Chapter1 Slides

Part%I%Compara+ve%Advantage%&%%

the%Basis%for%Trade%

©"Playconomics,"LHS"


Your"First"Model"

Defini+on:%%A"Model"is"a"simplified"representa<on"of"reality."


Your"First"Model"Assump+ons%"

•  There"are"only" ."•  There"are"only" ."•  When"trading,"there"are"

(nego<a<on/transporta<on"costs),""

(import"quotas,"tariffs)."

David"Ricardo"in"1817""“magic"4"numbers”"



A."One"Agent"Economy"

"

•  2 (Assump<on"1):"–  collec<ng"bananas"and"catching"rabbits""

•  Performing"an"ac<vity"involves"use"of"–  1kg"bananas"takes"1"hour"to"collect"–  1kg"rabbit"takes"2"hours"to"catch""

•  The"amount"of"resources"used"to"perform"a"produc<ve"ac<vity"determines"produc+vity%



•  % !"oWen"we"operate"in"a"constrained"environment"(i.e.,"financial%constraints,"+me%constraints)"

•  Alberto’s"<me"constraint:""24h/day"Z"8h"sleep""="16h"



•  Step"1:" "– 16h"collec<ng"bananas""• !"16kg"bananas"(16h"x"(1kg/1h))"• !"0kg"rabbit"

– 16h"catching"rabbit""• !"0kg"bananas"• !"8kg"rabbit"(16h"x"(1kg/2h))""



•  Step"2:" "– 16h"collec<ng"bananas"AND"rabbits"• !"8h"x"(1kg/1h)"="8kg"bananas"• !"8h"x"(1kg/2h)"="4kg"rabbit"

• !"4h"x"(1kg/1h)"="4kg"bananas"• !"12h"x"(1kg/2h)"="6kg"rabbit"

• !"1h"x"(1kg/1h)"="1kg"bananas"• !"15h"x"(1kg/2h)"="7.5kg"rabbit"•  …"



•  Step"3:" and"create""

Produc+on%Possibility%Curve%



Defini+on:%%The"Produc+on%Possibility%Curve%represents"all,possible,combina0ons"of"bananas"and"rabbits"that"can"be"produced"with"Alberto’s"labour"if"he"works"all,the,available,hours,(i.e,"the"whole"day)."



Defini+on%(general):%%The"Produc+on%Possibility%Curve%captures"all,maximum,output,possibili0es"for"two"(or"more)"goods,"given"a,set,of,inputs,(or"resources"Z"i.e.,"<me)"if,inputs,are,used,efficiently."





Defini+on:%%The"Produc+on%Possibility%Curve%represents"all,possible,combina0ons"of"bananas"and"rabbits"that"can"be"produced"with"Alberto’s"labour"if"he"works"all%the%available%hours%(i.e,"the"whole"day)."

…"if"all"inputs"(or"resources)"are"used"efficiently"(no"<me"to"waste)!!!"



Defini+on:%%An%Efficient%Produc+on%Point%represents"a"combina<on"of"goods"(bananas"&"rabbits)"for"which"currently"available"resources"(Alberto’s"<me)"do%not%allow%an"increase"in"the"produc<on"of"one"good"without"a"reduc<on"in"the"produc<on"of"the"other."All,the,points,on,the,PPC,are,efficient.,





Defini+on:%%An%Inefficient%Produc+on%Point%represents"a"combina<on"of"goods"(bananas"&"rabbits)"for"which"currently"available"resources"(Alberto’s"<me)"allow"an"increase"in"the"produc<on"of"one"good"without"a"reduc<on"in"the"produc<on"of"the"other."All,the,points,below,and,to,the,le=,of,the,PPC,are,inefficient.,





Defini+on:%%An%AGainable%Produc+on%Point%represents"any"combina<on"of"goods"(bananas"&"rabbits)"that"can"be"produced"with"the"currently"available"resources"(Alberto’s"<me)."All,the,points,on,the,PPC,or,below,and,to,the,le=,of,the,PPC,are,a>ainable.,





Defini+on:%%An%UnaGainable%Produc+on%Point%represents"any"combina<on"of"goods"(bananas"&"rabbits)"that"can%not"be"produced"with"the"currently"available"resources"(Alberto’s"<me)."All,the,points,that,lie,outside,of,the,PPC,are,una>ainable.,





•  What"if"

higher

%


B."Two"Agents"Economy"

"

•  2 :"–  collec<ng"bananas"and"catching"rabbits""

•  Performing"an"ac<vity"involves"use"of"–  1kg"bananas"takes"1"hour"to"collect"–  1kg"rabbit"takes"2"hours"to"catch"

•  Consump+on%needs:"4kg"of"rabbit"&"9kg"of"bananas"(clearly"unahainable!)"




