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Quentin Metsys, Moneychanger and his Wife, 1514 Economics 14

Lecture 12 - Gains from Trade

absolute and comparative advantage
production possibilities frontier
gains from trade

Absolute and Comparative Advantage

In Friday's experiment, both Richlanders and Poorlanders had 20 hours to devote to fishing and baking gread. It takes a Richlander 1 hour to catch a fish and 1 1/2 hours to bake a loaf of bread. For Poorlanders, it takes 3 hours to catch a fish and 2 hours to bake a loaf of bread.

the number of units produced per hour

In Richland, 1 fish can be produced in an hour and 2/3 of a loaf of bread can be produced per hour. In Poorland, fish productivity is 1/3 per hour and bread productivity is 1/2 per hour. Richland is more productive in producing both fish and bread.

absolute advantage
higher productivity in producing that good
comparative advantage
ratio of productivity in good A to good B is greater

Richland has an absolute advantage in producing both goods.

Productivity Ratios
Richland1/(2/3) = 3/2(2/3)/1 = 2/3
Poorland (1/3)/(1/2) = 2/3(1/2)/(1/3) = 3/2

Richland has the comparative advantage in fishing while Poorland has the comparative advantage in baking bread.

Production Possibilities Frontier

The production possbilities frontier shows all output combinations that can be produced without wasting resources.

production possibilities frontiers

In the absence of trade, you must consume what you produce yourself. That point must lie on your production possbilities frontier. For Richlanders, the best point they can attain without trade is 8 sandwiches; Poorlanders produce and consume 4 sandwiches.

Gains from Trade

gains from trade

If Richlanders and Poorlanders each specialize in the good in which they have a comparative advantage, they can then trade with one another and end up consuming more sandwiches than they were able to produce by themselves.

Richlanders produce only fish (20 each) while Poorlanders only bake bread (10 loaves each). Then, each Richlander trades 5 fish for 5 loaves of bread. Each Richlander must do this trade with two different Poorlanders. Then, each Richlander ends up consuming 10 sandwiches while each Poorlander ends up eating 5 sandwiches.

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