Fig. VI The Production Possibility Curves of Individuals X & Y (Repiclured)

1 z 3 4 5

Wheat

Regardless of which production possibility is on, they can collecdvely produce more of ;oods if each specializes in the good in which he I comparative advantage. The absolute advantage ilcvant. To see this basic point, suppose thai in ition Y would produce al A and that X would pro-at B. Now let X increase his wheat production by riinit and let Y increase clothing by one unit, i.e., increase their production in the good of their fonrative advantage and reduce production in the good. We can keep track ofthe changes in Table II. From the table we see that a 1 unit increase in heat production means a decrease in his clothing luction of 1/2 units given his production possibil-rve trade-off in Figure V. For Y increasing cloth-production by 1 unit means giving up 1/4 units of I. Summing these results on the right hand side column marked Total, we see that collectively now have 1/2 units more clothing and 3/4 units ; wheat, which is to say, more production of both s. Nonetheless, X and Y have only partially oiled the potential increase in output; additional ilization in the good of comparative advantage Jurther increase their joint production.

OF TRADE

The fact that the two can have greater total out-: of both goods if they specialize suggests that each lid specialize in producing only one good, hange some of their production for the other and thereby consume more of both goods. If f are to do so, however, they must come to some cement about the rate at which one good would be for the other. Such an agreement would set the

terms of trade. For example, three wheat in exchange for five clothing is one of many possible terms of trade. Moreover, the terms of trade must make both parties better off (or at the very least one part) better off and the other no worse ofO; otherwise the party made worse off would refuse to accept the terms offered. This is another way of saying that trade is beneficial.

Just as we can determine the comparative advantage through opportunity cost alone, so also can we determine the terms (within limits) at which the parties would come to an agreement; il has to be on terms that make both traders better off than either could do in isolation.

To work through such an example, lets assume, following David Ricardo (1772-1823), that England can produce a unit of cloth with the labor of 60 men and a unit of wine with the labor of 180 men. Portugal, on the other hand, can produce both a unit of cloth and a unit of wine with the labor of 50 men. Then specialization and trade, according to comparative advantage, will permit each country to consume more of both goods,

To see this, we must first calculate the opportunity costs. Let denote clothing, m denote man-hours, and w denote wine. Then in England, the opportunity cost is (lc/60m)-(lw/180m) = (3c)/(lw) -in other words, three cloth per unit of wine. As you can see, the man-hour terms inthis calculation cancel out. The Portuguese opportunity cost is similarly calculated as (lc/50m)(lw/50m) = (lc)/(lw) - in other words, one cloth per unit of wine. Thus, Portugal has a comparative adrantage in wine because of its lower opportunity cost (lc v. 3c), so if it specializes in wine and England in cloth, more of both goods can be produced as weve already seen.

Consider Portugals choices in Figure VII, where we see Portugal gives up 1 cloth to make 1 wine - or what is the same thing - gives up 1 wine to have 1 cloth along its dark production possibility curve. Now suppose English traders were to offer Portugal 1 cloth in exchange for 2 wine. Should Portugal accept these terms, it would move to the extreme right hand corner of its production possibilities curve, produce nothing but wine, and then trade some of its wine for

Table II The Gains From Specialization

Wheal Clothing

ze everything, we can saJj ;r off if 1 wine trades for ,,.11

cloth along the dashed trading path 1, where the slope of the terms of trade line is I/2 (1 cloth for 2 wine). Since accepting this offer would leave Portugal with less of everything somewhere inside its original production possibility curve, it would surely refuse. Similarly, Portugal will be no better off specializing in wine and trading for English cloth if England were to offer it a unit of cloth in exchange for a unit of Portuguese wine: These terms of trade exacdy match Portugals choices along its production possibihty curve. Next suppose England offers it 2 cloth for 1 wine. Now Portugal could specialize in wine by moving to the extreme right of its production possibilities curve and then exchange wine for cloth along the dashed terms of trade line 11 having a slope of 2 (2 cloth per 1 wine). Since this line lies outside Portugals production possibility curve, Portugal can have more of both goods and so is certainly better off. We can summarize all this by saying that Portugal will be better off than its situation in isolation anytime 1 wine trades for more than 1 cloth.

