2. Production Possibilities The table at the left shows the number of bananas OR potatoes that Gregory and Harrold can produce. So in 8 hours, Gregory can produce ____ bananas or ____ potatoes and Harrold can produce ____ bananas or ____ potatoes. Does either person have an absolute advantage? Created by Janet Orr 2009 2
3. Production Possibilities The table at the left shows the number of bananas OR potatoes that Gregory and Harrold can produce. So in 8 hours, Gregory can produce _32_ bananas OR _16_ potatoes and Harrold can produce _24_ bananas OR _8_ potatoes. Gregory has the absolute advantage in both since he can produce more of each commodity in the same amount of time. 4 bananas/hour times 8 hours = 32 bananas Created by Janet Orr 2009 3
4. If Gregory is more productive than Harrold, why would Gregory and Harrold ever think about trading? Isn’t the little guy going to be worse off and why would the big guy even be interested? Created by Janet Orr 2009 4
5. But what about comparative advantage? A person or country has a comparative advantage when they give up less of the other good to produce the first good. To determine comparative advantage, we have to look at opportunity costs. Created by Janet Orr 2009 5
6. Opportunity Costs The table at the left shows the number of bananas OR potatoes that Gregory and Harrold can produce. Opportunity cost is what is given up of the other good when I use my resources for one good. For example, if Gregory uses one hour to pick bananas then he gets 4 bananas but foregoes the opportunity of digging 2 potatoes. Therefore the cost of 1 banana is ½ potato foregone. Gregory has the comparative advantage in potatoes while Harrold has the comparative advantage in bananas. 4 B costs 2 P so 4/4 B costs 2/4 P or 1 B costs ½ P Gregory gives up only 2 bananas to dig 1 potato while Harrold would have to give up 3 bananas to get 1 potato. Conversely, Gregory would have to give up ½ potato to get 1 banana while Harrold only has to give up 1/3 potato to get 1 banana. Created by Janet Orr 2009 6
7. Now let’s see if having a comparative advantage makes specializing and trading a good thing. Created by Janet Orr 2009 7
8. Let’s say that Gregory and Harrold each work for 8 hours and at the end of the day, Gregory has 12 bananas and 10 potatoes while Harrold has 9 bananas and 5 potatoes. If Gregory and Harrold understand the advantages of comparative advantage they will agree to specialize and trade. They specialize in the food for which they have the comparative advantage. Note that the daily production of each food has increased with specialization. Daily production when each person spends 3 hours picking bananas and 5 hours digging potatoes. Daily production when each person specializes. Created by Janet Orr 2009 8
9. The terms of trade* are 1 potato for 2 ½ banana. *explained on a following slide If Gregory wants just as many bananas as he had originally then he will trade ____ potatoes for ____ bananas, leaving him with ____ bananas and ____ potatoes. Harrold, after trading away ____ bananas for ____ potatoes will have ____ bananas and ____ potatoes. Are both parties better off with specialization and trade? Daily production when each person spends 3 hours picking bananas and 5 hours digging potatoes. Daily production when each person specializes. Created by Janet Orr 2009 9
10. The terms of trade are 1 potato for 2 ½ banana.* explained on next slide If Gregory wants just as many potatoes as he had originally, then he will trade _6_ potatoes for _15_ bananas, leaving him with _15_ bananas and _10_ potatoes. Harrold, after trading away _15_ bananas for _6__ potatoes will have _9_ bananas and _6__ potatoes. Both parties are better off with specialization and trade! Gregory has 3 extra bananas and Harrold has 1 extra potato. Daily production when each person spends 3 hours picking bananas and 5 hours digging potatoes. Daily production when each person specializes. Daily food allotment when each person specializes and trades. Created by Janet Orr 2009 10
11. Terms of Trade The terms of trade will always be somewhere between the costs for the two parties. In this case, the costs are 1 potato for between 2 and 3 bananas. In order to get a potato, Harrold would have to give up 3 bananas. If he can get a potato for anything less than 3 bananas, then he will be agreeable. If Gregory can give up 1 potato and get more than 2 bananas for it, then he will be agreeable. Terms of trade are usually set by negotiation and can be more favorable to one side or the other depending on knowledge and bargaining skills. Created by Janet Orr 2009 11
12. Conclusion Specialization and trade makes both parties better off as long as a comparative advantage exists. The point of these exercises is for you to prove this point for yourself! Specialization and trade improve world-wide production. Economists say that specialization and trade improve efficiency. In other words, we get more production from the same amount of resources. Created by Janet Orr 2009 12