Remember:%4%rabbits+9%bananas%=%unaGainable%


•  2 :"–  collec<ng"bananas"and"catching"rabbits""

•  Performing"an"ac<vity"involves"use"of"–  1kg"bananas"takes"4"hours"to"collect"–  1kg"rabbit"takes"4"hours"to"catch"

•  " –"produc<ve"for"16h"per"day"""



•  Leo’s" "– 16h"collec<ng"bananas""• !"4kg"bananas"(16h"x"(1kg/4h))"• !"0kg"rabbit"

– 16h"catching"rabbit""• !"0kg"bananas"• !"4kg"rabbit"(16h"x"(1kg/4h))"

•  Consump+on%needs:"7kg"bananas"(clearly"unahainable!)"




Note:%7%bananas%=%unaGainable%(Leo)%


Can%Leo%help%Alberto%achieve%%his%consump+on%target?%





Defini+on:%%An"agent"(or"an"economy)"has"an"Absolute%Advantage%in"a"produc<ve"ac<vity"(like"collec<ng"bananas"or"catching"rabbits)"when"he/she"can"carry"on"this"ac<vity"with"less"resources"(i.e.,"less"<me)"than"another"agent.,





Opportunity%Cost!%



Defini+on:%%The"Opportunity%Cost"of"a"given"ac<on"is"the"value"of"the"next"best"alterna<ve"to"that"par<cular"ac<on.",










B."Two"Agents"Economy"Opportunity"Cost"made"(super)easy:"

OC%=%slope%of%the%PPC%!!%%"

""""""""""""""""""""""""% % % %%%%%%%%%%OCbananas%T%Alb%=%%% %% % %% % %% % %% % %% % %% % %% % %% %=%(8/16)kg%rabbit%

%% % %% % %% % %% % %% % %% %%%%%%%OCbananas%T%Leo%=%%% % % % % % % % % % % % %%%%=%(4/4)kg%rabbit"


B."Two"Agents"Economy"Opportunity"Cost"made"(super)easy:"""""""""""""""""""""""""

%%%%OCbananas%=%(loss%in%rabbit/gain%in%bananas)%

%OCrabbit%=%(loss%in%bananas/gain%in%rabbit)"

"





Defini+on:%%An"agent"(or"an"economy)"has"an"Compara+ve%Advantage%in"a"produc<ve"ac<vity"(like"collec<ng"bananas"or"catching"rabbits)"when"he/she"has"a"lower%opportunity%cost%of"carrying"this"ac<vity"than"another"agent.,





+1kg%

+1kg%

Gains%from%specializa+on%☺%%



Principle%of%Compara+ve%Advantage:%%Everyone"is"beher"off"if"each"agent"(or"each"country)"specializes"in"the"ac<vi<es"for"which"they"have"a"compara<ve"advantage."The,gains,from,specializa0on,grow,larger,as,the,difference,in,opportunity,cost,increases!,,


B."Two"Agents"Economy"Now"we’re"ready:"

%YES!%IF%%Z  ALBERTO%SPECIALIZES%IN%BANANAS%&%%Z  LEO%SPECIALIZES%IN%RABBITS%&%Z  THEY%TRADE!%BUT%AT%WHAT%PRICE?%


B."Two"Agents"Economy"THEY"TRADE!"BUT"AT"WHAT"PRICE?"%

•  Alberto"specializes"in"bananas"!"will"want"to"sell"to"Leo"at""–  pricebananas"≥"Alberto’s"cost"of"collec<ng"bananas"OR"–  "pricebananas"≥"Alberto’s"OCbananas(=0.5kg"rabbit)"

%

•  Leo"specializes"in"rabbits"!"will"want"bananas"as"long"as""–  Pricebananas"≤"Leo’s"cost"of"collec<ng"bananas"himself"OR"–  Pricebananas"≤"Leo’s"OCbananas"(=1kg"rabbit)"

0.5kg%rabbit%≤%pricebananas≤%1kg%rabbit%%%%


C."Economy"PPC"in"TwoZAgent"Economy"

"

•  Find"the"total"amount"of"rabbit"that"Leo"&"Alberto"can"produce"if"they"spend,all,their,0me,catching,rabbits,

•  Start"producing"bananas"–"Alberto"1st"kg"(why?)"

