2 THE ECONOMIC PROBLEM

Part 2
Plan

• Previous Class • Absolute and comparative

• PPF advantage
• PPF and OC • The Principle of Comparative
• PPF and MB Advantage
• Productive efficiency and • Shifts in Production Possibility
allocative efficiency
Comparative and Absolute
Advantage
 Gains from Trade

Comparative Advantage Absolute Advantage

. A person has a comparative
advantage in an activity if that person A person has an absolute
can perform the activity at a lower advantage if that person is
opportunity cost than anyone else more productive than others.

Absolute advantage involves comparing

productivities while comparative
advantage involves comparing opportunity
costs.

© 2019 Pearson Education Ltd.

Absolute
advantage
▪ one person has an absolute
advantage over another if he or
she takes fewer hours to perform
a task than the other person
▪ Or if he produce more in a given
amount of time
1. Comparative
advantage

one person has a

comparative advantage
over another if his or her
opportunity cost of
performing a task is lower
than the other person’s
opportunity cost
The Principle of Comparative
Advantage
The Principle of Comparative Advantage

The Principle of Comparative Advantage

Everyone does best when each concentrates
on the activity with the lowest opportunity cost
Comparative Advantage
Comparative advantage and
Production Possibilities
• Comparative advantage leads to
• Specialization and exchange of goods (trade)
• Increase in productivity
Comparative Advantage Example
Production Times Web Update Bike Repair
Ayden 20 minutes 10 minutes
Ghadah 30 minutes 30 minutes

◼Ayden and Ghadah can each update web pages and

repair bikes but Ayden has an absolute advantage in
both
▪ Because it takes Ayden less time to perform each task. For
comparative advantage we need to compare OC.
• In an 8 hour day, we can translate this into quantities
Production Output Web Update Bike Repair
Ayden 24 48
Ghadah 16 16
Comparative Advantage Example
Production Output Web Update Bike Repair
Ayden 24 48
Ghadah 16 16
For Ayden: To produce one unit of Web how many units of bike can not be produced 2
For Ayden: To repair one bike how many units of web can not be produced 0.5
For Ghada : To produce one unit of Web how many units of bike can not be produced 1
For Ghada : To repair one bike how many units of web can not be produced 1

Production Output
Opportunity Cost OC
WebWeb Update
Update OCBike
Bike Repair
Repair
Ayden 2 0.5
Ayden 2 repairs 0.5 update
Ghadah 1 1
Ghadah 1 repair 1 update
 Two Cases

• Output Without • Output With

Specialization Specialization
  No Specialization case
Production
 Assume both spend half of 8 hours Output Web Update Bike Repair total
 of working on production of Ayden 12 24 36
Ghadah 8 8 16
 each service
total 20 32 52

 With Specialization case Production Web Update Bike Repair

 Each will produce the good with
Output
lowest OC Ayden 0 48 48
Ghadah 16 0 16
 In 8 hours Ghadah will produce 16
64
web updates
 In 8 hours Ayden will repair 48 bike Result :Comparative advantage leads to
Increase in productivity
 Total Production = 64
Example 2: Gain From Trade

◼Hypothetical Economy
◼Two people
◼Two goods: coffee and Peanutsnuts
➢Work 6 hours per day
Example 2: Gain From Trade
Fatima’s
Production 24 A

Coffee (kg/day)
poassibilities Coffee Peanuts
16 B
A 24 0
B 16 4 C
8
C 8 8
D
D 0 12 4 8 12
peanuts (kg/day)
Kamal
production 12 A
Possibilitie Coffee PeanutsN

Coffee (kg/day)
B
s uts 8
D 0 24 C
4
C 4 16
D
B 8 8
8 16 24
A 12 0 peanuts (kg/day)
 ◼Two goods: coffee and nuts
➢Work 6 hours per day

Fatima’s PPF A Kamal PPF

24 A 12 24
Fatima’s PPC

Coffee (kg/day)
Coffee (kg/day)
Coffee (kg/day)

B
16 B 8
C 12
4
8 C Kamal’s
D PPC
D
8 16 24
4 8 12 12 24
Peanuts
Peanuts (kg/day) peanuts (kg/day)
(kg/day)

 Fatima’s Opportunity ◼ Kamal's opportunity cost of

cost of 1 coffee is ½ nut 1 coffee is 2 Peanuts Production OC Coffee OCpeanuts
◼ opportunity cost of ◼ His opportunity cost of Output
1 Peanut is 2 coffee 1 nut is ½ coffee Fatima ½ Peanuts 2 Coffee
Kamal 2 PeaNuts ½ Coffee
Gains from Specialization and Trade
Without trade, each person's consumption is lower

▪ Preferred diet is half nuts,

half coffee
24
• No trade: 8 kg of coffee
Coffee (kg/day)

and 8 kg of Peanuts
• Total output is 32
pounds
12
88 Productio Coffee Peanuts
8 n Output
Fatima 8 8 16
8 12 24 Kamal 8 8 16
Peanuts (kg/day)
total 16 16 32
 Gains from Specialization and Trade
With trade, each person's consumption can be greater than without
specialization case

Productio OC Coffee OCPeanuts Productio Coffee Peanuts

n Output n Output
Fatima ½ Peanuts 2 Coffee Fatima 24 0 24
Kamal 2 Peanuts ½ Coffee Kamal 0 24 24
total 24 24 48
8
Productio Coffee Peanuts Productio Coffee Peanuts
n Output n Output
Fatima +4 +4 24 Fatima 12 12 24
8
Kamal +4 +4 24 Kamal 12 12 24
totql 24 24 48 totql 24 24 48
Gains from Specialization and Trade
With trade, each person's consumption can be greater

Fatima and
24
Kamal
exchange
Coffee (kg/day)

12 peanuts, 12
coffee
12
88

8 12 24
Peanuts (kg/day)
Economic Growth
and Shifts in PPC
Economic Growth
• The Cost of Economic Growth
• To use resources in R&D and to produce new capital,
we must decrease our production of consumption
goods and services.
• So economic growth is not free.
• The opportunity cost of economic growth is less
current consumption.
 The Dynamic Economy
• What shifts the PPC?
• A PPC represents current choices Neutral Technical
• Changes in choices occur over time due to Change

• Increase in resources

Cola
• Investment in capital
• Population growth Pizza
• Increase in land
• Improvements in technology cause an
• Increase in productivity of resources
• Increases in knowledge
Shifts in PPC

Neutral Technical
Change Technical Change
in cola
Cola

Cola
Pizza Pizza

Technical Change
in pizza

Cola
Pizza
Absolute and Comparative Advantage

 Who has the absolute Advantage for producing ketchup

In 12 hours  Who has the absolute Advantage for producing Mustard

Ketchup Mustard  What is the Opportunity cost for bob to produce ketchup

 What is the Opportunity cost for bob to produce Mustard

Bob 6 Bottles 3 Bottles  What is the Opportunity cost for Tom to produce ketchup

 What is the Opportunity cost for Tom to produce Mustard

Tom 12 Bottles 4 Bottles
 Who has Comparative advantage in producing ketchup?

 Who has Comparative advantage in producing ketchup?