Similarly, looking at Englands situation in Figure VIII, we see England will be better off if 1 wine trades for anything less than 3 cloth. For example, if 1 wine trades for 2 cloth, England would be able to specialize entirely in cloth by moving to the extreme northwest of its producdon possibilities curve, allowing it to trade cloth for Portuguese wine along the terms of trade line . By doing so, England moves outside the production possibilities curve to which it was otherwise bound.

To summarize Portugal will be better off if 1 wine trades for ar more than 1 cloth. England wil be better off if j1 trades for anything less than 3 cloth. Therefore 1 could be made better off if they first specialize act ing to comparative advantage, and then trade l for anything between 1 cloth and 3 cloth. Thel step allows them to collectively produce more.f second allows them to individually consume men put the matter another way, they can both finding terms of trade with lie between the opn! nity costs. Since there are many such possible 1 however, we cannot predict which will emerge wi3 more information.

Because the ubiquity of scarcity forces all] eties to chose an economic system, its desirable! the system selected be capable of reaping the j from trade according to the principles of comp advantage. Although we shall not present the pr this book, the capitalistic system as guided and trolled by money prices can automatically achiey result. Conversely, centrally planned economic economies guided by tradition do not. To that < such societies impoverish their populace.

Fig. VIII Englands Choices

Clotii

Wine

1. Johnson, M. Bruce. On The Taking Issue (Boston: Lexington, 1977)

2. Ricardo, David, Principles of Political Economy & Taxation (London: 1817)

:UP QUESTIONS FOR SECTION I

warm-up questions are provided primarily as an § recognition and reinforcement of key concepts a than as typical exam material. If you have the jtest difficulty with these questions, you should read fCCdon again before proceeding any further. Several are advised before trying the questions.

tThe production possibilities curve shows: lounts of goods which will be produced (b) its of two resources available to produce a (c) the amount of unemployment (d) the ible combinadon of goods at a point in I all of the above.

ipportunity cost represents: (a) another income (b) another name for the produc-gbility curve (c) anything that has to be fore-= get something else (d) the most valued that has to be foregone to achieve some-

le slope of the production possibility curve the opportunity cost of the good on the hori-„iaxis (b) the opportunity cost of the good on axis (c) both opportunity costs (d) nei-ity cost (e) the absolute advantage of a

person has a comparative advantage in good the opportunity cost of producing x is less any other person (b) he has an absolute [e in producing good x (c) he has a compar-dvanced technology (d) the amount of given uce a unit of x is large (e) both a and d.

\Vhich of the following does not represent a production? (a) land (b) labor (c) capital ine (e) a share of stock.

;;.Which of the following produces a shift of the :tion possibilities frontier? (a) specialization icreased unemployment (c) technological (d) international trade (e) none of the

G. A country can produce extra units of clothing at a constant opportunity cost of two cars. At which of the following international terms of trade will it pa) the country to specialize in clothing production and export clothes in exchange for foreign cars? (a) 1 unit of clothing for 1 car (b) 2 cars for 1 unit of clothing (c) 3 cars for 1 unit of clothing (d) 1 unit of clothing for 1/3 cars (e) 5 units of clothing for 1 car.

H. If good X is on the horizontal axis of a production possibility curve and good Yis on the vertical, then the opportunity cost of good Y is: (a) constant

(b) the reciprocal ofthe slope of the curve (c) undefined (d) the slope of the production possibility curve (e) equal to the opportunity cost of good X.

I. A production possibility curve between goods X and Y indicates all of the following but: (a) the opportunity cost of good X (b) the size of the labor force (c) the opportunity cost of good Y (d) the amount of Y the consumer must give up to produce a unit of X (e) the maximum amount of Y the economy can have if it throws 100% of its resources into the production of Y. ......

J. Competition is fundamentally caused by: (a) the nature of the economic system (b) property rights

(c) scarcity (d) specializauon (e) middlemen.

A double coincidence of wants occurs when: (a) two people want the same good (b) a consumer buys a good in a shop, paying in cash (c) "A" wants what "B" has to offer and "B" wants what "A" has to offer (d) two traders want different things (e) comparative advantage does not exist.

L. An absolute advantage means that: (a) a comparative advantage is impossible (b) a comparative ad\antage has occurred (c) opportunity costs are equal (d) opportunity costs are not the same (e) one entity can produce more of both goods than the other entity.