comparative advantage
DESCRIPTION
A lecture for an introductory microeconomics class. Very basic. Covers a two-firm economy.TRANSCRIPT
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Role of Comparative Advantage in International trade
Economic growth
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Exchange and Opportunity Cost
Scenario: Madonna makes tens of millions of dollars a year from albums, tours and endorsements. At $10 million a year, for example, she would make approximately $1000 per hour. Being very athletic she can mow her own lawn in 1 hour. She could also hire a high school student Henry (who has absolutely no talent in music) to mow the lawn for her. Henry would take 2 hours for the job and charge $60.
Should Madonna mow her own lawn?
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Exchange and Opportunity Cost
Scarcity implies that the opportunity cost of spending more resources (time, labor etc.) on any one thing means that we have less resources available for other purposes.
This principle can help explain why it is better for people to specialize in what they do best rather than trying to do everything.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Absolute Advantage
Madonna clearly has an absolute advantage in both singing and lawn mowing compared to Henry because she takes less time than Henry to do both.
Absolute Advantage – One person has an absolute advantage over another if he takes fewer hours to perform a task than the other person
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Comparative Advantage
But she is relatively more proficient in singing than lawn mowing. That is to say her opportunity cost of lawn mowing is higher than that of Henry. So she should leave the lawn mowing to Henry even though she is actually better at it than Henry is.
Comparative Advantage - One person has a comparative advantage over another if his opportunity cost of performing a task is lower than the other person’s opportunity cost.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Comparative Advantage continued…
One of the most important insights of modern economics is that when two people (or nations) have different opportunity costs of different tasks, they can always increase the total value of available goods and services by trading with one another.
The principle of Comparative Advantage is the fundamental basis for International trade.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Here is an illustration of absolute and comparative advantage.
Suppose Paula and Beth are the only two people in a small community with skills in software programming and bike repair.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Paula has an absolute advantage in both activities.
Doesn’t mean she should do both.
Time to update
Paula
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Absolute and Comparative Advantage - Example
Beth’s OC of a web update is lower than Paula. So Beth should do web pages.
Paula’s OC of a bike repair is lower than Beth. So Paula should repair bikes.
Opportunity Cost of updating a web page
Opportunity Cost of a bicycle repair
Paula
*
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Does Specialization yield benefits? Yes.
Assume no specialization, an 8 hr. workday, and a demand for 16 web page updates.
Paula: 4hrs.+4hrs.; Beth 2hrs.+6hrs.
If they split their time, each doing both, and produce 16 web pages
Paula
Beth
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Benefits with Specialization
With Specialization, an 8 hr. work day, and a demand for 16 web updates.
Clearly Specialization is better.
Paula
Beth
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Support for entrepreneurship (CA in introduction of new products)
Value placed on craftsmanship (CA in production of high quality variants of established products)
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Economic Naturalist: On Comparative Advantage
TVs and VCRs were first developed and produced in the US and yet, today, the US accounts for a minority share of the total world production of these products. Why did the US fail to retain its lead in these markets?
Initial CA because of world class research and development ; military need; culture of entrepreneurship; skilled labor.
Once product designs stabilized and manufacturing operations were automated, cheap unskilled labor abroad took the lead.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Comparative Advantage and Production Possibilities
Recall: CA and specialization allows an economy to produce more than if each person tries to produce a little of everything.
So we introduce a graph to show what an economy can produce called the Production Possibilities Curve.
It is a graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Assume an economy with only one worker, Susan, that
Produces only 2 goods - coffee and nuts
Susan works 6 hrs/day
She can do both but has nimble fingers giving her and edge in coffee picking
No other resources except Susan’s labor are used to produce coffee
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Susan’s PPC
Nuts Coffee Nuts Coffee
12 0 6 0
8 8 4 2
4 16 2 4
0 24 0 6
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Chapter 2: Comparative Advantage: The Basis for Exchange
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16
8
4
8
24
Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Susan’s labor
A
B
C
D
12
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Susan’s PPC and Opportunity Cost
Susan’s OC of nuts = Loss in coffee/gain in nuts = 24/12 = 2 lbs. of coffee. It is the absolute value of the slope of Susan’s PPC
Susan’s OC of coffee = Loss in nuts/gain in coffee = 12/24 = 0.5 lb. of nuts. It is the reciprocal of the absolute value of the slope of Susan’s PPC
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Opportunity Cost and Price
Since Susan is the only person in the economy, her OC of producing a good, in effect, becomes its price.