•  Con<nue"to"produce"bananas"(“exhaust”"Alberto"and"only"then"move"to"Leo"–"why?)"

•  Find"the"total"amount"of"bananas"that"Leo"&"Alberto"can"produce"if"they"spend,all,their,0me,collec0ng,bananas"



"PPC%is%a%curve%bowing%out%from%origin%

SLOPE?%



Alberto’s%PPC%slope%(1)%

Leo’s%PPC%slope%(>Alberto’s)%(2)%



Principle%of%Increasing%Opportunity%Cost%(Low%Hanging%Fruit):%%In"the"process"of"increasing"the"produc<on"of"any"good,"first,employ,those,resources,with,the,lowest,opportunity,cost"and"only"once"these"are"exhausted"turn"to"resources"with"higher"cost."",



Principle%of%Increasing%Opportunity%Cost%(Low%Hanging%Fruit):%%In"the"process"of"increasing,the,produc0on,of"any"good,"first,employ,those,resources,with,the,lowest,opportunity,cost"and"only"once"these"are"exhausted"turn"to"resources"with"higher"cost."",

Need"to"have" :"



The"main"factors"driving" (i.e.,"push"the"economy"PPC"out"and"to"the"right)"are:""

•  """in" "!"factories,"equipment,""•  """in" "!labour"force,"•  Advancements"(")"in"!"educa<on,"R&D,"IT,"communica<ons"tech."


D."Trading"Between"Economies:""Why"Trade?"

"A"country’s"

does"not"depend"on"what"it"produces"(PPC),""but"on"what"it"consumes"(CPC)!"

"Consump+on%Possibility%Curve%(CPC)"


D."Trading"Between"Economies:""Interna<onal"Trade"

Defini+on:%%The"Consump+on%Possibility%Curve%represents"all,possible,combina0ons"of"two"goods"that"the"agents"in"an"economy"can"consume."

PPC%%%Vs%%CPC"



"



Defini+on:%%The"Consump+on%Possibility%Curve%represents"all,possible,combina0ons"of"two"goods"hat"the"economy"can"feasibly"consume"when"it"is"open"to"interna<onal"trade."""

depends%on%interna+onal%(world)%prices"



Say"1kg"bananas"="0.2"rabbit"(interna<onal"world"price)"


D."Trading"Between"Economies:""Interna<onal"Trade"(no"trade)"""

"""""""!"PPC%and%CPC%are%iden+cal"(trade"on"the"intern."market)""

"""""""!"CPC%is%to%the%right%and%above%the%PPC%%"

Consump+on%opportuni+es%in"an"open"economy"are"always"wider"than"in"a"closed"one!"

"

What"should"an"economy"consume?"DEPENDS!"

" Needs%&%Wants%=%Preferences"


E."EconomyZwide"PPC"in"a""ManyZAgent"Economy""

"

"Everything%we%discussed%so%far%s+ll%applies!%☺%



"

Curve%bowing%out%from%origin%

SLOPE?%



"

Slope%is%increasing!%What%does%this%mean?%

Because%PPC%is%a%smooth%curve%we%must%calculate%the%slope%IN%A%POINT!%



"

Slope%is%increasing!%What%does%this%mean?%


OC%of%bananas%in%terms%of%forgone%rabbits%is%increasing!%

F."Classic"Cri<ques"to"the"Model""We"assumed""

associated"to"performing"the"same"ac<vity"the"en<re"day"!"Boredom"doesn’t"kill"you!"

connected"with"trading"(i.e.,"nego<a<on"costs,"transporta<on"costs,"etc)"

!"would"limit"the"gains"from"specializa<on"by"making"specializa<on"(beyond"a"certain"level)"pointless"

for"goods/services"in"which"a"country"specializes"in"and"no"accoun<ng"for"social"norms"that"might"prevent"trading"



Documents

Chapter1 Slides