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Microeconomics 1, ECON1101

Week 2
Group D
Text: Frank, Jennings, and Bernanke: Ch 2 and Ch 8 pp 204-210
Outline
Opportunity cost and specialisation
The principle of comparative advantage
Sources of comparative advantage
The production possibility curve
Factors that shift the production possibility curve
Barriers to specialisation
Production and consumption possibilities and the benefits of
trade

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Opportunity Cost and Specialisation
Specialisation as an alternative to a system in
which everyone is a jack-of-all-trades
Specialisation and exchange produce higher
productivity
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The Theory of Comparative Advantage
Economists who first considered the benefits of international trade
focused on a countrys absolute advantage.
A country (a person) has an absolute advantage in a good when it can
produce it using fewer resources than another country (person).
In 1817, however, British economist David Ricardo disagreed.
A country (a person) has a comparative advantage in producing a
good if it can produce it at a lower opportunity cost than some other
country (person).
Mutually beneficial trade between any two countries is possible
whenever one country is relatively better at producing a good than the
other country.
Being relatively better means having ability to produce a good at a
lower opportunity cost.
At a lower sacrifice of other goods foregone

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Opportunity Cost and Comparative
Advantage
Birkhaman has an absolute advantage over Aadesh in both activities.
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Opportunity costs for Birkhaman and
Aadesh?

Despite Birkhaman having absolute advantage in both
activities, he has a comparative advantage in shoe repairs
as he has a lower opportunity cost in this activity and should
specialise in shoe repairs.

Aadesh has a comparative advantage in firewood collection
as he has a lower opportunity cost in this activity and should
specialise in firewood collection.
The Gains without Specialisation
Assume:
Each has an 8-hour work day. Birkhaman divides his time between 2
activities equally.
Aadesh spend 2 hours collecting fireworks & 6 hours to repair shoes.
Assume that the people who live in the village demand a total of 16
bundles of wood per day.
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The Gains with Specialisation
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Example 2.2
How can specialisation increase the total number of shoes
repaired and bundle of wood collected by Birkhaman and
Aadesh?
Sources of Comparative Advantage
Individual
Inborn talent
Education & training
Experience
National level
The distribution of economic resources-natural-human
& capital among the nations of the world is uneven.
The efficient production of various goods and services
requires different technologies or combinations of
resources.
Cultural institutions.
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Comparative Advantage over time
Can comparative advantage change over
time?
Comparative advantage is dynamic
The process of specialisation itself helps build
comparative advantage
Comparative advantage and strategic trade
policies
E.g. Japans economic success in the 1980s and its
strategic assistance to semiconductor industry

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Illustrating Comparative Advantage
Graphically
The Production possibilities curve (PPC)
A graph that describes the maximum amount of
one good that can be produced for every possible
level of production of the other good
Assume
A Small island economy that produces only 2 goods
coffee and nuts
Has only one worker, Jara, who works 6 hrs per day &
divides her time between the 2 activities.
She can pick 2kg. of nuts OR 4kg. Of coffee in an hour.

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Jaras production possibilities

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Jaras production possibilities
Downward slope of the PPC illustrates the scarcity
principle.
Attainable point:
Any combination of goods that can be produced using
currently available resources. All points either on or
below and to the left of the PPC are attainable.
Unattainable point:
Any combination of goods that cannot be produced
using currently available resources. All points lying
above and to the right of the PPC are unattainable.

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Attainable and efficient points on Jaras
production possibilities
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Comparative advantage and
production possibilities
Inefficient point:
Any combination of goods for which currently available
resources enable an increase in the production of one
good without a reduction in the production of the other.
Any point that lies below and to the left of the PPC is
inefficient.
Efficient point:
Any combination of goods for which currently available
resources do not allow an increase in the production of
one good without a reduction in the production of the
other. Any point on the PPC is an efficient point.

