Micro 1: Applications in Specialization and Trade

• One implication which arises from the modeling of scarcity is the principle of
specialization and trade.

• If the parties with comparative advantage at producing some goods will handle the
production of those goods, collectively, all parties will be able to consume more
goods than the alternative arrangement where all parties only consume the
products produced by them.

• That is, the outcome after specialization and trade will be that at least some will be
better off and no one will be worse off.

Example:
Consider two individuals (the heads of households I and II) who produce all their life
necessities by themselves. Assume that these necessities include only two types of
goods: food (F) and clothes (C). Individual I can produce, and consume, either 6 units
of clothe or 2 units of food, or any combination of these two. The second individual
(Individual II) can produce either 6 units of clothe or 6 units of food, or any
combination of these two.

Mapping out the convex combinations of those points will give us the PPF for each
household:

C C

6 6
PPF0
1
1
3

AI AII
3 3

PPF0
3 1
1 2 F 3 6 F

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• Suppose now that the two individuals chose to produce and consume at points AI
= (1, 3) and AII = (3, 3) respectively. The two individuals have organized their
households in a productively efficient manner.

• In such a situation, we call the economies are self-sufficient or Autarky. That is,
each household consumes exactly what it produces.

• The total outputs in the economy will be 6 units of cloth and 4 units of food.

• Defining Comparative Advantage as follows:

One household is said to have a comparative advantage in producing a good when

the opportunity cost of producing that good is lower than that of the other
household.

• The opportunity of producing cloth in household I is 1/3 unit of food, which is

lower that of household II. We thus say that household I has comparative
advantage in producing cloth.

• This implies that household II has comparative advantage in the production of

food since the PPFs of both economies are just straight lines (check).

• Specialization: As household I has comparative advantage in producing cloth, it

should specerlize in prodicing cloth only. As household II has comparative
advantage in producing food, it should specerlize in prodicing food only.

• If every unit of cloth consumed by both I and II are produced in household I, while
every unit of food consumed are produced at II, the total amount of food and
clothes will increase to 6 units of cloth and 6 units of food.

• Suppose that each household still carry on consuming 3 units of cloth. This means
that household II will have to buy 3 units of cloth from I.

• This is the end of Autarky, i.e., what each of them produces is no longer
necessarily what they will consume. Trade and exchange between the two
households are necessary.

• How many units of food will they be willing to give up in order to obtain those
units of cloth?

• Household I will not be willing to buy food for more than 3 units of cloth per unit
of food, because they can produce it by themselves at that price without
specialization.

• Household II will not be willing to sell food for less than 1 unit of cloth, because
this is their opportunity cost of producing food without specialization.

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• To facilitate trade and exchange, the price of a good must be less than the buyer’s
opportunity cost, but greater than the opportunity cost to the seller.

Seller’s Opportunity Cost ≤ Price ≤ Buyer’s Opportunity Cost

• In terms of the price of food, this will be,

Seller’s O.C. = 1 unit of cloth per unit of food ≤ PF ≤ Buyer’s O.C. = 3 units of
cloth per unit of food

• Suppose that the agreed price is 2 units of cloth per unit of food, this exchange
rate between cloth and food is depicted by the line with slope 2 in the following
two graphs.

• If the two households insist on consuming 3 units of cloth each, they will now be
able to consume more food (1.5 units of food compared to 1 unit of food for
household I, and 4.5 units of food compared to 3 units of food for household II).

• This shows that trade and specialization can potentially benefit both households.

More Example:
Robinson Crusoe can bake 10 loaves of bread in one hour or peel 20 potatoes. Friday
can bake 5 loaves of bread in an hour or peel 30 potatoes. If they believe in equality in
consumption, would they specialize and trade? If so, at what price will they exchange
bread for potatoes?

P P
30

1
20 6
PPF0
1
PPF1
2

15 15
PPF1

PPF0

2 6
5 10 B 5 B

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• Before specialization, the opportunity cost of baking bread for Robinson is peeling
2 units of potatoes. For Friday, it will be peeling 6 units of potatoes. Hence,
Robinson has a comparative advantage in baking bread.

This implies that Friday has a comparative advantage in peeling potatoes.

• Hence, Robinson should specialize in baking breads while Friday peeling

potatoes.

• Suppose each aims to consume the same amount of the products (equality in
consumption), the distribution would be 5 loaves of bread and 15 potatoes for
each.

• The price of a loaf of bread must be 3 potatoes and the price of a single potato is
1/3 of a loaf of bread.

• This price satisfies the required price range of:

Seller’s Opportunity Cost ≤ Price ≤ Buyer’s Opportunity Cost Hence,

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Homework

1. Two economies produce only two goods, x and y. Economy 1 can produce either
80 units of y or 20 units of x (or any linear combination of the two). Economy 2
can produce either 40 units of y or 20 units of x (or any linear combinations of the
two). Therefore, there exists no price for which economy 1 will gain from trading
with economy 2. True or false, explain.

2. Two economies produce only two goods, x and y. Economy 1 can produce either 2
billion units of y or 4 billion units of x (or any linear combination of the two).
Economy 2 can produce either 4 billion units of y or 2 billion units of x (or any
linear combinations of the two). If the international price of a unit of x is one unit
of y, and Economic 1 must have precisely 2 billion units of y, both economies will
consume the same amount of x and y as each other. True or false, explain.

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