TOPIC 3

• Economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members
• Trade expands the set of consumption opportunities
• Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity
• Consider your typical day: You wake up to an alarm clock made in Korea. You pour yourself orange juice made from Florida oranges and coffee from beans grown in Brazil. You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand. You watch the morning news broadcast from New York on your TV made in Japan. You drive to class in a car made of parts manufactured in a half-dozen different countries.
• In a global economy, we can satisfy our wants and needs by being economically self-sufficient or by specializing and trading with others, leading to economic interdependence
• Without trade, economic gains are diminished
• Interdependence occurs because people are better off when they specialize and trade with others. Patterns of production and trade are based upon differences in opportunity costs
• Differences in Costs of Production

  Two ways to measure differences in costs of production: the number of hours required to produce a unit of output and the opportunity cost of sacrificing one good for another
• The Rancher has an absolute advantage in the production of both meat and potatoes
• Who can produce potatoes at a lower cost--the farmer or the rancher?
• Comparative Advantage and Trade: The Rancher’s opportunity cost of an ounce of potatoes is ¼ an ounce of meat, whereas the Farmer’s opportunity cost of an ounce of potatoes is ½ an ounce of meat. The Rancher’s opportunity cost of a pound of meat is only 4 ounces of potatoes, while the Farmer’s opportunity cost of an ounce of meat is only 2 ounces of potatoes
• Principle of Comparative Advantage


  Differences in the costs of production determine who should produce what and how much should be traded for each product
• Absolute Advantage


  The comparison among producers of a good according to their productivity. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good
• Each the Farmer and the Rancher would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other
• Opportunity Cost and Comparative Advantage

  Compares producers of a good according to their opportunity cost. The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good
• Speaker: '...so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes'
• Farmer's opportunity cost of an ounce of potatoes

  1/2 an ounce of meat
• Benefits of Trade

  • Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage
• David Ricardo developed the principle of comparative advantage in his 1816 book Principles of Political Economy and Taxation
• The person with a smaller opportunity cost has a comparative advantage
• Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services
• Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage
• Imports are goods produced abroad and sold domestically
• Comparative Advantage and Trade

  • Comparative advantage and differences in opportunity costs are the basis for specialized production and trade
  • Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade
• Rancher's opportunity cost of a pound of meat

  4 ounces of potatoes
• Rancher's opportunity cost of an ounce of meat


  2 ounces of potatoes
• Exports are goods produced domestically and sold abroad
• Adam Smith performed a detailed analysis of trade and economic interdependence in his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations
• International trade can make some individuals worse off, even as it makes the country as a whole better off
• The person who can produce a good with a smaller quantity of inputs has an absolute advantage
• The gains from trade are based on comparative advantage, not absolute advantage
• The principle of comparative advantage applies to countries as well as people