● Why do people specialize and trade?

○ Comparative advantage is the name of the economic theory that explains how trade makes everyone better off,
and why impeding trade is not a good idea
● Tradeoffs → you have to give something up (?)
● Opportunity cost → what you give up to get something
○ These are the explicit expenditures plus implicit value - out of pocket money - of the next best alternative you had
to do without
● Gains from trade
○ Instead of trying to make everything you need yourself, you will be better off specializing in what you’re really
good at doing, and trade some of it for things that other people are better at making than you
● Self sufficiency keeps you down
○ Imagine if you made all your clothes, grew your food, build your own shelter with all the components you
harvested or made yourself → mess
○ No iphones, clothes, music or video downloads that contribute to a “good life”
● Specialize in the things you are best at, eg economist, engineer, doctor, throughout your entire career
○ Producing labour services - earn money from your career which is an immediate holding tank that allows you to
earn purchasing power from your work and then use that power to get the other things that you want that other
people can make better than you (macro)
● Specialize in trade
○ Use the money you earn to buy yourself all the cool things that other people make well in order to have a high
quality of life (already do this - free trade)
● How do I know what to specialize in?
○ Compare your opportunity costs with the opportunity costs of potential trading partners = what we mean when
we say “specialize in the thing you are best at”
○ Lowest opp cost - the thing you should specialize in
○ How to calculate it
■ What you have to give up to get a unit of something (ratio): give up / get (fraction eg money and food
○ How do I know how much I have to give up?
■ Need facts, data and then some calculations
● Your production possibilities
○ The data or facts about how much of each good or service you could produce per period or with a unit of
productive resources are known as your production possibilities = can be shown in a table or on a graph
■ Eg Production Opportunities for Meat or Potatoes produced by two people
● In one day (8 hours) Frank can produce 8 kg of meat or 32 kg of potatoes
● Rose can produce 24 kg of meat and 48 kg of potatoes
○ A researcher would find these stats,
report to economist for analysis
○ The intercept is the amount each good
that could be produced if all the persons
resources were put into the production
of only the good on each axis (ie if they
specialized totally in either good)
○ Specializing and trading will allow everyone to consume a better combination (combo of
meat and potatoes that makes them feel better off) outside their production
possibilities frontier
● What are the gains from trade?
○ Get yourself a better combo of things which you would not have had access to if you stayed self sufficient
○ Trade allows your to consume at a point beyond your PPF = makes you better off = this is your gain from trade
■ Not a zero sum game
● Absolute advantage
 ○ Whoever can produce more of a product in a particular period or with a unit of productive resources has an
absolute advantage in the production of that product
○ They have the highest productivity (Rose does from our previous example)
○ Does not settle the question of who should produce what
● Comparative advantage vs absolute
○ Productivity
○ Opportunity cost → ratio
○ You have an absolute advantage if you are the least cost producer (most efficient producer) in the production of
every good or service
○ You have a comparative advantage if you have the lowest opp cost in the production of a particular good or service
■ Lawyer and secretary
● In a small town, we have a lawyer who is the best, requires the services of the secretary
● Every secretary who tries fails and lawyer is fed up
● He says he can do it better than anyone = should the lawyer?
○ For every hour the lawyer takes to do the secretarial work, he loses out on a big amount
of income
○ Worth it for the lawyer to put all his time and energy into his work than spending money
on the secretary who can’t do it right
■ Lawyer should only practice law, not secretarial work
○ Products should be made by who has the lowest opp cost
■ Comparative advantage = compare each person’s opp cost in producing a particular product
■ Whoever has the lowest opp cost has a c comparative advantage in the production of that product
○ Steps to discover comparative advantages
■ 1) List the data
■ 2) Calculate the opp costs on a per unit basis (give up and get)
■ 3) Identify the lowest opp cost for each product
● Always one person will have the lowest opp cost for one product, and the other person will have
the lowest opp cost for the other product unless the other person has the exact same capabilities
(production possibilities) as you
○ There would be no gains from trade
○ In example:
■ Rose has the comparative advantage in meat, so she should specialize in meat
■ Frank has the comparative advantage in potatoes, so he should specialize in potatoes
● Frank has the lowest opportunity cost
● Rose’s productivity is higher (she has an absolute advantage when producing meat and potatoes)
○ Even if you have an absolute advantage in the production of both goods, one person will
end up with a comparative advantage in one thing / another person will have a
comparative advantage of another thing
■ Comparative advantage = you have the lower opp cost
■ Opp cost = how much you give up to get a unit of something
● The exchange rate for trade
