Name ______________________________________________ LECTURE NOTES

Principles of Microeconomics Dr. Sauer

Chapter 3: Interdependence and Gains from Trade In England, it takes 100 minutes to produce a bottle of wine and 120 minutes to produce a bolt of cloth. In Portugal, it takes 80 minutes to produce a bottle of wine and 90 minutes to produce a bold of cloth. Consider a 10 hour work day. Complete the table with each countrys maximum output of each good. bottles of wine England Portugal England: If it devotes the entire 10 hours to wine, it can produce If it devotes the entire 10 hours to cloth, it can produce bolts of cloth

Portugal: If it devotes the entire 10 hours to wine, it can produce If it devotes the entire 10 hours to cloth, it can produce

In 10 hours, _____________ can produce more wine. Economists would say that Portugal has ______________________ advantage in producing wine. Absolute advantage is the ability to produce - ________ of a good than another producer, with a given amount of resources or - the good at the ________________________________ In 10 hours, _______________ can produce more cloth, so wed say it has absolute advantage in cloth. Given the information in the table above, on the axis below plot each nations PPF. Be sure to label each axis. England Portugal

Suppose that each is self-sufficient. That is, each nation produces both wine and cloth without trading. Suppose that England chooses to produce 3 bottles of wine and 2.5 bolds of cloth. Confirm that this production takes 10 hours.

Suppose that Portugal chooses to produce 3 bottles of wine and 4 bolts of cloth. Confirm that this production takes 10 hours.

Illustrate eachs choice on their PPF above.

Suppose now the two decide to specialize in the production of one good and trade with the other country. What task should each specialize in? Well look at ___________________________________ to find out. We dont have money in this example. Englands total cost of one bottle of wine is the cloth it forgoes making during that time. Portugals opportunity cost of one bottle of wine is the cloth it forgoes making during that time.

England:

opportunity cost of producing 1 bottle of wine =

Portugal:

opportunity cost of producing 1 bottle of wine =

_____________ gives up fewer bolts of cloth while producing wine.

England gives up ___________________________________ while making wine than Portugal does. England has a _____________________ opportunity cost of making wine than Portugal does. Economists would say England has ________________________________ in producing cloth. Comparative advantage is the ability to produce at the lowest __________________________ cost. 2

England:

opportunity cost of producing 1 bolt of cloth =

Portugal:

opportunity cost of producing 1 bolt of cloth =

________________ gives up fewer bottles of wine while making cloth. ________________ has comparative advantage in making cloth.

So what if they each specialized in the production of the good that they had comparative advantage in and then traded? _______________ would specialize in wine and _______________ would specialize in cloth. The two of them would need to _______________ a rate to trade edited pages for typed words. The trade price Englands cost of 1 bottle of wine is 0.83 bolts of cloth. It would be willing to part with a bottle of wine for _____________________ bolts of cloth. - ____________________ price for a bottle of wine is 0.83 bolts of cloth Portugals cost of 1 bottle of wine is 0.89 bolts of cloth. It would be willing to pay _________________________ bolts of cloth for 1 bottle of wine. - ____________________ price for a bottle of wine is 0.89 bolts of cloth The price of a bottle of wine will be _______________________________ bolts of cloth. The price of a bolt of cloth will be between ______________________________________________. (The trade price of good A will be between each partys opportunity cost in terms of good B.)

Suppose that they agree to a price of 1.15 bottles of wine for 1 bolt of cloth. Plot each nations consumption possibilities on your original graphs. Englands consumption - could keep all 6 bottles of wine for self If it traded away all 6 bottles, how much cloth could it get?

With specialization and trade, England can end up with more wine and cloth than if it did not trade. Trade makes England better off. 3

Portugals consumption - could keep all 6.67 bolts of cloth If it traded away all 6.67 bolts, how much wine could it get in return?

With specialization and trade, Portugal can end up with more cloth and wine than if it were selfsufficient. Trade makes Portugal better off.

In general with specialization and trade, ____________________________ can be made better off. What do we mean by better off? consumption possibilities > consumption possibilities with trade with no trade

Historical Economic Theory Adam Smith (1776) An Inquiry Into the Nature and Causes of the Wealth of Nations ~ never attempt to make at home what will cost more to make than buy - absolute advantage David Ricardo (1817) Principles of Political Economy and Taxation ~ developed the principle of comparative advantage