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Pitt ECON 0110 - Opportunity Cost and Comparative Advantage
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ECON 0110 1st Edition Lecture 7Section5&6 opportunity cost and comparative advantageLast lecture: we talked about the possibility possible frontier.Current lecture: we talked about opportunity cost and comparativeadvantage.Suppose we are on the PPFI.e., we are producing efficientlyTo produce more of one item, we must give up some of the other itemOPPORTUNITY COSTThe opportunity cost of choosing one item is the best alternative that we give up when we make a choiceThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.Suppose we are inside the PPFIn this case, we can increase production of either or both of the items by becoming more efficientIf we are ON the PPF, in order to increase output of one item, we must give up the opportunity of having some of the other itemMeasuring opportunity cost when the PPF is a straight line and has a constant slopeCONSTANT OPPORTUNITY COSTTo get one more unit of one item, we always give up a constant amount of the other itemEXAMPLE OF CONSTANT OPPORTUNITY COSTSuppose a country can produce lumber (variable Y) or food (variable X)With specialization, assume the country could produce 500 units of lumber and 0 units of food, or 400 units of food and 0 units of lumber.Assume the PPF is a straight line. In this case, the opportunity cost of producing one more unit of one item is a constant amount of the other item.The cost of producing 400 units of food is that we give up the opportunity of producing 500 units of lumber.The cost per single unit of food is 500/400 units of lumber.Thus, the opportunity cost of one more unit of food is 1.25 units oflumber.The cost of producing 500 units of lumber is that we give up the opportunity of producing 400 units of food.The cost per single unit of lumber is 400/500 units of food.Thus, the opportunity cost of one more unit of lumber is 0.80 unitsof food.Let X denote the item which is being increased. Let ∆X denote the number of units to be increased.Let Y be the item which is being given up. Let ∆Y denote the number of units to be given up in exchange for more units of X.The OPPORTUNITY COST of 1 unit of X is equal to ∆Y/∆X.OPPORTUNITY COST = ∆Y/∆X.EXAMPLE:The cost of producing 400 units of food is that we give up the opportunity of producing 500 units of lumber.∆X = 400∆Y = 500OPPORTUNITY COST = ∆Y/∆X = 500/400 = 1.25INCREASING OPPORTUNITY COSTEventually, the cost of an additional unit of X is greater than the cost of the previous unit of XEXAMPLE OF INCREASING OPPORTUNITY COSTS:Suppose a country produces lumber (variable Y) and/or food (variable X).Suppose the country specializes in all lumber.To produce 1 unit of food reduces the production of lumber by very little. Just produce the unit of food on the most fertile ground.Eventually, to produce more food requires that we use less fertile land and need to we clear large amounts of forest to grow more foodINCREASING OPPORTUNITY COSTThe slope of the PPF is not constantThe slope becomes steeper (more negative) as X increasesMORAL OF THE STORY:Eventually, to produce more of an item, an increasing amount of resources not well suited to producing that item will have to be usedSECTION 6: THEORY OF COMPARATIVE ADVANTAGE Specialization and free trade benefit all trading parties Two producers can both gain by specializing in the production of the item in which they have a comparative advantage and then trading with each other ABSOLUTE ADVANTAGE Producer A has an absolute advantage over Producer B in the production of a given item if, by using a given amount of resources, Producer A can produce more of the given item than Producer B Alternatively, absolute advantage is the ability to make something using fewer resources than other producers use. If A has absolute advantage over B, then A is “better” at producingthe item. COMPARATIVE ADVANTAGE Comparative advantage is the ability to produce something at a lower opportunity cost than other producers Is there any reason for these two to trade? Assume that the US and China both produce efficiently. Thus, each country is ON its PPF, rather than inside its PPF. Now pick a point on each country’s PPF to illustrate each country’s preferred output selection. Suppose China produces 500 cell phones and 6,000 calculators. Note that this is a point on the For China, it is possible that consuming 500 cell phones and 6,000 calculators is preferred to some points that are outside the PPF. But any point OUTSIDE its PPF where China has at least500 cell phones and at least 6,000 calculators is definitely preferred to the original point. For the US, it is possible that consuming 800 cell phones and 1,000 calculators is preferred to some points that are outside the PPF. But any point OUTSIDE its PPF where the US has at least 800 cell phones and at least 1,000 calculators is definitely preferred to the original point Let us calculate the opportunity cost of producing extra cell phones or extra calculators in each country. Opportunity cost of producing in China In Figure 1, assume we start at the origin. If China specialized in calculators, it could produce 8,000 calculators by giving up the opportunity of producing 2,000 cell phones. The opportunity cost of 8,000 calculators is 2,000 cell phones. Thus, in China, the opportunity cost of 1 calculator is 2,000/8,000 = 0.25 cell phones. Once again, suppose in Figure 1, we start at the origin and assume China specialized in cell phones. China could produce 2,000 cell phones by giving up the opportunity of producing 8,000 calculators. The opportunity cost of 2,000 cell phones is 8,000 calculators. Thus, in China, the opportunity cost of 1 cell phone is 8,000/2,000 = 4.0 calculators. Opportunity cost of producing in the US In Figure 2, assume we start at the origin. If the US specialized in calculators, it could produce 2,000 calculators by giving up the opportunity of producing 1,600 cell phones. The opportunity cost of 2,000 calculators is 1,600 cell phones. That is, in the US, the opportunity cost of 1 calculator is 1,600/2,000 = 0.80 cell phones. Once again, suppose in Figure 2, we start at the origin and assume the US specialized in cell phones. The US could produce 1,600 cell phones by giving up the opportunity of producing 2,000 calculators. The opportunity cost of 1,600 cell phones is 2,000 calculators. That is, in the


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Pitt ECON 0110 - Opportunity Cost and Comparative Advantage

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