Hi folks, Chace here again to finish off
chapter 2.  The second major concept that
we wanted to get a handle on was
comparative advantage.  Comparative
advantage was first introduced by
David Ricardo, and David Ricardo was an
Englishman, and he was concerned about
the level of protection that was being
afforded English agriculturalists.  This
was helping them to sell their grain, and
it was also helping landlords to collect
large rents; however, it was driving up
food prices and it was costing
capitalists and industrialists more and
more in terms of wages, so Ricardo was
concerned that this was slowing down the
overall growth in the economy, and he
wanted to convince folks that they
should be more open to free trade.  So the
argument that was perhaps the most
persuasive, and still holds the most
currency today, is comparative advantage.
and Ricardo thought that people were way
too fixated on absolute advantage and..
absolute advantage is essentially being
able to produce more output than a
competitor using the same resources.  You could probably just think about this
even more simply as your just better at
it than the other trading partner, but he
said whether or not you were better at
something than someone else didn't
really matter in terms of whether or not
it made sense to trade with that person.
He said the thing that you should really
be most concerned about is comparative
advantage, comparative advantage was the ability to produce output at a lower
opportunity cost than competitors.  In
other words, when you decided to do
something you didn't miss out as much on output, alternative output, as your
competitor might.  So if you decide you're
going to go out and you are going to
make a guitar you might only miss out on
making 1/3 of a motorcycle, if that was
the other thing you could have done with
your time.  Whereas, your trading partner
that you're considering..they might go
out there and if they decide to make a
guitar they could miss out on a whole
motorcycle
that would mean that they would have a
higher opportunity cost.  You'll remember
this opportunity cost concept we covered
it briefly with our guns and butter
example from the PPF. When we wanted more butter we missed out on guns same sort
of thing here. 
Well Ricardo will effectively argues, and
I'll show you numerically here in a
second, that you can get a better outcome
if people would just follow their
comparative advantages.. and what he means
by follow their comparative advantages
is you want to figure out in what you
have a comparative advantage... specialize
in that and then go ahead and trade for
whatever it is that the other person is
going to create for you.
Ok, so let's go ahead and take a look
at a work example.  if we're going to try
to follow the law of comparative
advantage as Ricardo suggested ,then
we're going to need to be able to figure
out opportunity cost, so I've got two
fictitious countries down hereand their
production possibilities within a given
time period with a same amount
of resources. Alba can produce 60 units of
lead or 30 wool.  Aragonia can produce
30 or 10.  What I want you to recognize right
off the bat is that Alba has an absolute
advantage in both lead for wool.  Now this
might lead you to ask is Alba too good
for Aragonia, if Ricardo is right then
no they're not ...they should still
specialize and they should trade.. but
we've got to figure out what it is
they're going to specialize in.  We've got
to calculate opportunity costs first, so
when we're talking about opportunity
costs the easiest way to wrangle the
math is to start thinking about whatever
you want the opportunity cost of needs
to go on the bottom of a fraction.  So if
you want to know the opportunity cost of
wool, then we're going to have how much
lead are we missing out on per every
unit of wool that we create,  or we're
going to put lead over wool... So in the
case of Alba here,  if we want to know the
opportunity cost of wool Alba is going
to lose out on
two units of lead for every one unit of
wool that they decide to create... and the
way that I know that that is the answer
is because I'm going to go ahead and I'm
going to put in 60 lead, which is what
they were capable of, and I'm going to
put that over 30 wool, which is what they
were capable of, so what this is
basically telling us is that Alba is
going to miss out on two lead per wool
that they choose to create. OK, great
so you understand that Alba misses out
on two lead for every wool that they want
to make, but comparative means that has
to be compared to someone ...right?, so we've
got to do Aragonia,  And when we start
looking at Aragonia.. we're going to do
the same exact thing.  We're going to go
ahead and we're going to put their lead
over their wool and we're going to find
out that that means that they are going
to miss out on three lead per wool.  Now
it's easy to see now that Alba in fact has
the lower opportunity cost. Two is less than
three.  When they go out and make a wool
they only miss out on two units of lead,
whereas, when Aragonia does it Aragonia
actually going to miss out on three
units of lead. 
