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Lecture 2 Part 1

The document discusses the concepts of comparative advantage and market exchange, emphasizing the importance of specialization and trade. It introduces the Production Possibilities Frontier (PPF) as a graphical representation of maximum production capabilities and highlights the role of opportunity costs in determining comparative advantage. Additionally, it covers the significance of free markets and property rights in facilitating efficient trade and production.

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Connor Soares
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5 views

Lecture 2 Part 1

The document discusses the concepts of comparative advantage and market exchange, emphasizing the importance of specialization and trade. It introduces the Production Possibilities Frontier (PPF) as a graphical representation of maximum production capabilities and highlights the role of opportunity costs in determining comparative advantage. Additionally, it covers the significance of free markets and property rights in facilitating efficient trade and production.

Uploaded by

Connor Soares
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Lecture 2, Part 1

Comparative Advantage

Readings: Chapter 1, pp 32-41


Market Exchange
Daniel Kahneman
◦ Mutually beneficial exchange
i time spent studying hours
◦ Specialisation and Trade
iit feedback
stable and reliable
Environment
Market Exchange
◦ Why specialisation and trade?

◦ Key Ideas

1. Production Possibilities Frontier (PPF)

2. Comparative Advantage
Production Possibilities Frontier

Graphing the production possibility frontier


◦ A curve showing the maximum attainable
combinations of two products that may be
produced with available resources.
◦ Note that resources are fixed
Production Possibilities Frontier
The idea of PPF applies at the level of

◦ Individual
◦ Company
◦ Nation
◦ World
Tesla’s PPF
Tesla’s PPF
PPF of an economy
Production Possibilities Frontier
Increasing marginal opportunity costs

◦ The bowed-out shape of the production possibility


frontier illustrates the concept of increasing marginal
opportunity costs.

The more resources already devoted to an activity, the smaller the


payoff to devoting additional resources to that activity.
PPF and Economic Growth
Economic growth

o Economic growth: The expansion of society’s production


potential.

o Economic growth can be illustrated using the production


possibility frontier.
PPF and Economic Growth
Comparative Advantage and Trade
o We can use the PPF and the concept of opportunity cost to
explain the economic gains from specialisation and trade.

9
o We use a simple example of two people—Alice and Bob

o And two goods, apples and cherries, measured in kilograms


(kgs).
C more resources

higher productivity
Comparative Advantage and Trade
Comparative Advantage and Trade

Alice Bob
apples cherries apples cherries
Athtainppffes Go 0 20

All time
0 20 O 20
in cherries
No trade
Alice Bob
over over

z Zo

g 7
60 Apples 20
Apples
No trade
Alice Bob
over owner

20 Zo

lo lo
7 7
30 60Apples to Apples
Specialisation and trade
Alice Bob
omen owner

20 Zo
lo lo

30 607Apples to 7
Apples

Apples 301 10 90
Cherries lo t 10 20
Specialisation and trade
Alice Bob
over
daresay
za Zo

7 7
60 Apples 20
Apples
Specialisation and trade
Alice Bob
cwur genre

za Zo

7 7
60Apples Apples

Apples 60
Cherries 20
Absolute and Comparative Advantage

o
Alice TRADE agrees
Absolute advantage: The ability Bob firm or
of an individual,
country to produce more of a gooda or service than
competitors usingapples
the same amount of resources.
w
o Comparative advantage: The ability of an individual, firm,
q iei.TO
or country to produce a good or service at a lower
30 Yo cost than other producers. to
opportunity Apples

to apples reapples
lo cherries lo cherries
Comparative Advantage and Trade
Absolute and Comparative Advantage

o
opportunity cost
The basis for trade is comparative advantage, not absolute
advantage.
Alice Bob
omen
o Individuals, firms,aemen
or countries are better off if they specialise
in producing goods and services for which they have a
comparative advantage and obtain other desirable goods and
7 by3trading.
go services a 1 1
10 10
7 7
30 60Apples to Apples
The Market System

o Market: A group of buyers and sellers of a good or service and


the institution or arrangement by which they come together
to trade.

o Product markets: Markets for goods, such as computers, and


services, such as medical treatment.

o Factor markets: Markets for the factors of production, such as


labour, capital, natural resources, and entrepreneurial ability.
Free Market

o Free market: A market with few government restrictions on


how a good or service can be produced or sold, or on how a
factor of production can be employed.

o Adam Smith argued the benefits of a free market system in


his famous book:

An Inquiry into the Nature and Causes of the Wealth of


Nations (published in 1776).
Free Market

o Smith assumed individuals act in a rational, self-interested


way.

o If not restricted by government, then firms would be led by


the invisible hand of the market to provide consumers with
what they wanted.
Free Market
The market coordinates the activities of the many people and companies around the world who
contribute to the making of a ‘simple’ pencil.
─ Growing the cedar wood (California and Oregon)
─ Producing the equipment needed to harvest the wood
─ Harvesting the wood, transporting the logs
─ Cutting the logs into thin slices
─ Lacquer
─ Mining the graphite (Sri Lanka)
─ Clay (Mississippi River)
─ Wax (Mexico)
─ Rubber (Dutch East Indies)
─ Pumice (Italy)
The legal basis of a successful market
o Property rights: The rights individuals or firms have to the
exclusive use of their property, including the right to buy or sell it.

o To enforce contracts and property rights there must be an


independent court system with impartial judges.

o Production will fall if property rights are not well enforced—a


move to a point inside the PPF.

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