Lecture Outline – Comparative Advantage and Trade

1. Introduction
 Explain how trade makes people better off when their preferences (i.e. tastes) differ.
- People put different values on the same product/service
 Explain how trade increases productivity through specialization and the division of
knowledge.
- Trade increases availability of knowledge, and knowledge increases productivity
2. A Model of Scarcity, Tradeoffs, and Opportunity Costs – The Production Possibilities
Frontier (PPF); sometimes called the Production Possibilities Curve (PPC)
 What assumptions are used to draw a PPF?
- Assume that one has two choices
 Explain the following:
o Why is it impossible to attain a point outside of the PPF?
- Resources are scarce
o Why is a point inside of the PPF labeled “inefficient?”
- There are more resources that could be used for production
 Use the PPF to identify the opportunity cost of the good listed on the x-axis.
- Loss of the good listed on the y-axis
 Use the PPF to identify the opportunity cost of the good listed on the y-axis.
- Loss of the good listed on the x-axis
3. The Theory of Comparative Advantage
 Define and differentiate between absolute advantage and comparative advantage
- Absolute advantage: when one can produce more quantity with the same source
- Comparative advantage: when one has lower opportunity cost of producing
good/service
 Two trading entities (i.e. individual, countries) can benefit if they specialize and trade
according to their comparative advantage. Explain.
- Since each entity has comparative advantage in different good, each of them can
specialize in good in which they have comparative advantage. Then, trading each good
at a cost between each entity’s opportunity cost of that good will benefit them both.
 If we assume that both countries specialize according to their comparative advantage,
then how do we find terms of trade that will cause both entities (i.e. individuals,
countries) to be better off?
 - Trade each good at a cost between each country’s opportunity cost of that good
 Explain why comparative advantage – not absolute advantage – is the basis for trade.
Support your answer with an example that shows that a rich entity and a poor entity
can both benefit by trading with each other.
- Typically, a rich entity will have absolute advantage on both goods. However, both rich
entity and a poor entity have comparative advantage on different goods, since both
entities must have lower opportunity cost on different goods. So, trading each good in
which they have comparative advantage (thus lower opportunity cost) will benefit them
both.