Lecture 4Outline of Last Lecture I. The Ten Big Ideas, ideas 8-10II. Chapter Two: The Power of Trade and Comparative AdvantageOutline of Current Lecture I. Specialization and TradeII. The Price of TradeCurrent LectureRecap: Graph: Compare farmer’s PPF with rancher’s PPF (top graphs)- Note: If there is no trade, the farmer (A) (rancher-B) chooses this [A(B)] production and consumption. They are consuming what they are producing. Q: How would you quantify this added benefit? ECON 1 1st EditionWithout trade: Meat PotatoesFarmer (A) 4 oz 16 0zRancher (B) 12 oz 24 ozI. Specialization and TradeQ: How can the farmer and the rancher be better off by trading? Let’s say that the farmer decides to spend all 8 hours producing potatoes (specializing). The rancher spends6 hours/day raising cattle and 2 hours/day growing potatoes. What happens? Meat PotatoesFarmer 0 oz 32 ozRancher 18 oz in 6 hrs 12 oz in 6 hoursProductionWith trade: Farmer Meat PotatoesRancherMeat PotatoesProduction 0 oz 32 oz 18 oz 12 ozTrade Get 5 oz give 15 oz Give 5oz get 15 ozConsumption 5 oz 17 oz 13 oz 27 ozWithout Trade 4 oz 16 oz 12 oz 24 oz Gains +1 oz +1 oz +1 oz +3 oz They can consume moreafter trade. Graph: Consumption with trade-Central idea: Both are better off by trading! - We need to consider comparative advantage. Technically speaking, the farmer has advantage in both. The farmer has a comparative advantage over the rancher when making potatoes. II. Comparative AdvantageDef.: Absolute advantage: the ability to produce a good using fewer inputs than another producer. Ex: In this example, time is the input. Def.: Comparative advantage: The ability to produce a good at a lower opportunity cost than another producer.Opportunity cost table: 1oz meat 1oz potatoesFarmer 4oz potatoes ¼oz meat Rancher 2oz potatoes 1/2oz meat One is the reciprocal of the other. *Farmer: can do 4oz of potatoes OR 1oz of meat. o Who’s the low cost producer of potatoes? The farmer.o The rancher is the low cost producer of meat. o The gains come from the comparative NOT absolute advantage. III: The Price of TradeQuestion to self: What determines the price at which trade takes place?-Q: If there are gains to be made, how should they be shared between trading parties? -A: In general, for both parties to benefit from trade, the price at which they trade must lie between the two opportunity costs. o Ex: farmer gets 5oz of meat for the 15oz of potatoes. This is the same as 1oz of meat for 3oz of potatoes (in the range of 2-4).If these principles were extended to international trade, the same gains would apply. -Q: Should the U.S. trade with other countries? Yes. It allows the other countries to achieve prosperity. o On average, everyone can achieve equal prosperity but there are circumstances where that is not the case. o Ex: We trade food for cars with china, but the workers who make cars in the U.S. are affected and do not gain