Thus the price she has to pay for an additional pound of nuts is 2 lbs. of coffee (absolute value of the slope of Susan’s PPC)
Similarly, the price she has to pay for an additional pound of coffee is ½ a pound of nuts.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Nuts
(lb/day)
A
B
Coffee
(lb/day)
24
0
16
8
4
8
12
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Attainable, Unattainable and Efficient Points on Susan’s PPF
Attainable Point: a combination of goods that can be produced using current resources
Unattainable Point: a combination that cannot be produced using current resources
Efficient Point: a combination of goods whose production cannot be increased without a reduction in the production of something else
Inefficient Point: a combination of goods for which current resources enable an increase in the production of one good without a reduction in the production of the other
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Introducing Tom’s Production Possibilities Frontier
Tom’s PPC: Tom is better at picking nuts. He works 6 hours a day
Production in lbs. Hours spent picking
Nuts Coffee Nuts Coffee
24 0 6 0
16 4 4 2
8 8 2 4
0 12 0 6
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Chapter 2: Comparative Advantage: The Basis for Exchange
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0
Nuts
(lb/day)
How Individual Productivity Affects the Slope and Position of the Production Possibilities Curve
Tom’s Production Possibilities Curve for a 6 hour day
Coffee
(lb/day)
4
8
8
16
A
B
C
D
12
Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor
24
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Comparative Advantage and Tom’s Production Possibilities
Tom’s OC of nuts = Loss in coffee/gain in nuts = 12/24 = 0.5 lb. of coffee. This is the absolute value of the slope of Tom’s PPC
Tom’s OC of coffee = Loss in nuts/gain in coffee = 24/12 = 2 lbs. of nuts. It is the reciprocal of the absolute value of the slope of Tom’s PPC
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Comparing Susan and Tom’s PPC
Susan has an absolute advantage in producing coffee while Tom has an absolute advantage in producing nuts.
Shows up as a difference in the vertical and horizontal intercepts of their respective PPCs.
Susan has a comparative advantage in producing coffee while Tom has a comparative advantage in producing nuts.
Shows up as a difference in the slopes (absolute value) of their respective PPCs; Susan 2; Tom ½.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Nuts
(lb/day)
0
Coffee
(lb/day)
12
24
Tom has an absolute and comparative advantage in gathering nuts
24
12
Susan has an absolute and comparative advantage in picking coffee
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Susan’s Production Possibilities Curve
Susan & Tom allocate their time so that each produces half nuts and half coffee. Producing & consuming at B.
Tom’s Output = 2 hrs picking nuts = 8 lbs 4 hrs picking coffee = 8 lbs
Susan’s Output = 2 hrs picking coffee = 8lbs 4 hrs picking nuts = 8 lbs
Total Output = 16 lbs each
8
8
B
Coffee
(lb/day)
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Nuts
(lb/day)
0
12
24
12
24
Susan’s PPC
Tom’s comparative advantage is in nuts so he specializes in nuts and produces 24 lbs
Susan’s comparative advantage is in coffee so she specializes in coffee and produces 24 lbs
Susan gives Tom 12 lbs of coffee for 12 lbs of nuts
E
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Without trade, each person can consume along his production possibilities curve
What you produce determines what you consume
With trade, each person's consumption can be greater than production
Produce according to comparative advantage
Trade to get what you want
Gains from Specialization and Exchange/Trade
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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The gains from specialization grow larger as the difference in opportunity cost increases
For Example
Comparative Advantage
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Chapter 2: Comparative Advantage: The Basis for Exchange
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The gains from specialization grow larger as the difference in opportunity cost increases
Without Specialization
Tom: 5 hrs coffee = 5 lb 1 hr nuts = 5 lb
Susan: 1 hr coffee = 5 lb 5 hrs nuts = 5 lb
Total: 10 lb 10 lb
With Specialization
Total: 30 lb 30 lb
Comparative Advantage
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Why is trade is win-win situation?
