Micro Lecture 3

Comparative Advantage and Trade & The Market
System
Peng Shen
October 10, 2021
Peng Shen Comparative advantage & the Market System October 10, 2021 1 / 26
Review of Lecture 1
Scarcity
Review of Lecture 1
Scarcity
Economics: the study of how to make choices “wisely” (to best attain the
goals given the scarce resource)
Review of Lecture 1
Scarcity
Microeconomics:
the consumers, the firms, the government
Review of Lecture 1
Scarcity
Microeconomics:
three questions: what, how, who
it depends on the type of economy: centrally planned economy, market
economy or mixed economy
Positive analysis vs. Normative analysis
Review of Lecture 1
Scarcity
Microeconomics:
three questions: what, how, who
it depends on the type of economy: centrally planned economy, market
economy or mixed economy
Positive analysis vs. Normative analysis

Economic models
Review of Lecture 2
Production Possibilities Frontier (PPF)
Figure 1: The green curve: PPF
Review of Lecture 2
Opportunity cost: the highest-valued alternative that must be given up to

engage in an activity
Marginal opportunity cost
Quantity Quantity Marginal oc of more iPads
Choice of iPhone of iPad A to B 50/150 = 1/3 iphone
per day per day B to C 100/150 = 2/3 iphone
A 300 0 C to D 150/100 = 3/2 iphones
B 250 150
C 150 300 Marginal oc of more iPhones
D 0 400 D to C
C to B
Table 1: Some of the combinations that B to A
Apple can produce at most per day
Review of Lecture 2

Marginal opportunity cost
Quantity Quantity Marginal oc of more iPads
Choice of iPhone of iPad A to B 50/150 = 1/3 iphone
per day per day B to C 100/150 = 2/3 iphone
A 300 0 C to D 150/100 = 3/2 iphones
B 250 150
C 150 300 Marginal oc of more iPhones
D 0 400 D to C 100/150 = 2/3 ipad
C to B 150/100 = 3/2 ipads
Table 2: Some of the combinations that B to A 150/50 = 3 ipads
Apple can produce at most per day
Review of Lecture 2

Review of Lecture 2

Example: Suppose that you have a free ticket to a concert by Band X.
The ticket has no resale value. On the night of the concert your next-best
alternative entertainment is a performance by Band Y for which the
tickets cost $40. You like Band Y and would usually be willing to pay $50
for a ticket to see them. What is the opportunity cost of using your free
ticket and seeing Band X instead of Band Y ?
Review of Lecture 2

Example: Suppose that you have a free ticket to a concert by Band X.
The ticket has no resale value. On the night of the concert your next-best
alternative entertainment is a performance by Band Y for which the
tickets cost $40. You like Band Y and would usually be willing to pay $50
for a ticket to see them. What is the opportunity cost of using your free
ticket and seeing Band X instead of Band Y ?
Answer: $10
Aside: A Related Concept – Sunk Cost
Sunk cost: the resources that you have ALREADY devoted to an activity,
which already happened in the PAST
Example: You are constructing a building, you finished the first 2 floors,
and already spent $5 billion. To finish construction, you have to spend $6
billion more. However, due to decrease in housing price, your building can
only sell for $10 billion after completion. Should you continue to finish the
building?
Example: You are constructing a building, you finished the first 2 floors,
and already spent $5 billion. To finish construction, you have to spend $6
billion more. However, due to decrease in housing price, your building can
only sell for $10 billion after completion. Should you continue to finish the
building?
Answer: Here, $5 billion is Sunk Cost, it should not be considered in
decision for future activities. If we assume there is zero interest rate and
no other better investment opportunities, then the answer is YES. The
economic profits for continuing the construction is $10 billion revenue - $6
billion cost = $4 billion.
Review of Lecture 2
The shape of PPF:

bowed outward: increasing marginal opportunity cost
straight line: constant marginal opportunity cost
Shift in PPF when the amount of available resources or technology changes
Example
1 Comparative advantage and Trade
2 The market system
Motivation for today’s lecture
Most people specialize in certain work as their jobs.

People with different jobs are trading implicitly.
Most people specialize in certain work as their jobs.

