TRADE-OFFS AND TRADE

FALL 2013

Comparative Advantage

Production Possibilities for Two Castaways(a) Tom’s Production Possibilities

28 400

30

9

Qu

anti

ty o

f co

conu

ts

Quantity of fish

Production Possibilities for Two Castaways

1060

20

8

Hank’sPPF

Qu

anti

ty o

f co

conu

ts

Quantity of fish

(a) Hank’s Production Possibilities

Tom and Hank’s Opportunity Costs

Tom’s Opportunity Cost

Hank’s Opportunity Cost

One fish 3/4 coconut 2 coconuts

One coconut 4/3 fish 1/2 fish

Specialize and Trade

Both castaways are better off when they each specialize in what they are good at and trade.

This is true of countries as well – and it is related to the concept of comparative advantage.

How the Castaways Gain from Trade

Comparative Advantage and Gains from Trade

28 400

30

910

1060

20

810

(a) Tom’s Production and Consumption

Tom’s consumption without trade

30

Tom'sPPF

Hank'sPPF

Quantity of coconuts Quantity of coconuts

Quantity of fishQuantity of fish

Tom’s consumption with trade

Tom’s production with trade

(b) Hank’s Production and Consumption

Hank’s production with trade

Hank’s consumption with trade

Hank’s consumption without trade

II. Absolute vs. Comparative Advantage

Absolute advantage: Greater total outputComparative Advantage: Opportunity cost for

producing something is lower for one person (or country) than the other.

III. The Circular-Flow Diagram

Model that represents the transactions in an economy by flows around a circle.

The Circular-Flow Diagram

Money

FactorsGoods

andservices

Factors

Households

Firms

Markets for goods and services

Factor Markets

Goodsand

services

Money Money

Money