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How two parties can get better outcomes by specializing in their comparative advantage and trading
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Let's now move away from the world of the hunter-gatherer and into the dinnerware market.
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.
Let's say we have a producer, Charlie, and if he were to focus all of his time on cups, he could produce -.
Let me put these [labels]10, 20, 30.
If he were to focus all of his time on cups, he could produce 30 cups, and if he were to focus all of his time on plates, he could produce 10 plates.
And we're going to assume he has a linear, Production Possibilities, Frontier.
This is what his PPF is going to look like.
We draw a little bit, actually connect the 2 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 Charlie.
Now, let's think about his opportunity, cost.
And, because this is a linear PPF.
His opportunity cost does not change.
Slope of this line is not changing.
It's, not that bow-shaped curve that we saw for the hunter gatherer.
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, is equal to 30 cups.
If you want the opportunity cost for one plate, you just divide both sides by 10, and so you get the opportunity cost of 1.
Plate, is equal to 3 cups.
That's, fair enough.
Let's think about the same scenario or, let's think about another producer, in this market for dinner, ware.
Let's call her Patty.
If Patty focused all of her time on cups.
She could produce 10 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 for Patty.
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 10 cups.
So, her opportunity costs to produce 30 plates is equal to 10 cups.
If you divide both sides by 30, the opportunity cost of her producing 1 plate, in terms of cups, is 10.
Divided by 30, is 1/3, 1/3 of a cup.
This is interesting.
We can now compare their relative opportunity.
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, especially when you measure it 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.
So relative to Charlie.
We say, because her opportunity cost is lower in producing plates, 1/3 relative to 3.
We say that Patty has the comparative advantage in plates, relative to Charlie.
And, it's not just because she can produce - We'll, see situations in maybe the next video, where we'll actually show this.
It, doesn't even have to be the case that she can 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.
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.
Let's think about it.
The other way, around.
Who, has a comparative advantage in cups? Well.
If we divide both sides of this right over here by 3.
Well, let's swap both sides.
So the opportunity costs for Charlie of producing 3 cups, is equal to 1 plate.
If you divide both sides by 3, opportunity, cost of 1 cup is 1/3 of a plate.
We go to the situation for Patty.
Let's swap these 2 around, the opportunity cost for 10 cups is 30.
You divide both sides by 10.
The opportunity cost of 1 cup is equal to 3 plates.
And obviously, and we've talked about this before.
The opportunity cost of 1 incremental unit is the same thing as the marginal cost of a cup.
Who has the lower opportunity cost for producing cups? Well,? Let's see, Charlie can produce a cup, or Charlie's opportunity.
Cost for producing an extra cup is 1/3 of a plate, and Patty's is 3.
So Charlie has the lower opportunity cost for producing a cup.
It's only 1/3 plate relative to 3 plates.
This is where Charlie has the comparative advantage.
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.
So what we can see is, 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.
Let's see how they can actually do.
So we've said that Charlie has a comparative advantage in cups.
Cost of producing a cup is lower than it is for Patty.
It's, only 1/3 of a plate relative to 3 plates.
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.
So Charlie specializing in cups means he's going to focus only on cups.
So he's going to produce 30 cups.
Every day., And Patty specializing in plates means that she's going to produce 30 plates every day.
(Let me do this in a different color: 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 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 fix the price here.
We're, going to talk more about markets in the future.
But I assume that they agree to trade at 1 cup for 1 plate.
This makes sense for either of them, because this trading price, or this market price, is lower than their opportunity.
Here's Charlie, he's got all of these cups, left to his own devices.
If he wanted an extra plate, he would have to spend 3 cups, but now in the market, with this price over here, he only has to spend 1 cup for an extra plate.
This makes sense for him because the market price is lower than his opportunity.
He would definitely rather get a plate in the market than have to do it by producing it.
It‘s, cheaper this way.
And, the same thing for Patty.
She has all of these plates.
But if she wants a cup, left by herself, she would have to spend 3 plates to do.
She would have to give up 3 plates.
But now in the market.
She would only have to give up 1 plate.
This is a good deal.
This is lower than her opportunity.
So she'll want to transact.
