● Why do people specialize and trade?

○ Comparative advantage is the name of the economic theory that explains how trade makes everyone better off, and
why impeding trade is not a good idea
● Tradeoffs
○ Getting something means giving up something else
● Opportunity cost → what you give up to get something
○ These are the explicit expenditures plus implicit value - out of pocket money - of the next best alternative you had to
do without
● Gains from trade
○ Instead of trying to make everything you need yourself, you will be better off specializing in what you’re really
good at doing, and trade some of it for things that other people are better at making than you
● Self sufficiency keeps you down
○ Imagine if you made all your clothes, grew your food, build your own shelter with all the components you
harvested or made yourself → mess
○ No iphones, clothes, music or video downloads that contribute to a “good life”
● Specialize in the things you are best at, eg economist, engineer, doctor, throughout your entire career
○ Producing labour services - earn money from your career which is an immediate holding tank that allows you to earn
purchasing power from your work and then use that power to get the other things that you want that other people can
make better than you (macro)
● Specialize in trade
○ Use the money you earn to buy yourself all the cool things that other people make well in order to have a high
quality of life (already do this - free trade)
● How do I know what to specialize in?
○ Compare your opportunity costs with the opportunity costs of potential trading partners = what we mean when we
say “specialize in the thing you are best at”
○ Lowest opp cost - the thing you should specialize in
○ How to calculate it
■ What you have to give up to get a unit of something (ratio): give up / get (fraction eg money and food
○ How do I know how much I have to give up?
■ Need facts and data about what you are capable of producing
■ Then do some calculations
● Your production possibilities
○ The data or facts about how much of each good or service you could produce per period or with a unit of productive
resources are known as your production possibilities = can be shown in a table or on a graph
■ Eg Production Opportunities for Meat or Potatoes produced by Frank and Rose
○ Specializing and trading will allow everyone to consume a better combination (combo of meat and potatoes that
makes them feel better off) outside their production possibilities frontier
● What are the gains from trade?
○ The reason is to get yourself a better combination of meat and potatoes, which you would not have access to if you
stayed self sufficient
○ Both trading partners become better off, one does not gain at the expense of the other
■ Trade allows you to consume at a point beyond your PPF, which makes you better off → your gain from
trade
■ Not a zero sum game
● Absolute advantage
○ Whoever can produce more of a product in a particular period or with a unit of productive resources has an absolute
advantage in the production of that product
○ They have the highest productivity (Rose does from our previous example)
○ Each product should be produced by the person with the lowest opportunity cost
● Comparative advantage
○ Compare each person’s opportunity cost in producing a particular product
○ Whoever has the lowest opportunity cost has a comparative advantage in the production of that product
● Steps to discovering comparative advantages
 ○ Step 1: List the data
○ Step 2: Calculate the opportunity costs on a “per unit” basis
○ Step 3: Identify the lowest opportunity cost for each product
■ * One person will always have the lowest opportunity cost for one product, and the other person will have
the lowest opportunity cost for the other product
■ * Unless the other person has the exact same capabilities / production possibilities as you, which is
extremely unlikely; this would be the only time when there would be no gains from trade
■ In example:
● Rose has the comparative advantage in meat, so she should specialize in meat
● Frank has the comparative advantage in potatoes, so he should specialize in potatoes
○ Rose’s productivity is higher (she has an absolute advantage when producing meat and
potatoes)
■ Even if you have an absolute advantage in the production of both goods, one
person will end up with a comparative advantage in one thing / another person
will have a comparative advantage of another thing
● Comparative advantage = you have the lower opp cost
● Opp cost = how much you give up to get a unit of something
● Comparative advantage vs absolute advantage
○ Productivity
○ Opportunity cost → ratio
○ You have an absolute advantage if you are the least cost producer (most efficient producer) in the production of
every good or service
○ You have a comparative advantage if you have the lowest opp cost in the production of a particular good or service
■ Lawyer and secretary
● In a small town, we have a lawyer who is the best, requires the services of the secretary
● Every secretary who tries fails and lawyer is fed up
● He says he can do it better than anyone = should the lawyer?
○ For every hour the lawyer takes to do the secretarial work, he loses out on a big amount
of income
○ Worth it for the lawyer to put all his time and energy into his work than spending money
on the secretary who can’t do it right
■ Lawyer should only practice law, not secretarial work
○ Products should be made by who has the lowest opp cost
■ Comparative advantage = compare each person’s opp cost in producing a particular product
■ Whoever has the lowest opp cost has a c comparative advantage in the production of that product
● The exchange rate for trade
○ Two ways to get a product: produce it yourself or produce something else that you trade away to get it
■ An exchange rate that is between the opp costs of the potential trade partners allows each person to obtain
the other product more cheaply than if they made everything him/herself
● Opportunity cost is constant for individuals
○ The ppf of a person is a straight line with a constant slope which reflects constant opportunity costs
○ This is because one person will have the same ability to produce more unit of a product regardless if they are
producing just a little or a lot of it
■ Eg when you do a part time job, you can do the same job for 3-4 hours @ the same productivity
○ When a country wants to produce more of something, it must transfer resources that are less and less productive in
the alternative field, so the opportunity cost rises and gives a country’s PPF a curved, concave shape
■ Slopes of the PFFs indicate opportunity cost ratios
■ A trading exchange rate acceptable to both Frank and Rose will lie between the slopes of their PPFS (it will
be between their opportunity costs)
○ After trade, both people end up being able to consume a better combo of meat and potatoes than what was possible
when they were self sufficient
■ Note: usually both individuals would specialize completely in the production of the product where they
have a competitive advantage - in our example, Frank specializes completely, but Rose continues to
produce both goods but at different quantities
 ● Shows how trade → gains, even under different circumstances
● Eg in the real world, ppl r never half engineer half doctor
○ How do they settle on an exact exchange rate or for trade?
■ By negotiating.
■ If one is an economic or political bully, he or she will try to take the most gains for him/herself, leaving the
trading partner with a very small gain, but still enough to give an incentive to trade (otherwise the bully
would not be able to gain anything)
■ But the best answer is = markets will determine the exchange rates for trade, just as they determine most
prices for goods and services within the economy
● Opportunity cost is essentially a price
■ Getting more of both goods doesn’t always make us better of
● Question of getting access to combinations that make you better off (combos that you don't have
access to)
● Eg cat food and beef; to be better off you’d eat more beef and less cat food
● Point beyond your PFF is a point that you cannot produce (but not all combos beyond PPF won’t
make you better off)