Because Trade is a voluntary exchange between two parties. So had it not been beneficial, trade would not have taken place.
Trade: A Win-Win Situation
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
A country can gain by importing goods from another country even when it can produce the same good at a lower cost than the other country. It just makes sense to specialize in producing the other good which it can produce at an even lower cost. It can use all the savings so generated to exchange it for whatever it wants to consume.
Trade: A Win-Win Situation
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Bushels of Wheat Bushels of Corn
80,000 A 0
60,000 B 40,000
40,000 C 70,000
20,000 D 90,000
0 E 100,000
*
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Productions Possibilities Frontier
Bushels of Wheat
Bushels of Corn
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Opportunity Cost of Wheat
E to D: OC of 20,000 extra bushels of wheat is 10,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is ½ a bushel of corn.
D to C: OC of 20,000 extra bushels of wheat is 20,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is 1 bushel of corn.
C to B: OC of 20,000 extra bushels of wheat is 30,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is 1½ bushels of corn.
B to A: OC of 20,000 extra bushels of wheat is 40,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is 2 bushels of corn.
Sudeshna C. Bandyopadhyay
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Opportunity Cost of Corn
A to B: OC of 40,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is ½ a bushel of wheat.
B to C: OC of 30,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is 2/3 of a bushel of wheat.
C to D: OC of 20,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is 1 bushel of wheat.
D to E: OC of 10,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is 2 bushels of wheat.
Sudeshna C. Bandyopadhyay
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
“The Low-Hanging-Fruit Principle” – Increasing OC
Low hanging fruit is easier and cheaper to pick – low OC
So if you pick bottom up you come out ahead (pick the lower ones first and enjoy the revenue from its sale sooner)
In expanding the production of any good, first employ those resources with the lowest opportunity costs, and only afterward turn to resources with higher opportunity costs
Increasing Opportunity Cost
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Scarcity of resources
The Principle of Increasing Opportunity Cost (“The Low-Hanging-Fruit Principle”)
Shape of the PPC
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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A nation will have to figure out the trade-off between consumption (producing consumption goods) and investment (producing capital goods).
A Consumption Good is a good/service that is available for immediate consumption and does not add to the future productive ability of the nation. Example: A tanning session.
A Capital Good is a good/service that helps in further production and is not directly consumable. Example: Machines.
Nation’s PPC - Revisited
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
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A nations achieves Economic growth by giving up current consumption and producing capital goods to enhance the nation’s long run productive ability.
Economic growth is represented by a rightward shift of the PPC.
Main factors that drive Economic growth are:
Increasing Productive Resources
Population growth
Increasing education
Chapter 2: Comparative Advantage: The Basis for Exchange
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Economic Growth in two Nations
Consumption Goods
Capital Goods
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Specialization is easier when
Markets are connected
Transportation for goods
Communications for services
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
What do you think?
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Outsourcing
Medical transcription Medical tourism
Limits to outsourcing
Not amenable to computerization
Greatest security for workers is the ability to adapt quickly to changing circumstances
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Economic Naturalist
If trade between nations is so beneficial, why are free-trade agreements so controversial?
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Role of Comparative Advantage in International trade
Economic growth
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Exchange and Opportunity Cost
Scenario: Madonna makes tens of millions of dollars a year from albums, tours and endorsements. At $10 million a year, for example, she would make approximately $1000 per hour. Being very athletic she can mow her own lawn in 1 hour. She could also hire a high school student Henry (who has absolutely no talent in music) to mow the lawn for her. Henry would take 2 hours for the job and charge $60.
