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A Parable for the Modern Economy

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- Imagine . . .
- only two goods: potatoes and meat
- only two people: a potato farmer and a cattle rancher

- What should each produce?
- Why should they trade?

By ignoring each other:

- Each consumes what they each produce.
- The production possibilities frontier is also theconsumption possibilities frontier.
Without trade, economic gains are diminished.

Each would be better off if they specializedin producingthe product they are more suited to produce, and thentradewith each other.

The law of comparative advantage states that an individual or nation is better off producing goods and services for which it has a comparative advantage.

- Who should produce what?
- How much should be traded for each product?

Differences in the costs of production determine the following:

- The farmer should produce potatoes.
- The rancher should produce meat.

- The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good.
- Or the one who can produce the most with the resources available has an absolute advantage.

- The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.
- Comparative advantage determines who will produce which good NOT absolute advantage.

Step One

- Determine if production is in output or input terms
- Output is number produced or completed within a given time frame (4 lbs in 40 hours).
- Input is hours, materials, etc. needed to produce 1 unit of output (10 hours per lb.).

Step Two

- If problem is stated in output terms go to step three.
- Change input problems to output problems
- If you need 10 hours to produce 1 lb potatoes, you can produce 4 lbs in 40 hours.
- If you need 20 hours to produce 1 lb meat, you can produce 2 lbs in 40 hours.

Step Three

- Set up ratios comparing the amounts of what you are producing to what you are giving up producing.
- When the farmer produces 2 lbs meat he gives up producing 4 lbs potatoes (2 meat : 4 potatoes)
- When the rancher produces 40 lbs meat he gives up producing 5 lbs potatoes (40 meat : 5 potatoes)

Step Four

- Reduce ratio to 1 : __
- For the farmer 2 meat : 4 potatoes is the same as
- 1 meat : 2 potatoes or 1 potato : ½ meat

- For the rancher 40 meat : 5 potatoes is the same as
- 1 meat : 1/8 potato or 1 potato : 8 meat

- For the farmer 2 meat : 4 potatoes is the same as

Step Five

- Compare ratios between countries/producers for each product
- Farmer1 lb potatoes : ½ lb meat
- Rancher1 lb potatoes : 8 lb meat
- Farmer 1 lb meat : 2 lb potatoes
- Rancher 1 lb meat : 1/8 lb potatoes

Step Six

- Determine which country has the lowest opportunity cost (is giving up the least), and therefore comparative advantage in each product.
- The farmer has comparative advantage in potatoes. For every 1 potato he gives up 1/2 lb meat compared to 8 lbs meat for the rancher.
- The rancher has comparative advantage in meat. For every 1 meat she gives up 1/8 lb potatoes compared to 2 lb potatoes for the farmer.

Step One

- Graph production/consumption possibilities based on maximum amounts of each good.
- These will be the end points and you will draw a straight line connecting to two points.

Meat (pounds)

(a) The Farmer’s Production

Possibilities Frontier

2

0

4

Potatoes (pounds)

Meat (pounds)

40

(b) The Rancher’s Production

Possibilities Frontier

5

0

Potatoes (pounds)

Step Two

- Determine terms of trade
- Terms must fall between each party’s opportunity cost for each good
Farmer’s costRancher’s cost

1 lb potato : ½ lb meat1 lb potato : 8 lbs meat

Terms of Trade: 1lb potato = 3 lbs meat

1 lb meat : 2 lbs potato1 lb meat : 1/8 lb potato

Terms of Trade:1 lb meat = 1/3 lb potato

- Terms must fall between each party’s opportunity cost for each good

Step Three

- Determine trade possibilities assuming specialization based on comparative advantage.
- For example if the farmer produces all the potatoes he can (4 lbs) and trades them all to the rancher at terms of trade 1 lb potato = 3 lbs meat he will receive 12 lbs of meat in return.
- Farmer - 4 lbs potatoes = 12 lbs meat
- Rancher - 40 lbs meat = 13.33 lbs potatoes

Farmer’s consumption with trade

Farmer’s consumption without trade

Meat (pounds)

A*

3

2

A

1

0

2

3

4

Potatoes (pounds)

Rancher’s consumption with trade

Rancher’s consumption without trade

Meat (pounds)

40

B*

21

20

B

2.5

3

5

0

Potatoes (pounds)

Gains From Trade

- The farmer gains 2 lbs of meat and 1 lb of potatoes
- The rancher gains 1 lbs of meat and ½ lb of potatoes

Benefits of Trade

Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.