People with different jobs are trading implicitly.
An Apple-Inc.-product contains hundreds of parts that are designed,

manufactured, and assembled by firms around the world.
Firm Location of the Firm iPad Component Supplied

AKM Japan Motion sensor
Bosch Germany Accelerometer
Dialog Semiconductor Germany Power manager chip
... ... ...
Table 3: Some of the firms that have suppled Apple with iPad component.
An Inquiry into the Nature and

Causes of the Wealth of Nations
Chapter 1 ”Of the Division of
Labour”
The first sentence reads as follows:
“The greatest improvement in the
productive powers of labour, and
the greater part of the skill,
dexterity, and judgment with which
Figure 2: Adam Smith (June 16 [O.S. 5
it is any where directed or applied,
June], 1723–July 17, 1790): a Scottish
economist seem to have been the effects of the
division of labour.”
Trade
Suppose you and your neighbor both want to consume apples and
cherries. Will trade takes place in the following cases?
Case 1: You only have apple trees and your neighbor only have cherry
trees. Trade: X
Trade
trees. Trade: X
Case 2: You both have apple and cherry trees. You are good at
picking apples, and your neighbor is good at picking cherries.
Trade:
Trade
trees. Trade: X
Trade: X
Case 3: You both have apple and cherry trees. Your neighbor is
better at picking both apples and cherries. Trade:
Trade
trees. Trade: X
Trade: X
better at picking both apples and cherries. Trade: X
In this lecture, we will discuss Case 2 & 3. For simplicity, we use
straight-line PPF
Trade
trees. Trade: X
Trade: X
better at picking both apples and cherries. Trade: X
In this lecture, we will discuss Case 2 & 3. For simplicity, we use
straight-line PPF −→ with marginal opportunity cost (oc) being constant
Case 2
Calculate the following values
Figure 3: Your and your neighbor’s PPF
Case 2
(Hint: what is your gain? What are

you giving up?)
Your marginal oc for apples:
Case 2
(Hint: what is your gain? What are

you giving up?)
Your marginal oc for apples: 15/45

= 1/3 lb of cherries
Your marginal oc for cherries: ?
Your neighbor’s marginal oc for

apples: ?
Figure 3: Your and your neighbor’s PPF Your neighbor’s marginal oc for
cherries: ?
Case 2
Your marginal oc for apples: 15/45

= 1/3 lb cherries
Your marginal oc for cherries:
45/15 = 3 lbs apples
apples: 40/20 = 2 lbs cherries.
cherries: 20/40 = 1/2 lb apples
Comparative advantage
Comparative advantage: the ability of an individual, a firm, or a country

to produce a good or service at a lower marginal opportunity cost than
other competitors.
Your marginal oc for apples is lower than your neighbor’s: you have a
comparative advantage in picking apples.
Your neighbor’s marginal oc for cherries is lower than yours: your
neighbor has a comparative advantage in picking cherries.
Comparative advantage
Comparative advantage: the ability of an individual, a firm, or a country

to produce a good or service at a lower marginal opportunity cost than
other competitors.
Your marginal oc for apples is lower than your neighbor’s: you have a
comparative advantage in picking apples.
Your neighbor’s marginal oc for cherries is lower than yours: your
neighbor has a comparative advantage in picking cherries.
Generally in a case with two individuals and two activities,
It is impossible for a person to have comparative advantage in both

activities.
If one has a comparative advantage in one activity, then the other
person must have a comparative advantage in the other activity.
Gains from trade
Without trade: the consumption bundle is on the PPF. The consumption

bundle is the production bundle.
Figure 5: Your production and Figure 6: Your neighbor’s production

consumption without trade and consumption without trade
Gains from trade
With trade:
Specialize in the activity with comparative advantage
suppose trade 20 lbs apples for 20 lbs cherries
Figure 7: Your production and Figure 8: Your neighbor’s production

consumption with trade and consumption with trade
Gains from trade
Both you and your neighbor can consume at a point above the individual
PPFs of your own.
You and your neighbor are both better off after the trade.
Gains from trade
Both you and your neighbor can consume at a point above the individual
PPFs of your own.
What if your neighbor is better at picking both apples and cherries?
Case 3
Assume that you and your neighbor have the same amount of resources
(time and efforts).
Absolute advantage
Your neighbor has an absolute advantage in picking both apples and

cherries.
Absolute advantage is the ability of an individual, a firm, or a country to
produce more of a good or service than competitors, using the same
amount of resources.
Absolute advantage

cherries.
Question: who has comparative advantage in apples? who in cherries?
Absolute advantage

cherries.
Question: who has comparative advantage in apples? who in cherries?
(Hint: by definition of comparative advantage, you need to compare the

marginal oc)
Case 3
Your marginal oc for apples: 1 cherry

Your neighbor’s marginal oc for apples: 60/30=2 lbs cherries
Case 3

You have a comparative advantage in picking apples.
Your neighbor has a comparative advantage in picking cherries.
Case 3