Should Madonna mow her own lawn?
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Exchange and Opportunity Cost
Scarcity implies that the opportunity cost of spending more resources (time, labor etc.) on any one thing means that we have less resources available for other purposes.
This principle can help explain why it is better for people to specialize in what they do best rather than trying to do everything.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Absolute Advantage
Madonna clearly has an absolute advantage in both singing and lawn mowing compared to Henry because she takes less time than Henry to do both.
Absolute Advantage – One person has an absolute advantage over another if he takes fewer hours to perform a task than the other person
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Comparative Advantage
But she is relatively more proficient in singing than lawn mowing. That is to say her opportunity cost of lawn mowing is higher than that of Henry. So she should leave the lawn mowing to Henry even though she is actually better at it than Henry is.
Comparative Advantage - One person has a comparative advantage over another if his opportunity cost of performing a task is lower than the other person’s opportunity cost.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Comparative Advantage continued…
One of the most important insights of modern economics is that when two people (or nations) have different opportunity costs of different tasks, they can always increase the total value of available goods and services by trading with one another.
The principle of Comparative Advantage is the fundamental basis for International trade.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Here is an illustration of absolute and comparative advantage.
Suppose Paula and Beth are the only two people in a small community with skills in software programming and bike repair.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Paula has an absolute advantage in both activities.
Doesn’t mean she should do both.
Time to update
Paula
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MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Absolute and Comparative Advantage - Example
Beth’s OC of a web update is lower than Paula. So Beth should do web pages.
Paula’s OC of a bike repair is lower than Beth. So Paula should repair bikes.
Opportunity Cost of updating a web page
Opportunity Cost of a bicycle repair
Paula
*
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Does Specialization yield benefits? Yes.
Assume no specialization, an 8 hr. workday, and a demand for 16 web page updates.
Paula: 4hrs.+4hrs.; Beth 2hrs.+6hrs.
If they split their time, each doing both, and produce 16 web pages
Paula
Beth
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Benefits with Specialization
With Specialization, an 8 hr. work day, and a demand for 16 web updates.
Clearly Specialization is better.
Paula
Beth
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Support for entrepreneurship (CA in introduction of new products)
Value placed on craftsmanship (CA in production of high quality variants of established products)
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Economic Naturalist: On Comparative Advantage
TVs and VCRs were first developed and produced in the US and yet, today, the US accounts for a minority share of the total world production of these products. Why did the US fail to retain its lead in these markets?
Initial CA because of world class research and development ; military need; culture of entrepreneurship; skilled labor.
Once product designs stabilized and manufacturing operations were automated, cheap unskilled labor abroad took the lead.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Comparative Advantage and Production Possibilities
Recall: CA and specialization allows an economy to produce more than if each person tries to produce a little of everything.
So we introduce a graph to show what an economy can produce called the Production Possibilities Curve.
It is a graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Assume an economy with only one worker, Susan, that
Produces only 2 goods - coffee and nuts
Susan works 6 hrs/day
She can do both but has nimble fingers giving her and edge in coffee picking
No other resources except Susan’s labor are used to produce coffee
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Susan’s PPC
Nuts Coffee Nuts Coffee
12 0 6 0
8 8 4 2
4 16 2 4
0 24 0 6
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
16
8
4
8
24
Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Susan’s labor
A
B
C
D
12
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Susan’s PPC and Opportunity Cost
Susan’s OC of nuts = Loss in coffee/gain in nuts = 24/12 = 2 lbs. of coffee. It is the absolute value of the slope of Susan’s PPC
Susan’s OC of coffee = Loss in nuts/gain in coffee = 12/24 = 0.5 lb. of nuts. It is the reciprocal of the absolute value of the slope of Susan’s PPC
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Opportunity Cost and Price
Since Susan is the only person in the economy, her OC of producing a good, in effect, becomes its price.
