Topic 1: Comparative Advantage and the Basis for Trade

Model:
o a simplified representation of reality

David Ricardo 1817 magic four numbers assumptions:

1) Only 2 possible activities
2) Only 2 individuals
3) No transactions costs (negotiation/transportation costs) when trading and
no trade barriers (import quotas, tariffs)

Production Possibility Curve (PPC): captures all maximum output possibilities

for 2 or more goods, given a set of inputs if inputs are used efficiently
Efficient Production Point:
o Represents a 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.
o All the points on the PPC are efficient.

Inefficient Production Point:

o Represents a combination of goods for
which currently available resources allow
an increase in the production of one good
without a reduction in the production of
the other.
o All the points below and to the left of the
PPC are inefficient
Attainable Production Point:
o Represents any combination of goods
that can be produced with the currently
available resources.
o All the points on the PPC or below and to
the left of the PPC are attainable.
Unattainable Production Point:
o Represents any combination of goods
that cannot be produced with the
currently available resources.
o All the points that lie outside of the PPC
are unattainable.
Opportunity Cost of X variable=gradient of the PPC
Opportunity Cost of Y variable=inverse gradient of the PPC
Bow (concave to the origin):

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 Topic 1: Comparative Advantage and the Basis for Trade
o Shape of PPC is the result of scarcity and implies increasing
opportunity cost.

How to construct a PPC:

1) Find the total amount of y-variable that agents can produce if they spend
all the time producing y. Mark this point.
2) Expand production of x-variable by 1 unit. The person with comparative
advantage should do it first. Continue to expand production until the
person runs out of working hours. Mark that point. Next person with
comparative advantage should produce the x-variable. Continue to expand
production until the person runs out of working hours. Mark that point.
3) Find the total amount of x-variable that agents can produce if they spend
all the time producing x. Mark this point. Connect points.

Scarcity Principle (no-free-lunch principle):

o Although we have boundless needs and wants, the resources available
to use are limited. Consequently, having more of one good thing usually
means having less of another.

Absolute advantage:
o When one can perform an activity with less resources than another
Opportunity Cost:
o The cost of the next best alternative action
Comparative Advantage:
o When one has a lower opportunity cost of performing an activity than
another
Principle of Comparative Advantage:
o Everyone is better off if each agent/country specializes in the activities
for which they have a comparative advantage
o Specialization: when one concentrates on a certain task
o Gains from specialization: additional units attained due to
specialization
The Low-Hanging Fruit Principle (Increasing Opportunity Cost):
o In expanding the production of any good, one first employs those
resources with the lowest opportunity cost and only these are
exhausted turn to resources with higher cost

Shifting PPC out relates to increasing resources (capital, labour, technology)

1) An increase in infrastructures such as factories, equipment etc
2) Increase in population, and so labour force
3) Advancements in knowledge and technology, via education, R&D, IT and
communications technologies

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 Topic 1: Comparative Advantage and the Basis for Trade
Consumption Possibility Curve (CPC): represents all possible combinations of
goods that the economy can feasibly consume when it is open to
international trade.
1) If a country is a closed economy:
PPC and CPC are identical because agents must consume whatever
they produce
2) If a country is an open economy:
CPC is to the right and above PPC because part of what the agents
produce can be traded for other goods and services, which relieves
the restrictions on consumption

*A change in the international price and preferences affect the CPC

Classic Critiques to the Model:

1) no psychological cost associated to performing the same activity the
entire day
2) no transaction costs (negotiation/transportation costs)
3) no import quotas or tariffs (would limit the gains from specialisation by
making specialisation (beyond a certain level) pointless
4) no change in preferences (needs & wants) for products in which a country
specialises in and no accounting for social norms (political, religious) that
might prevent trading

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