You have a comparative advantage in picking apples.
Your neighbor has a comparative advantage in picking cherries.
It is possible to have an absolute advantage in producing a good or
service without having a comparative advantage.
It is possible to have a comparative advantage in producing a good or
service without having an absolute advantage.
Gains from trade
With trade:
Specialize at the activity with comparative advantage
Suppose trade 10 lbs apples for 15 lbs cherries.
The market system
A market is a group of buyers and sellers of a good or service and the

institution or arrangement by which they come together to trade.
Product market: a market for goods–such as computers–or services–such
as medical treatment.
Factor market: a market for the factors of production, such as labor,
capital, natural resources, and entrepreneurial ability.
Labor: the mental and physical capacity of workers to produce goods
and services.
Natural resources: land, water, oil and other raw materials
Capital: the physical plants, machinery, and equipment used to
produce other goods.
Entrepreneurship: the creative ability of individuals to seek profits by
combining resources to produce goods and services
The market system
Product market:
Buyers: households
Sellers: firms
Price
An important Factor market – Labor market:
Buyers: firms
Sellers: households
Wage
The market system
Figure 9: Circular-flow diagram
Example: government shutdown
The second United States federal government shutdown of 2018 and

ongoing as of January 2019 began at midnight EST on Saturday,
December 22nd.
the Economist– On January 11th the Transportation Security
Administration (TSA), the government agency that operates the security
checks for passengers at airports, was unable to pay its workers, who have
now been unpaid since December 22nd. On January 10th the number of
workers calling in sick increased by 55% on the same day a year ago,
according to the agency. And the situation is only likely to get worse.
Miami airport has already been forced to closes one of its concourses due
to a lack of TSA employees on duty. Back

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Comparative Advantage and Trade & The Market

October 10, 2021

Positive analysis vs. Normative analysis

Positive analysis vs. Normative analysis

Production Possibilities Frontier (PPF)

Figure 1: The green curve: PPF

Opportunity cost: the highest-valued alternative that must be given up to

Opportunity cost: the highest-valued alternative that must be given up to

Opportunity cost: the highest-valued alternative that must be given up to

Opportunity cost: the highest-valued alternative that must be given up to

Opportunity cost: the highest-valued alternative that must be given up to

The shape of PPF:

2 The market system

Most people specialize in certain work as their jobs.

Most people specialize in certain work as their jobs.

An Apple-Inc.-product contains hundreds of parts that are designed,

Firm Location of the Firm iPad Component Supplied

An Inquiry into the Nature and

Calculate the following values

Figure 3: Your and your neighbor’s PPF

Calculate the following values

(Hint: what is your gain? What are

Your marginal oc for apples:

Figure 3: Your and your neighbor’s PPF

Calculate the following values

(Hint: what is your gain? What are

Your marginal oc for apples: 15/45

Your marginal oc for cherries: ?

Your neighbor’s marginal oc for

Your marginal oc for apples: 15/45

Figure 4: Your and your neighbor’s PPF

Comparative advantage: the ability of an individual, a firm, or a country

Comparative advantage: the ability of an individual, a firm, or a country

It is impossible for a person to have comparative advantage in both

Without trade: the consumption bundle is on the PPF. The consumption

Figure 5: Your production and Figure 6: Your neighbor’s production

Figure 7: Your production and Figure 8: Your neighbor’s production

Your neighbor has an absolute advantage in picking both apples and

Your neighbor has an absolute advantage in picking both apples and

Question: who has comparative advantage in apples? who in cherries?

Your neighbor has an absolute advantage in picking both apples and

Question: who has comparative advantage in apples? who in cherries?

(Hint: by definition of comparative advantage, you need to compare the

Your marginal oc for apples: 1 cherry

Your marginal oc for apples: 1 cherry

Your marginal oc for apples: 1 cherry

A market is a group of buyers and sellers of a good or service and the

Figure 9: Circular-flow diagram

The second United States federal government shutdown of 2018 and

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