Thus the price she has to pay for an additional pound of nuts is 2 lbs. of coffee (absolute value of the slope of Susan’s PPC)
Similarly, the price she has to pay for an additional pound of coffee is ½ a pound of nuts.
Chapter 2: Comparative Advantage: The Basis for Exchange
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Nuts
(lb/day)
A
B
Coffee
(lb/day)
24
0
16
8
4
8
12
MB
MC
Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Attainable, Unattainable and Efficient Points on Susan’s PPF
Attainable Point: a combination of goods that can be produced using current resources
Unattainable Point: a combination that cannot be produced using current resources
Efficient Point: a combination of goods whose production cannot be increased without a reduction in the production of something else
Inefficient Point: a combination of goods for which current resources enable an increase in the production of one good without a reduction in the production of the other
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Introducing Tom’s Production Possibilities Frontier
Tom’s PPC: Tom is better at picking nuts. He works 6 hours a day
Production in lbs. Hours spent picking
Nuts Coffee Nuts Coffee
24 0 6 0
16 4 4 2
8 8 2 4
0 12 0 6
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Chapter 2: Comparative Advantage: The Basis for Exchange
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0
Nuts
(lb/day)
How Individual Productivity Affects the Slope and Position of the Production Possibilities Curve
Tom’s Production Possibilities Curve for a 6 hour day
Coffee
(lb/day)
4
8
8
16
A
B
C
D
12
Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor
24
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Comparative Advantage and Tom’s Production Possibilities
Tom’s OC of nuts = Loss in coffee/gain in nuts = 12/24 = 0.5 lb. of coffee. This is the absolute value of the slope of Tom’s PPC
Tom’s OC of coffee = Loss in nuts/gain in coffee = 24/12 = 2 lbs. of nuts. It is the reciprocal of the absolute value of the slope of Tom’s PPC
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Comparing Susan and Tom’s PPC
Susan has an absolute advantage in producing coffee while Tom has an absolute advantage in producing nuts.
Shows up as a difference in the vertical and horizontal intercepts of their respective PPCs.
Susan has a comparative advantage in producing coffee while Tom has a comparative advantage in producing nuts.
Shows up as a difference in the slopes (absolute value) of their respective PPCs; Susan 2; Tom ½.
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Nuts
(lb/day)
0
Coffee
(lb/day)
12
24
Tom has an absolute and comparative advantage in gathering nuts
24
12
Susan has an absolute and comparative advantage in picking coffee
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Susan’s Production Possibilities Curve
Susan & Tom allocate their time so that each produces half nuts and half coffee. Producing & consuming at B.
Tom’s Output = 2 hrs picking nuts = 8 lbs 4 hrs picking coffee = 8 lbs
Susan’s Output = 2 hrs picking coffee = 8lbs 4 hrs picking nuts = 8 lbs
Total Output = 16 lbs each
8
8
B
Coffee
(lb/day)
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Nuts
(lb/day)
0
12
24
12
24
Susan’s PPC
Tom’s comparative advantage is in nuts so he specializes in nuts and produces 24 lbs
Susan’s comparative advantage is in coffee so she specializes in coffee and produces 24 lbs
Susan gives Tom 12 lbs of coffee for 12 lbs of nuts
E
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Without trade, each person can consume along his production possibilities curve
What you produce determines what you consume
With trade, each person's consumption can be greater than production
Produce according to comparative advantage
Trade to get what you want
Gains from Specialization and Exchange/Trade
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
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The gains from specialization grow larger as the difference in opportunity cost increases
For Example
Comparative Advantage
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Chapter 2: Comparative Advantage: The Basis for Exchange
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The gains from specialization grow larger as the difference in opportunity cost increases
Without Specialization
Tom: 5 hrs coffee = 5 lb 1 hr nuts = 5 lb
Susan: 1 hr coffee = 5 lb 5 hrs nuts = 5 lb
Total: 10 lb 10 lb
With Specialization
Total: 30 lb 30 lb
Comparative Advantage
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Why is trade is win-win situation?
