Microeconomics Lecture 1B:
Applications to Theory of Specialisation & Trade
Reference: EC 1002 Subject Guide Chapter 1: The study of Economics
1. INTRODUCTION
One implication which arises from the modelling of scarcity is the principle
of specialisation & trade.
If the parties with comparative advantage at producing some goods will
handle the production of those goods, collectively, all parties will be
able to consume more goods than the alternative arrangement where all
parties only consume the products they produced on their own.
That is, the outcome after specialisation & trade will be that at least some
will be better off & no one will be worse off.
2. COMPARATIVE ADVANTAGE, SPECIALISATION & TRADE
Consider 2 individuals (the heads of households I & II) who produce all
their life necessities by themselves.
Assume that these necessities include only 2 types of goods: food (F) &
clothes (C).
Individual I can produce, & consume, either 6 units of clothes or 2 units of
food, or any combination of these two.
The second individual (Individual II) can produce either 6 units of clothes
or 6 units of food, or any combination of these two.
Mapping out the combinations of those points will give us the PPF for each
household:
Figure 1: Household I
6
Figure 2: Household II
6
6
1
3
AII
AI
PPF0
1
PPF0 II
Suppose now that the two individuals chose to produce & consume at
points AI = (1, 3) & AII = (3, 3) respectively. The two individuals have
organized their households in a productively efficient manner.
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
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In such a situation, these economies are self-sufficient or Autarky. That
is, each household consumes exactly what it produces.
The total output from both economies is 6 units of clothes & 4 units of
food.
Comparative advantage: A household is said to have a comparative
advantage in producing a good when the opportunity cost of producing
that good is lower than that of the other household.
The opportunity of producing clothes in household I is 1/3 unit of food,
which is lower that of household II. We thus say that household I has
comparative advantage in producing clothes.
This implies that household II has comparative advantage in the
production of food.
Specialisation: As household I has comparative advantage in producing
clothes, it should specialise in producing clothes only. As household II
has comparative advantage in producing food, it should specialise in
producing food only.
If every unit of clothes consumed by both I & II are produced in household
I, while every unit of food consumed are produced at II, the total amount
of food & clothes will increase to 6 units of clothes & 6 units of food.
Suppose that each household still carry on consuming 3 units of clothes.
This means that household II will have to buy 3 units of clothes from I.
This is the end of Autarky, i.e., what each of them produces is no
longer necessarily what they will consume. Trade & exchange
between the two households are necessary.
How many units of food will they be willing to give up in order to obtain
those units of clothes?
Household I will not be willing to buy food for more than 3 units of clothes
per unit of food, because they can produce it by themselves at that price
without specialisation.
Household II will not be willing to sell food for less than 1 unit of clothes,
because this is their opportunity cost of producing food without
specialisation.
To facilitate trade & exchange, the price of a good must be less than the
buyers opportunity cost, but greater than the opportunity cost to the seller.
Sellers Opportunity Cost Price Buyers Opportunity Cost
In terms of the price of food, this will be:
1 unit of clothes per unit of food = Sellers O.C. PF Buyers O.C. = 3
units of clothes per unit of food
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
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Suppose that the agreed price is 2 units of clothes per unit of food, this
exchange rate between clothes & food is depicted by the line with slope 2
in the following two graphs.
C
Figure 1: Household I
Figure 2: Household II
6
CPF0II
6
1
3
BII
AI
AII
CPF0I
PPF0I
PPF0 II
1 2
1.5
4.5
If the two households insist on consuming 3 units of clothes each, they
will now be able to consume more food (household I: 1 food 1.5 food;
household II: 3 food 4.5 food).
This shows that trade & specialisation can be mutually beneficial.
3. ADDITIONAL EXAMPLE
Robinson Crusoe can bake 10 loaves of bread in one hour or peel 20
potatoes.
Friday can bake 5 loaves of bread in an hour or peel 30 potatoes.
If they believe in equality in consumption, would they specialise & trade? If
so, at what price will they exchange bread for potatoes?
30
30
Figure 3: Robinson Crusoe
1
3
Figure 4: Friday
1
6
CPF0RC
1
3
CPF0F
20
1
2
BRC
15
BF
15
PPF0F
PPF0F
10
10
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
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Before specialisation, the opportunity cost of baking bread for Robinson is
peeling 2 potatoes. For Friday, it will be peeling 6 potatoes. Hence,
Robinson has a comparative advantage in baking bread.
This implies that Friday has a comparative advantage in peeling
potatoes.
Hence, Robinson should specialise in baking breads while Friday
should specialise in peeling potatoes.
The total output after specialisation would be 10 loaves of bread & 30
peeled potatoes.
Suppose each aims to consume the same amount of the products
(equality in consumption), the distribution would be 5 loaves of bread &
15 potatoes for each.
The price of a loaf of bread must be 3 potatoes & the price of a single
potato is 1/3 of a loaf of bread.