Therefore, Alba is going to specialize
in wool.  That means of course that Argonia is going to specialize in lead... and
this might not seem immediately obvious
but what I want you to recognize is that
if we were to figure out the opportunity
cost of lead all we do with these
fractions is flip them over and look at
the reciprocals... and we'd see that in
fact Alba would miss out on a half a
unit of wool per lead and Arargonia
would only miss
on 1/3 of the unit of wool per lead.
Hence, they would have the comparative
advantage in lead.   So we know who's going
to do what now.  Let's go ahead and start
broadening this example out a bit.  Okay,
so when we were looking at wool we
understood that Alba was going to lose
out on two lead per wool and they were in
fact going to specialize in that.  Aragonia
did not specialize in it, because they
were going to miss out on three lead per
wool.  Once you've got this worked out you
can always tell what the terms of trade
are going to be between two countries, or
the terms of trade that will make trade
acceptable.  In order for them to actually
be willing to exchange the relative
price of one good to another has got to
be between these terms of trade, so Alba
we know is making wool.   So if they were
stopped making wool at any given moment
they could go out and they could choose
to create two lead.  So if they're going to
trade away wool they're definitely going
to want to get back more than two lead,
otherwise they may as well have just
done it themselves.  Aragonia on the
other hand if they're going to go out
and they're going to be purchasing wool
from Alba they're never going to want to
pay more than three lead per wool,
because at any given moment they can
stop making three units of lead and they
can make a unit of wool by themselves.. So
any terms of trades that actually fall
in between these two 2.1, 2.4, 2.8, anything
between two and three is actually going
to be acceptable to both.  So let's say
that it's 2.6 lead per wool
is the price that's actually going in
the market. They're going to find this
acceptable, and they are going to engage
in trade Alba is going to be happy to
receive two point six Oregonian is going
to be
absolutely happy to pay less than three,
i.e.
2.6.. so this is what's going to guide
trade...and another way of thinking about
this is that both of these folks are
getting a better deal than what they
would have got had they been doing it on
their own.  That's going to be critical
for understanding this next slide.  Okay,
so we understand comparative advantage
we understand how to calculate opportunity
costs so we can figure out what we have
the comparative advantage in... and we also
understand that by trading we can do
better than if we were to do it by
ourselves,  so that must mean that we can
escape the PPF.  I want to show that to
you graphically now, and in order to
start bridging the two together I need
you to realize that that basic
information that I gave you about Alba
can be used to show a PPF.  So I'm going
to go ahead and make our Y variable lead
and our X variable wool.  It's similar to
when we're talking about guns and butter.
If you were to have spent all of your
time as Alba and you spent all of it on
lead.  You could have created 60 unit of lead or you could have created thirty
units of wool. What we're going to see
then is you basically have trade offs.  At
any given point you could have stopped
making a wool and chose to make two lead instead
and this is course would move
you along the PPF.  If you kept making that
trade-off you would eventually get to
the point where you were making 60 lead
up here at our intercept and your of course making 0 wool at that point. So how do we
escape this with trade?  Well I'm hoping it's
pretty obvious at this point that if you
can trade at anything between 2 & 3, 
right? in our example we were talking
about 2.6,  let's go ahead and make this
2.5 for the sake of easier math.. if you can
trade 2.5 lead
per wool then this is amazing, because
you're going to go out there and you're
going to start selling wool and instead
of moving over one wool and only up two
lead, which is what your PBS is doing.
You're now going to be able to move over
one wool but you're going to go up 2.5
lead. That means that instead of going
along the line you actually move over
one and then you move up further than
you would have.  That's going to put you
at a point outside of your PPF,  because
every time you trade with your trading
partner you're getting two and a half,
rather than just the two had you done the
trade off with yourself.   This is of
course how you can jump outside of the
PPF, but this is only possible with
specialization and trade.
