F

P

16

64

8

40

■

Friday’s PPF

■A

B8

F

P

16

3224

■

Robinson’s PPF

B

A■

When people specialize in their comparative advantage, and trade in markets for other goods, wealth increases.

Notice that no extra resources are used.

Using the Low-Cost Producer conserves scarce resources.

Specialization and trade REDUCES scarcity!

Gains From Trade

Specialization and trade creates wealth.

With trade we get more goods from fewer resources.

Trade (in aggregate) makes societies better off.

Trade improves welfare even if one party is bigger, smarter, or more productive than another.

The Big Picture