Because Trade is a voluntary exchange between two parties. So had it not been beneficial, trade would not have taken place.
Trade: A Win-Win Situation
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Chapter 2: Comparative Advantage: The Basis for Exchange
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A country can gain by importing goods from another country even when it can produce the same good at a lower cost than the other country. It just makes sense to specialize in producing the other good which it can produce at an even lower cost. It can use all the savings so generated to exchange it for whatever it wants to consume.
Trade: A Win-Win Situation
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Bushels of Wheat Bushels of Corn
80,000 A 0
60,000 B 40,000
40,000 C 70,000
20,000 D 90,000
0 E 100,000
*
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Productions Possibilities Frontier
Bushels of Wheat
Bushels of Corn
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Opportunity Cost of Wheat
E to D: OC of 20,000 extra bushels of wheat is 10,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is ½ a bushel of corn.
D to C: OC of 20,000 extra bushels of wheat is 20,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is 1 bushel of corn.
C to B: OC of 20,000 extra bushels of wheat is 30,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is 1½ bushels of corn.
B to A: OC of 20,000 extra bushels of wheat is 40,000 bushels of corn. Therefore, the OC of 1 extra bushel of wheat is 2 bushels of corn.
Sudeshna C. Bandyopadhyay
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Opportunity Cost of Corn
A to B: OC of 40,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is ½ a bushel of wheat.
B to C: OC of 30,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is 2/3 of a bushel of wheat.
C to D: OC of 20,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is 1 bushel of wheat.
D to E: OC of 10,000 extra bushels of corn is 20,000 bushels of wheat. Therefore, the OC of 1 extra bushel of corn is 2 bushels of wheat.
Sudeshna C. Bandyopadhyay
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Chapter 2: Comparative Advantage: The Basis for Exchange
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“The Low-Hanging-Fruit Principle” – Increasing OC
Low hanging fruit is easier and cheaper to pick – low OC
So if you pick bottom up you come out ahead (pick the lower ones first and enjoy the revenue from its sale sooner)
In expanding the production of any good, first employ those resources with the lowest opportunity costs, and only afterward turn to resources with higher opportunity costs
Increasing Opportunity Cost
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Scarcity of resources
The Principle of Increasing Opportunity Cost (“The Low-Hanging-Fruit Principle”)
Shape of the PPC
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Chapter 2: Comparative Advantage: The Basis for Exchange
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A nation will have to figure out the trade-off between consumption (producing consumption goods) and investment (producing capital goods).
A Consumption Good is a good/service that is available for immediate consumption and does not add to the future productive ability of the nation. Example: A tanning session.
A Capital Good is a good/service that helps in further production and is not directly consumable. Example: Machines.
Nation’s PPC - Revisited
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Chapter 2: Comparative Advantage: The Basis for Exchange
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A nations achieves Economic growth by giving up current consumption and producing capital goods to enhance the nation’s long run productive ability.
Economic growth is represented by a rightward shift of the PPC.
Main factors that drive Economic growth are:
Increasing Productive Resources
Population growth
Increasing education
Chapter 2: Comparative Advantage: The Basis for Exchange
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Economic Growth in two Nations
Consumption Goods
Capital Goods
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Chapter 2: Comparative Advantage: The Basis for Exchange
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Specialization is easier when
Markets are connected
Transportation for goods
Communications for services
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
What do you think?
Chapter 2: Comparative Advantage: The Basis for Exchange
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Copyright c 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Outsourcing
Medical transcription Medical tourism
Limits to outsourcing
Not amenable to computerization
Greatest security for workers is the ability to adapt quickly to changing circumstances
Chapter 2: Comparative Advantage: The Basis for Exchange
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Chapter 2: Comparative Advantage: The Basis for Exchange
Slide *
Economic Naturalist
If trade between nations is so beneficial, why are free-trade agreements so controversial?
Chapter 2: Comparative Advantage: The Basis for Exchange
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