Economics 1 Notes on Comparative Advantage Supply and Demand 2 A Linear Production Model The linear production model assumes that the possible outputs

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1 Economics 1 Notes on Comparative Advantage Supply and Demand 1 Some Questions about Free Trade If two individuals or two nations with diering production skills trade, who gains and who loses? If one individual is better at producing every good than another is it possible for them both to gain by trade? individual, If two goods are produced, how can we predict which type of individual will produce each good?

2 Economics 1 Notes on Comparative Advantage Supply and Demand 2 A Linear Production Model The linear production model assumes that the possible outputs two goods (say sh and bread) a linear equation of the form: of cff + cbb = H F and B are outputs of sh and bread and cf and cb are where number of hours of labor used to produce sh and bread. the Example In Richland it takes 1 hour to catch a sh and 3/2 hours to { a loaf of bread. To catch F sh and make B units of make will take F + (3=2)B hours. A Richlander who has 20 bread to spend catching sh and making bread can produce hours (non-negative) combination of sh F and bread B such any F + (3=2)B = 20. that

3 Economics 1 Notes on Comparative Advantage Supply and Demand 3 Some Denitions Productivity{A worker's productivity for any good is the of units that the worker can produce in one hour. number Absolute Advantage{Worker 1 has absolute advantage over 2 in the production of a good if Worker 1's Worker for that good is higher than Worker 2's. productivity Comparative Advantage{Where there are 2 goods, A and Worker 1 has comparative advantage over worker 2 in B, A if the ratio of Worker 1's productivity in producing A to Worker 1's productivity in producing B exceeds producing the corresponding ratio for Worker 2. Constant Returns to Scale There are constant returns to if doubling the amount of inputs exactly doubles output. scale

4 Economics 1 Notes on Comparative Advantage Supply and Demand 4 The Eects of Trade Even if Worker 1 has absolute advantage over Worker 2 in good, it is impossible for Worker 1 to have comparative every advantage in every good. Trade between two individuals with dierent comparative advantages benets both traders. With free trade, specialization is according to comparative advantage With constant returns to scale there are no gains to trade people with identical tastes and technologies. between

5 Economics 1 Notes on Comparative Advantage Supply and Demand 5 Production Possibility Sets A production possibility set diagram shows alternative of sh and bread that are possible for an combinations individual or for an economy to produce. Combinations that involve no waste are on the "upper right" of the production possibility set. These points are boundary known as the production possibility frontier. With the linear production model, the production possibility is given by a straight line with equation of the form frontier cff + cbb = H: Positive outputs below this line could be achieved by wasting goods.

6 Economics 1 Notes on Comparative Advantage Supply and Demand 6 Richlanders in Our Experiment In our experiment, it took Richlanders 1 hour to catch a sh and 1.5 hours to make a loaf of bread. Richlanders had a total of 20 hours to allocate between shcatching and breadmaking. To catch F sh and make B loaves of bread takes a Richlander F + 1:5B hours. Therefore a Richlander's production possibility set includes all (non-negative) combinations F and B of sh and bread the such that F + 1:5B 20:

7 Economics 1 Notes on Comparative Advantage Supply and Demand 7 A Richlander's Production Possibility Set A B Units of Bread Units of Fish

8 Economics 1 Notes on Comparative Advantage Supply and Demand 8 Poorlanders in Our Experiment In our experiment, it took Poorlanders 3 hours to catch a sh and 2 hours to make a loaf of bread. Poorlanders had a total of 20 hours to allocate between shcatching and breadmaking. To catch F sh and make B loaves of bread takes a Poorlander 3F + 2B hours. Therefore a Poorlander's production possibility set includes all (non-negative) combinations F and B of sh and bread the such that 3F + 2B 20:

9 Economics 1 Notes on Comparative Advantage Supply and Demand 9 A Poorlander's Production Possibility Set Units of Bread Units of Fish

10 Economics 1 Notes on Comparative Advantage Supply and Demand 10 Measuring Comparative Advantage Poorlanders productivity in bread production is 1/2 unit of per hour and in sh production is 1/3 sh per hour. The bread of their productivity in bread to their productivity in sh ratio = 3 2. is Richlanders productivity in bread production is 2/3 unit of per hour and in sh production is 1 sh per hour. The bread of their productivity in bread to their productivity in sh ratio = 2 3, is We see that although Richlander's are more productive in both and bread than Poorlanders, Poorlanders have comparative sh advantage in bread. (And Richlanders have comparative advantage in wine.)

11 Economics 1 Notes on Comparative Advantage Supply and Demand 11 National Production Possibility Sets A national production possibility set shows all of the of output that are possible in total for a nation. combinations In our example, suppose that Richland had 10 people and Poorland had 20 people. Since everybody in Richland is the same and there are 10 in Richland, the national production possibility set for people will be like the individual production possibility set Richland that everything is multiplied by 10. except Since everybody in Poorland is the same and there are 20 the national production possibility set is like the people, production possibility set except that everything is individual by 20. multiplied

12 Economics 1 Notes on Comparative Advantage Supply and Demand 12 Richland's National Production Possibility Set Units of Bread Units of Fish

13 Economics 1 Notes on Comparative Advantage Supply and Demand 13 Poorland's National Production Possibility Set Units of Bread Units of Fish

14 Economics 1 Notes on Comparative Advantage Supply and Demand 14 The International Production Possibility Set The international production possibility set shows all of the of output that are possible for the two countries combinations in total. Top construct this set, we must think about how individuals specialize. If everybody in both countries specialized in sh, total output sh would be = 200 from Richlanders plus of = from Poorlanders, or a total of This 20 us point A on the graph. gives If everybody specialized in bread, total output of bread would ( ) + (20 10) = This gives us point B on the be graph.

15 Economics 1 Notes on Comparative Advantage Supply and Demand 15 If Richlanders all specialized in sh, and Poorlanders all in bread, total output of sh would be specialized 20 = 200 and total output of bread would be = 200. This gives us point C on the graph. 20 Points on the line segment AC are achieved by having all specialize in bread and varying the proportions of Poorlanders and sh produced by Richlanders. Points on BC are bread by having Richlanders specialize in sh and varying achieved the proportions of bread and sh produced by Poorlanders. If Richlanders all specialized in bread and Poorlanders in sh, output of bread would be = and output of the would be = 2 3. This is point D on the graph. sh that D is not on the production possibility frontier. Notice

16 Economics 1 Notes on Comparative Advantage Supply and Demand 16 International Production Possibility Set A D 0 B C Units of Bread Units of Fish

17 Economics 1 Notes on Comparative Advantage Supply and Demand 17 Competitive Equilibrium with Trade Competitive prices equalize total supply and demand for each good. Where there are just two goods, competitive supply and depend on the relative prices of these goods. demand In this special example, demanders always want equal amounts of sh and bread. In international competition for this example, supply will equal if all of the Richlanders produce sh and all of the demand produce bread. This will happen at prices such Poorlanders the ratio or the price of sh to the price of bread is that between 2/3 and 3/2.