And, so they can do, each of them, so for example, Charlie could keep trading cups for plates and he could end up anywhere on this line.
Over there., And Patty could actually do the same thing:.
She could trade the 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 that they both want to get to that 15-15 scenario.
So they can both trade 15 cups to the other person.
Could trade 15 cups for 15 plates and obviously Patty would be trading 15 plates 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.
Hopefully you found that interesting.
They could get these gains of.
They specialize in their comparative advantage.
The theory of comparative advantage teaches that nations should specialize in the production of the goods in which they have the lowest opportunity cost (a comparative advantage), and trade with other nations.Are the gains from specialization and trade based on comparative advantage? ›
The theory of comparative advantage teaches us that nations should specialize in the production of the goods in which they have the lowest opportunity cost (a comparative advantage), and trade with other nations. When nations specialize, this exchange creates gains from trade.How comparative advantage explains the gains from trade? ›
Comparative advantage is used to explain why companies, countries, or individuals can benefit from trade. When used to describe international trade, comparative advantage refers to the products that a country can produce more cheaply or easily than other countries.What is an example of specialization comparative advantage? ›
Charlie has a comparative advantage in producing cups, while Patty has a comparative advantage in producing plates. By specializing in these areas and then trading with each other, both producers are able to get outcomes that they wouldn't have been able to achieve on their own.What is an example of a gain from trade? ›
An example of gains from trade can be seen in the case of two countries that both produce two different products. Both countries gain more value by trading with each other the products they have more of but need less of.What is an example of specialization in trade? ›
1 If, for example, a country can produce bananas at a lower cost than oranges, it can choose to specialize and dedicate all its resources to the production of bananas, using some of them to trade for oranges. Specialization also occurs within a country's borders, as is the case with the United States.What is comparative advantage and how does specialization and trade add to a nation's output? ›
Comparative advantage urges nations to engage in true free trade and to specialize in areas where they have the highest expertise and most success – instead of looking to bolster weak industries from foreign competition by imposing protective tariffs that otherwise stifle the production that leads to overall gains in ...What are the advantages and disadvantages of specialization in trade? ›
The advantages of specialisation and division of labour include increased output, less wastage, and lower unit costs. The disadvantages of specialisation and division of labour include increased boredom, overreliance, finite resources, and changing tastes.What are the benefits of trade and specialization? ›
Whenever countries have different opportunity costs in production they can benefit from specialization and trade. Benefits of specialization include greater economic efficiency, consumer benefits, and opportunities for growth for competitive sectors.What is the main advantage of specialization results from? ›
Specialization Leads to Economies of Scale
Once specialization occurs, resulting in economies of scale, a company is able to reduce the price for its goods or services because it costs less to make their goods or provide their services. This provides a competitive advantage in the market place.
Companies with a comparative advantage can sell goods and services at lower prices than their competitors, resulting in higher sales margins and profitability. Comparative advantage provides more than just lower costs. Trading with other countries can also lead to new work opportunities where none previously existed.What are two examples of specialization? ›
Specialization is producing a limited number of goods instead of a wide variety to more efficiently produce those goods. For example, a nation with easy access to lumber should specialize in furniture and building materials because they will be able to produce those goods efficiently.What is the best example of specialization? ›
For example, one country might specialize in producing coffee beans, which gives this specific country a competitive advantage. It can also give this country the ability to produce a large number of high-quality coffee beans using the resources that it already has.Is specialization based on comparative or absolute advantage? ›
Specialization. Production specialization according to comparative advantage, not absolute advantage, results in exchange opportunities that lead to consumption opportunities beyond the PPC.Is specialization absolute or comparative advantage? ›
While comparative advantage encourages specialization in relation to production costs and comparative advantages of other nations, absolute advantage emphasizes specialization in an industry where an entity is ultimately superior.Is comparative advantage a specialization? ›
This practice of producing only that which you have a comparative advantage in making is called specialization and allows for surpluses to be produced in the economy.Is comparative advantage the basis for trade? ›
Comparative advantage is a key principle in international trade and forms the basis of why free trade is beneficial to countries. The theory of comparative advantage shows that even if a country enjoys an absolute advantage in the production of goods, trade can still be beneficial to both trading partners.