This price satisfies the required price range of:
Sellers Opportunity Cost Price Buyers Opportunity Cost
Hence they would specialise based on their comparative advantage, trade
& be better off than the autarky situation.
4. EXTRA PRACTICES
1. Two economies produce only two goods, X & Y. Economy 1 can produce
either 80 units of Y or 20 units of X (or any linear combination of the two).
Economy 2 can produce either 40 units of Y or 20 units of X (or any linear
combinations of the two). Therefore, there exists no price for which
economy 1 will gain from trading with economy 2. True or false, explain.
2. Two economies produce only two goods, X & Y. Economy 1 can produce
either 2 billion units of y or 4 billion units of X (or any linear combination of
the two). Economy 2 can produce either 4 billion units of Y or 2 billion units
of X (or any linear combinations of the two). If the international price of a
unit of X is one unit of Y, & Economic 1 must have precisely 2 billion units
of Y, both economies will consume the same amount of X & Y as each
other. True or false, explain.
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
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5. SUGGESTED SOLUTIONS for EXTRA PRACTICES
1. Two economies produce only two goods, X & Y. Economy 1 can produce
either 80 units of Y or 20 units of X (or any linear combination of the two).
Economy 2 can produce either 40 units of Y or 20 units of X (or any linear
combinations of the two). Therefore, there exists no price for which
economy 1 will gain from trading with economy 2. True or false, explain.
Y
80
50
PPF1
PPF1
40
40
30
PPF0
10
20
Economy 1
20
10
20
Economy 2
The opportunity cost of producing x for Economy 1 is 4 units of y per unit of x.
The opportunity cost of producing x for Economy 2 is 2 units of y per unit of x.
Hence, Economy 2 has comparative advantage in producing x & should
specialise in producing x.
This implies that Economy 1 has comparative advantage in producing y &
should specialise in producing y.
To gain from trading with economy 2, the price needs to satisfy the following:
Sellers Opportunity Cost Price < Buyers Opportunity Cost
Price of x must be:
2 units of y per unit of x one unit of x < 4 units of y per unit of x
If the price of one unit of x is 3 units of y & assuming each economy needs 10
units of x, economy 2 can sell 10 units of x to economy 1. In return, economy
1 will give economy 2 30 units of y. The new allocations are not attainable
before specialisation & trade. Hence, both will gain from trading with each
other. The statement is false.
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
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2. Two economies produce only two goods, X & Y. Economy 1 can produce
either 2 billion units of y or 4 billion units of X (or any linear combination of
the two). Economy 2 can produce either 4 billion units of Y or 2 billion units
of X (or any linear combinations of the two). If the international price of a
unit of X is one unit of Y, & Economic 1 must have precisely 2 billion units
of Y, both economies will consume the same amount of X & Y as each
other. True or false, explain.
PPF1
2
PPF0
PPF1
PPF0
Economy 1
Economy 2
The opportunity cost of producing x for Economy 1 is units of y per unit of x.
The opportunity cost of producing x for Economy 2 is 2 units of y per unit of x.
Hence, Economy 1 has comparative advantage in producing x and should
specialize in producing x.
This implies that Economy 2 has comparative advantage in producing y and
should specialize in producing y.
Given that price of x is one unit of y per unit of x, if Economy 1 can sell 2
billion units of x to Economy 2, Economy 2 needs to give Economy 1 2 billion
units of y. Both economies will consume the same amount of x and y as each
other.
Hence, the statement is true.
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
Page 6
80
4
0
40
PPF0
PPF0
10
20
20
10
2
0
Economy 2
Economy 1
80
5
0
PPF1
4
0
40
PPF1
30
PPF0
10
20
Economy 1
20
10
2
0
Economy 2
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
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2
PPF0
PPF0
Economy 1
Economy 2
PPF1
2
2
PPF1
PPF0
PPF0
2
Economy 1
Economy 2
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
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80
5
0
PPF1
40
4
0
PPF1
30
PPF0
PPF0
10
20
Economy 1
20
10
2
0
Economy 2
The opportunity cost of producing X for Economy 1 is 4 units of Y per unit of
X. The opportunity cost of producing X for Economy 2 is 2 units of Y per unit
of X. Hence, Economy 2 has comparative advantage in producing X and
should specialize in producing X.
This implies that Economy 1 has comparative advantage in producing y and
should specialize in producing y.
To gain from trading with economy 2, the price needs to satisfy the following
Sellers Opportunity Cost Price < Buyers Opportunity Cost
Price of X must be:
2 units of y per unit of X one unit of X < 4 units of y per unit of X
If the price of one unit of X is 3 units of Y and assuming each economy needs
10 units of X, economy 2 can sell 10 units of X to economy 1. In return,
economy 1 will give economy 2 30 units of Y. The new allocations are not
attainable before specialization and trade. Hence, both will gain from trading
with each other. The statement is false.
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Prepared by Dr. Zhang Jianlin. Copyright: Singapore Institute of Management. Edited by William Tan v.16 Sep 14
Page 9
