Comparative advantage Today: An introduction to the advantages of trade.

Comparative advantage

Today: An introduction to the advantages of trade

Becky’s linear production possibilities curve

Becky’s linear production possibilities curve What points

are attainable?

What points are efficient?

Attainable and efficient points Efficient points

Any point on the production possibility curve

These points are efficient, since additional production of one good necessarily means that another good has lower production

Attainable points F/B define an attainable point to be “any

combination of goods that can be produced using currently available resources” (p. 43)

Back to Becky Efficient

points: w, x, y, z, v

Attainable points: t, w, x, y, z, v

Unattainable point: u

Next, let’s look at a two-person economy Suppose

that Barbara and Sherry have the Production Possibility Curves (PPCs) as shown

Next, let’s look at a two-person economy Barbara can

do one of the following: Copy 50 tests

if she does not type letters

Type 25 letters and copy no tests

Something in between

Next, let’s look at a two-person economy Sherry can do

one of the following: Copy 25 tests

and do nothing else

Type 50 letters and do nothing else

Something in between

Opportunity cost How much of one

activity needs to be given up in order to do one more of the other?

Example: Barbara could type one less letter in order to copy two more tests

Absolute advantage and comparative advantage Absolute advantage

“One person has an absolute advantage over another if he or she takes fewer hours to perform a task than the other person” (F/B p. 36)

Comparative advantage “One person has a comparative advantage

over another if his or her opportunity cost of performing a task is lower than the other person’s opportunity cost” (F/B p. 37)

New example

Productivity in pizza

production

Productivity in salad production

Greg 20 pizzas cooked per

hour

10 salads made per hour

David 16 pizzas cooked per

hour

4 salads made per hour

Drop units to save space Notice that

Greg has absolute advantage in producing both pizzas and salads

However, we will see that each person has a comparative advantage in producing one of the goods

Productivity in pizza productio

n

Productivity in salad

production

Greg 20 / hour 10 / hour

David

16 / hour 4 / hour

Comparative advantage

Before we can determine comparative advantage, we must ask about each person “how much of ____ must I give up in order to produce an additional ____?” In other words, we need to determine

the opportunity cost of making one more pizza or one more salad for both Greg and David

Opportunity cost table

Note that the two numbers in each row are mathematical inverses of each other

Opportunity cost of cooking

a pizza

Opportunity cost of making a salad

Greg ½ salad 2 pizzas

David ¼ salad 4 pizzas

Comparative advantage

To find comparative advantage for each person, find the lowest number in each column

Opportunity cost of cooking

a pizza

Opportunity cost of making a salad

Greg ½ salad 2 pizzas

David ¼ salad 4 pizzas

Comparative advantage

David has comparative advantage in cooking pizzas

Greg has comparative advantage in making salads

Opportunity cost of cooking

a pizza

Opportunity cost of making a salad

Greg ½ salad 2 pizzas

David ¼ salad 4 pizzas

Some things to note

Absolute advantage The same person could have absolute

advantage in everything Comparative advantage in a two-

person, two-good economy Each person will almost always have

comparative advantage in exactly one of the two goods

From Greg and David to a big economy

To produce an efficient point in an economy, each good needs to be produced with lowest opportunity cost

All units in this graph in millions

From Greg and David to a big economy Notice that opportunity cost of pizzas

increases from A to C Opportunity cost increases as more is

produced

All units in this graph in millions

Changes in a production possibilities curve

Some factors that can shift a production possibilities curve Change in population War Investment in buildings, machines,

and other forms of capital Research and development in

technology

From comparative advantage to trade

Recall that Greg had comparative advantage at making salads, while David’s was making pizzas

Greg could make more salads than he wants to eat and trade them for pizzas from David Both can be made better off with

trade

International trade In the real world, trade is more complex

than simple two-good economies When trade becomes more open between

countries, there are typically millions of winners and often only thousands of losers Prices go down for goods on average The few displaced workers must find an

alternate form of work, typically at a lower wage

International trade We will examine more about

international trade in the next lecture For more on international trade, read

Ch. 9 Think about how trade benefits your

everyday life Example: You could speculate about the

price of gas if OPEC countries stopped producing oil