Overview
This lecture covers the concepts of comparative advantage, absolute advantage, opportunity cost, and how mutually beneficial terms of trade are established between producers, with examples and calculation methods.
Comparative vs. Absolute Advantage
- Absolute advantage is the ability to produce more of a good or service with the same resources.
- Comparative advantage is the ability to produce a good at a lower opportunity cost than another person or country.
- Specializing in goods where you have a comparative advantage increases efficiency and total output.
Opportunity Cost & Specialization
- Opportunity cost is what is given up to produce or acquire something else.
- Comparative advantage is determined by comparing opportunity costs, not absolute productivity.
- Parties should specialize in the product where they have the lower opportunity cost.
Terms of Trade
- Terms of trade refer to the exchange rate for goods between two producers.
- Mutually beneficial trade occurs when the exchange rate falls between the two parties’ opportunity costs for a good.
- Trade allows both parties to consume beyond their production possibilities curve (PPC).
Example: LeBron James’ Lawn Mowing
- LeBron’s opportunity cost for mowing his lawn is $100,000 (the value of a missed commercial).
- Scotty’s opportunity cost is $40 (wages lost at McDonald’s).
- LeBron has the absolute advantage (mows faster), but Scotty has the comparative advantage (lower opportunity cost).
- A payment between $40 and $100,000 for mowing benefits both.
Calculating Opportunity Cost: Output Problems
- For output problems, calculate per unit opportunity cost using output values.
- The party with the lower opportunity cost should specialize in that product.
- E.g. Joe and Jen: Joe specializes in A, Jen in B, based on their respective opportunity costs.
Calculating Opportunity Cost: Input Problems
- For input problems (less input is better), calculate opportunity cost by reversing the denominator.
- The party who gives up less input per unit has the comparative advantage.
Benefits of Specialization & Trade
- Both parties gain from trade if terms are set between their opportunity costs.
- Specialization and trade allow both to reach consumption levels outside their original PPC.
Key Terms & Definitions
- Absolute Advantage — Ability to produce more of a good with the same resources.
- Comparative Advantage — Ability to produce a good at a lower opportunity cost.
- Opportunity Cost — Value of what is given up to obtain something else.
- Terms of Trade — Exchange rate for goods between two parties.
- PPC (Production Possibility Curve) — Graph showing maximum possible output combinations.
Action Items / Next Steps
- Practice opportunity cost problems (output and input cases).
- Review assigned textbook sections and linked videos for deeper understanding.
- Complete any practice FRQs related to comparative advantage and terms of trade.