Part%I%Compara+ve%Advantage%&%%
the%Basis%for%Trade%
©"Playconomics,"LHS"
©"Playconomics,"LHS"
Your"First"Model"
Defini+on:%%A"Model"is"a"simplified"representa<on"of"reality."
©"Playconomics,"LHS"
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”"
©"Playconomics,"LHS"
©"Playconomics,"LHS"
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%
©"Playconomics,"LHS"
A."One"Agent"Economy"
• % !"oWen"we"operate"in"a"constrained"environment"(i.e.,"financial%constraints,"+me%constraints)"
• Alberto’s"<me"constraint:""24h/day"Z"8h"sleep""="16h"
©"Playconomics,"LHS"
A."One"Agent"Economy"
• 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))""
©"Playconomics,"LHS"
A."One"Agent"Economy"
• 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"• …"
©"Playconomics,"LHS"
A."One"Agent"Economy"
• Step"3:" and"create""
Produc+on%Possibility%Curve%
©"Playconomics,"LHS"
A."One"Agent"Economy"
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)."
©"Playconomics,"LHS"
A."One"Agent"Economy"
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."
©"Playconomics,"LHS"
A."One"Agent"Economy"
©"Playconomics,"LHS"
A."One"Agent"Economy"
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)!!!"
©"Playconomics,"LHS"
A."One"Agent"Economy"
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.,
©"Playconomics,"LHS"
A."One"Agent"Economy"
©"Playconomics,"LHS"
A."One"Agent"Economy"
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.,
©"Playconomics,"LHS"
A."One"Agent"Economy"
©"Playconomics,"LHS"
A."One"Agent"Economy"
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.,
©"Playconomics,"LHS"
A."One"Agent"Economy"
©"Playconomics,"LHS"
A."One"Agent"Economy"
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.,
©"Playconomics,"LHS"
A."One"Agent"Economy"
©"Playconomics,"LHS"
A."One"Agent"Economy"
• What"if"
higher
%
©"Playconomics,"LHS"
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!)"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
Remember:%4%rabbits+9%bananas%=%unaGainable%
B."Two"Agents"Economy"
• 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"""
©"Playconomics,"LHS"
B."Two"Agents"Economy"
• 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!)"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
Note:%7%bananas%=%unaGainable%(Leo)%
B."Two"Agents"Economy"
Can%Leo%help%Alberto%achieve%%his%consump+on%target?%
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
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.,
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
Opportunity%Cost!%
©"Playconomics,"LHS"
B."Two"Agents"Economy"
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.",
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
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"
©"Playconomics,"LHS"
B."Two"Agents"Economy"Opportunity"Cost"made"(super)easy:"""""""""""""""""""""""""
%%%%OCbananas%=%(loss%in%rabbit/gain%in%bananas)%
%OCrabbit%=%(loss%in%bananas/gain%in%rabbit)"
"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
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.,
©"Playconomics,"LHS"
B."Two"Agents"Economy"
©"Playconomics,"LHS"
B."Two"Agents"Economy"
+1kg%
+1kg%
Gains%from%specializa+on%☺%%
©"Playconomics,"LHS"
B."Two"Agents"Economy"
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!,,
©"Playconomics,"LHS"
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?%
©"Playconomics,"LHS"
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%%%%
©"Playconomics,"LHS"
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"
©"Playconomics,"LHS"
C."Economy"PPC"in"TwoZAgent"Economy"
"PPC%is%a%curve%bowing%out%from%origin%
SLOPE?%
©"Playconomics,"LHS"
C."Economy"PPC"in"TwoZAgent"Economy"
Alberto’s%PPC%slope%(1)%
Leo’s%PPC%slope%(>Alberto’s)%(2)%
©"Playconomics,"LHS"
C."Economy"PPC"in"TwoZAgent"Economy"
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."",
©"Playconomics,"LHS"
C."Economy"PPC"in"TwoZAgent"Economy"
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" :"
©"Playconomics,"LHS"
C."Economy"PPC"in"TwoZAgent"Economy"
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."
©"Playconomics,"LHS"
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)"
©"Playconomics,"LHS"
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"
©"Playconomics,"LHS"
D."Trading"Between"Economies:""Interna<onal"Trade"
"
©"Playconomics,"LHS"
D."Trading"Between"Economies:""Interna<onal"Trade"
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"
©"Playconomics,"LHS"
D."Trading"Between"Economies:""Interna<onal"Trade"
Say"1kg"bananas"="0.2"rabbit"(interna<onal"world"price)"
©"Playconomics,"LHS"
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"
©"Playconomics,"LHS"
E."EconomyZwide"PPC"in"a""ManyZAgent"Economy""
"
"Everything%we%discussed%so%far%s+ll%applies!%☺%
©"Playconomics,"LHS"
E."EconomyZwide"PPC"in"a""ManyZAgent"Economy""
"
Curve%bowing%out%from%origin%
SLOPE?%
©"Playconomics,"LHS"
E."EconomyZwide"PPC"in"a""ManyZAgent"Economy""
"
Slope%is%increasing!%What%does%this%mean?%
Because%PPC%is%a%smooth%curve%we%must%calculate%the%slope%IN%A%POINT!%
©"Playconomics,"LHS"
E."EconomyZwide"PPC"in"a""ManyZAgent"Economy""
"
Slope%is%increasing!%What%does%this%mean?%
©"Playconomics,"LHS"
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"
©"Playconomics,"LHS"
©"Playconomics,"LHS"
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