○ Two ways to get a product: produce it yourself or produce something else that you trade away to get it
■ An exchange rate that is between the opp costs of the potential trade partners allows each person to
obtain the other product more cheaply than if they made everything him/herself
■ In previous example:
● When she is self sufficient, Rose has to forego the production of two potatoes to produce 1 unit
of meat
● Frank gives up four potatoes to produce one unit of meat
● Rose would have an incentive to trade if she could get more than two potatoes for a unit of meat
she produces
 ● Frank would have an incentive to trade if he could give up fewer than four potatoes to get a unit
of meat
■ An exchange rate for trade that lies between 2p and 4p would allow each person to have a better
opportunity cost than when they are self sufficient (eg 3p for 1m → exchange rate)
■ Could also look at this from another angle: if 3p for 1m is the exchange rate they agree upon, we can
express it as a ratio: give up 3 potatoes: get 1 meat
● This is the opportunity cost in grade for a unit of meat
● To show the opportunity cost in trade of a unit of potatoes, take the reciprocal:
○ Give up 1 meat : get 3 potatoes = give up 0.33 3 meat: get 1 potato
○ If different opp costs, room in the middle to give you a better exchange rate thru trade
○ Negotiated exchange rate is better from both points of view (they both gain)
● Again, looking at the opportunity costs:
○ Rose would have to give up 0.5 meat to produce one potato
○ Frank would have to give up 0.25 meat to produce one potato
■ Rose would trade if she could give up less than 0.5 meat that she produced in
exchange for a unit of potatoes
■ Frank would trade if he could get more than 0.25 meat for one unit of potatoes
that he produces (unfinished)
■ However you look at it, both people are better off with trade
● Slope of ppf is opportunity cost
○ On a graph, the slope of a line is rise/run or change in y/change in x
○ If meat is on the vertical axis and potatoes on the horizontal axis, then the slope is
change in meat / change in potatoes
○ The slope shows the rate at which you would have to give up meat to get potatoes -
which is the opportunity cost of getting 1 potato
● Slope = change in meat over change in potatoes = 3m / 32 p for Frank = 0.25m / 1 p, 24m / 48 p =
0.5m / 1p for Rose
○ Same value as opportunity cost
● Right now, we are looking at each person's opportunity cost for potatoes, not which person has
the lowest opportunity cost for each good
● Opportunity cost is constant for individuals
○ The ppf of a person is a straight line with a constant slope which reflects constant opportunity costs
○ This is because one person will have the same ability to produce more unit of a product regardless if they are
producing just a little or a lot of it
■ Eg when you do a part time job, you can do the same job for 3-4 hours @ the same productivity
○ When a country wants to produce more of something, it must transfer resources that are less and less productive
in the alternative field, so the opportunity cost rises and gives a country’s PPF a curved, concave shape
■ Slopes of the PFFs indicate opportunity cost ratios
■ A trading exchange rate acceptable to both Frank and Rose will lie between the slopes of their PPFS (it will
be between their opportunity costs)
● 1 p / 0.333m → acceptable to both Frank and Rose
● Remember: Frank had comparative advantage in potatoes
○ For every potato he does not produce, he is able to produce 0.25 meats in that time and
effort
○ Instead of missing out on a potato, he specializes in potatoes and trades 1 but gets more
meat (0.33 meats)
● Rose has comparative advantage in meat
○ If rose is self sufficient, to get 1 potato, she has to give up the production of 0.25 meat
○ ? what does she get tho
○ After trade, both people end up being able to consume a better combo of meat and potatoes than what was
possible when they were self sufficient
 ■ Note: usually both individuals would specialize completely in the production of the product where they
have a competitive advantage - in our example, Frank specializes completely, but Rose continues to
produce both goods but at different quantities
● Shows how trade → gains, even under different circumstances
● Eg in the real world, ppl r never half engineer half doctor
○ Frank gives 15 excess meats to Rose
○ Individuals specialize completely
○ The textbook has them agreeing to exchange 15 p for 15 m, which would be an opportunity cost with trade of 3p
for 1m or 0.33m for 1p
○ Does the exchange rate have to be 3p for 1m? No. There will be an incentive to trade as long as the trading
exchange rate is
○ How do they settle on an exact exchange rate or for trade?
■ By negating.
■ If one is an economic or political bully, he or she will try to take the most gains for him/herself, leaving the
trading partner with a very small gian, but still enough to give an incentive to trade (otherwise the bully
would not be able to gain anything)
■ Or =, if they were already overwhelmed by all the material in this chapter, they might just split it down the
middle
■ But the best answer is = markets will determine the exchange rates for trade, just as they determine most
prices for goods and services within the economy
● Opportunity cost is essentially a price
■ Getting more of both goods doesn’t always make us better of
● Question of getting access to combinations that make you better off (combos that you don't have
access to)
● Eg cat food and beef
● Point beyond your PFF is a point that you cannot produce (but not all combos beyond PPF won’t
make you better off)