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Current time:0:00Total duration:8:56

Comparative advantage, specialization, and gains from trade

AP.MACRO:
MKT‑1 (EU)
,
MKT‑1.A (LO)
,
MKT‑1.A.1 (EK)
,
MKT‑1.A.2 (EK)
,
MKT‑1.B (LO)
,
MKT‑1.B.1 (EK)
,
MKT‑1.B.2 (EK)
AP.MICRO:
MKT‑2 (EU)
,
MKT‑2.A (LO)
,
MKT‑2.A.1 (EK)
,
MKT‑2.A.2 (EK)
,
MKT‑2.B (LO)
,
MKT‑2.B.1 (EK)
,
MKT‑2.B.2 (EK)

Video transcript

let's now move away from the world of the hunter-gatherer and into the dinnerware market so let's say we're going to talk about two products two types of dinnerware we'll have cups on this axis and we will have plates on this axis and let's say we have a producer Charlie and if you were to focus all of his time on cups he could produce so let me let me put these ten ten twenty thirty so if you were to focus all of his time on cups he could produce 30 cups and if you were to focus all of his time on plates he could produce ten plates and we're going to assume he has a linear production possibilities frontier so this is what his PPF is going to look like let me draw it a little bit actually connect the two dots so that's I want to make it more looking like a line so that's about as good as I can do so that right over there is the PPF for for Charlie now let's think about his opportunity cost and because this is a linear PPF his opportunity cost does not change the slope of this line is not changing it's not that Bo shaped curve that we saw for the hunter-gatherer so it's going to be a fixed opportunity cost for one product relative to the other at any point along this production possibilities frontier so let's say we're sitting over here this will just make things simple to just think about the end points and he's producing 30 cups what is his opportunity cost of producing 10 plates well to produce 10 plates he's going to have to give up those 30 cups so his opportunity cost of producing 10 plates 10 plates is equal to 30 cups 30 cups or if you want the opportunity cost for one plate you just divide both sides by 10 and so you get the opportunity cost of one plate is equal to three cups is equal to three cups that's fair enough now let's think about let's think about the same scenario or let's think about another producer in this market for dinner where let's call her Patty if Patty focused all of her time on cups she could produce ten cups in a day and if she focused all of her time on plates she could produce 30 plates in a day so that is and she also has a linear production possibilities frontier so that right over there is the PPF PPF for Patty for Patty and let's think about her opportunity cost for producing a plate so the opportunity cost if she's sitting right over here and she was focused all on cups and if she wanted to produce 30 plates and I'm intentionally using the end points to make the math more obvious if she wanted to produce 30 plates then she would have to give up ten cups so her opportunity cost to produce 30 plates 30 plates is equal to ten cups is equal to ten cups or if you divide both sides by 30 the opportunity cost of her producing one plate one plate in terms of cups is ten divided by 30 is 1/3 1/3 of a cup now this is interesting we can now compare their relative opportunity costs the opportunity cost for Charlie to produce a plate is 3 cups the opportunity cost for Patty to produce a plate is 1/3 of a cup so for Patty and yet especially when you measured in terms of cups it is cheaper for her to produce a plate she has a lower opportunity cost than charlie does in producing plates and so relative to charlie we say because her opportunity cost is lower in producing plates one third relative to three we say that Patty has the comparative advantage comparative advantage advantage in plates in plates relative to relative to Charlie and we're going to and it's not just because she can produce and and we'll we'll see situations maybe in the next video where we actually show this it doesn't even have to be the case that she can even produce more plates in a given day this is not why she has a comparative advantage this is called an absolute advantage and we'll talk about that more she has a comparative advantage because her opportunity cost is lower her opportunity cost for producing a plate is lower than it is for charlie now let's think about what the other way around who has a comparative advantage in cups well if we divide both sides of this right over here by 3 see that if or let's swap both sides so the opportunity costs for Charlie of producing three cups is equal to one plate one plate or if you divide both sides by three opportunity cost of one cup is one-third is one-third of a plate if we go to the situation for Patty so let's go the Patty let's swap these two around the opportunity cost for ten cups ten cups is 30 plates 30 plates if you divide both sides by ten the opportunity cost of one cup is equal to three plates is equal to three plates and obviously and we've talked about this before the opportunity cost of one incremental unit that's the same thing as the marginal cost of a cup the marginal cost of a cup but anyway who has the lower opportunity cost for producing cups well let's see charlie can produce a cup at or Charlie's opportunity cost for producing an extra cup as a third of a plate and Paddy's is three plates so Charlie has the lower opportunity cost for producing a cup so it's only one third plate relative to three plates so this is where Charlie has the comparative comparative IDI comparative advantage and what we're going to see is if both of these parties specialize in their comparative advantage and then trade they can get outcomes that are beyond each of their individual production possibility frontiers so what we can see is so for example they can get an outcome where they are each able to get 15 cups and 15 plates which would have been impossible left to their own devices so let's see how they could actually do it so we've said that Charlie has a comparative advantage in cups his opportunity cost of producing a cup is lower than it is for patty it's only 1/3 of a plate relative to three plates so let's make him specialize in cups so cup specialties so he's going to specialize in cups and patty for the same reason is going to specialize in plates is going to specialize in plates so him special charlie specializing in cups means he's going to focus only on cups so he's going to produce 30 cups every day 30 cups every day and specializing in plates means that she's going to produce 30 plates every day she let me do this in a different color she or I'll just do the magenta she's going to produce 30 plates every day now imagine I'm going to make an assumption here but imagine that they both do that but they don't will only each only want to have what they're producing they want to have some combination of them so they decide to trade and I'm going to just fix the price here we're going to talk more about markets in the future but I assume that they agree to trade at one cup one cup for one plate and this makes sense for either of them because they're this this trading price or you can all say this market price is lower than their opportunity costs so here's Charlie he's got all of these cups there it left to his own devices if he wanted an extra plate he would have to spend three cups but now in the market at this price over here he only has to spend one cup for an extra plate so he this makes sense for him because the market price is lower than his opportunity cost so he would definitely rather get a plate in the market than have to do it by producing it himself it's cheaper this way and the same thing for patty she has all of these plates but if she wants a cup left her by herself she would have to spend three plates to do it she would have to give up three plates but now in the market she would only have to give up one plate she would only have to give up one plate so this is a good deal this is lower than our opportunity cost so she'll want to transact and so they can do each of them so for example charlie can keep trading cups for plates and he could end up anywhere on this line right over there and Patty could actually do the same thing she could trade cups for plates and end up someplace over there but obviously where they end up is dependent on how much the other one is willing to trade but let's say they both want to get to that 15/15 scenario so they can both trade 15 cups to the other person so Charlie could trade 15 cups for 15 plates and obviously Patty would be trading 15 plays for 15 cups and they would both be able to get right over there which is a situation that was unattainable left to their own production possibilities so hopefully you found that interesting that you'd by specializing they could get these gains of trade and they specialized in the their comparative advantage