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Individual productivity and the slope and
position of the PPC
To see how the slope and
position of the PPC
depend on an individual
productivity, lets compare
Jaras PPC to that of
Pengs, who is less
productive at picking
coffee but more
productive at picking nuts.
Peng can pick 4kg. Of nuts
OR 2kg. Of coffee per
hour.
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Opportunity Cost and Comparative
Advantage
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Individual production possibilities curves
compared( Different opportunity costs)
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Production without specialisation
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Production with specialisation
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Gains from specialisation
Specialising enables both Jara and Peng
to increase the total output by 8kg
To consume at a point, such as E, outside the PPC,
by exchanging goods
What give rise to gains from specialisation?
Opportunity cost differential
The gains from specialisation grow larger as
the difference in opportunity cost increases

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Production possibilities for a many-person
economy
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Law of increasing opportunity costs
The PPC is concave to the origin because
of the law of increasing opportunity costs
More and more of a good must be given up to
obtain additional units of the other good
Based on the fact that economic resources are
not completely adaptable to alternative uses;
they are imperfect substitutes
Resources lack perfect flexibility or
interchange ability

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Factors that shift the PPC
Increasing productive resources
Investment in new factories and equipment
Population growth
Improvements in knowledge and technology
Investment in education, R&D and ICT
Gains from specialisation

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Economic growth: an outward shift in the
economys PPC
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Why have some countries slow to
specialise?
Population density and geographical isolation
Laws and customs that limit the freedom to
exchange goods and services. E.g. Former East
Germany & North Korea

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Present choice and future possibilities
The PPC can be used to:
Illustrate the importance of societys choice
between current and future consumption
Demonstrate the economic basis for trade
between nations

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Economic growth in two countries

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Chapter 8
Production and consumption possibilities and the
benefits of trade

Countries have different amount of resources.
They differ in population density, labor skills, fertility, climate,
raw materials, capital equipment, etc.
These differences tend to persist because resources are
relatively IMMOBILE between countries. Thus, the ability to
supply goods & services differ between countries.
What this means is that the relative costs of producing goods
& services will vary from country to country.
It is these differences in relative costs that form the basis of
trade.

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Comparative advantage as a basis for
trade
If countries specialize according to comparative advantage, a more
efficient use of given resources occurs
That is, with the same resources, the world can produce more of
at least one good
Without decreasing production of any other good
By trading some of its comparative advantage good for the other good,
each country can consume more of both goods
As long as such benefits continue, a country can gain even greater
benefits by shifting more and more of its resources toward its
comparative advantage good
As long as opportunity costs differ, specialization and trade can be
beneficial to all involved
Remains true regardless of whether parties are different
nations, different states, or different individuals
Remains true even if one party has an all-round absolute
advantage or disadvantage

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Production possibilities curve for Brazils
many-worker economy
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PPC for a two-good economy shows the maximum amount of one
good that can be produced at every possible level of production of
the other good
Production and consumption possibilities
and the benefits of trade
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Closed economy:
An economy that does not trade with
the rest of the world

Open economy:
An economy that trades with the rest
of the world
Consumption possibilities with and without
international trade
Consumption possibilities:
The combination of goods and services that a countrys
citizens might feasibly consume
The relationship between countrys consumption possibilities
& its production possibilities depends on whether the country
is open to international trade.
In a closed economy:
A societys consumption possibilities are identical to its
production possibilities
In an open economy:
A societys consumption possibilities are typically greater
than its production possibilities

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Production possibilities curve for a many-
worker economy
Example:
Brazils 2-good economy - coffee and
computers
Two workers who work 50 weeks/year
Carlos
Can produce 100 kg of coffee/week or 1 computer
Maria
Can produce 100 kg of coffee/week or 2 computers

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Brazils consumption possibilities with
trade
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Consumption possibilities in a many-
worker economy
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Production and consumption possibilities and
the benefits of trade
Graphically, consumption possibilities for an open
economy are described by a downward line that just
touches the PPC
The slope of this line equals the amount of the good
on the vertical axis that must be traded on the
international market to obtain 1 unit of good on the
horizontal axis
A country maximises its consumption possibilities by
producing at the point where the consumption
possibilities line just touches the PPC and trade

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