A case study aboutComparative Advantage

• The opportunity cost of a good or service is its cost in terms of the forgone opportunity to pursue the one best possible alternative activity with the same time or resources

Comparative Advantage: the ability to produce a good or service at a lower opportunity cost than someone else.

Law of comparative advantage: ◦ proposition that the joint output of trading

partners will be greatest when each good is produced by the low opportunity cost producer.

3

• Economic actors will be better off if they choose to produce those things for which they have the lowest opportunity costs, and trade for those with higher costs. – This is called specialization.

• Choices based on lowest opportunity costs involve giving up the least amount of other things.

Specialization is based on Comparative Advantage!

4

• Established the Theory of Comparative Advantage – Especially in foreign Trade.

• Expected eventual “steady state” with mass poverty.

• Paired with Thomas Malthus

• Economics as the “dismal science”

• Principles of Political Economy and Taxation, 1817

Assume that labor inputs per unit of output are constant for 2 goods and two countries:

Labor inputs in Spain:◦ 4 hours per ton of fish◦ 2 hours per ton of grain

Labor inputs in Norway◦ 5 hours per ton of fish◦ 5 hours per ton of grain

Opportunity cost means the cost of something measured in terms of the opportunities that must be sacrificed in order to get it

In Spain, opportunity cost of 1 ton of fish is 2 tons of grain

In Norway, opportunity cost of 1 ton of fish is 1 ton of grain

Labor inputs in Spain: 4 hours per ton of fish 2 hours per ton of grainLabor inputs in Norway 5 hours per ton of fish 5 hours per ton of grain

Spain is said to have an absolute advantage in producing both goods because production uses absolutely fewer resources

A country is said to have a comparative advantage in producing a good if it has a lower opportunity cost than trading partners

Spain has a comparative advantage in production of grain

Norway has a comparative advantage in production of fish

When opportunity costs of goods differ, both countries can gain from trade if each exports the good in which it has a comparative advantage

Before trade, Spain produces and consumes at point A and Norway at point A’. World consumption is at point P, inside the world production possibility frontier.

After trade, specializes in grain (point B) and trades part of the grain for fish, moving to consumption point C. Norway specializes in fish (point B’) and reaches consumption point B’ through trade.

World efficiency is improved and point Q on the world production possibility frontier is reached.

Dolan, Economics Combined Version 4e, Ch. 7

A country is said to have a comparative advantage in producing a good if it has a lower opportunity cost than trading partners

To gain from trade, a country should◦ Export goods in which it has a comparative advantage◦ Import goods in which it does not

Trade is advantageous to both parties of the ratio (price) at which goods are exchanged is between the opportunity cost ratios for the two countries

Dolan, Economics Combined Version 4e, Ch. 7

Source: PDClipart.org

Countries tend to export goods that make intensive use of the factors of production that the country possesses in relative abundance.◦ US produces capital and Human Capital intensive

products◦ Bangladesh tends to produce low-skilled labor

intensive products

IMF / Bretton Woods GATT WTO

Demand Matters Financial transactions and balance of trade

◦ Exchange rates Protectionism

◦ Tariffs◦ Quotas◦ “Voluntary” restraints◦ Subsidies

Regional Trading Blocks ◦ MFN Within Blocks – Barriers between

Europe◦ Coal and Steel◦ European Community◦ European Union

NAFTA ASEAN

Though whole national economies benefit unambiguously, the impact on specific groups within any given economy varies widely◦ Some gain through sales opportunities (exporters)◦ MANY gain through improved quality, variety, and

price of consumer goods◦ Some lose dramatically in competition with

foreign producers who enjoy a comparative advantage

Trade benefits are:◦ Diffuse ◦ Sometimes uncertain◦ Usually poorly understood◦ Very difficult to use as a rallying cry for political

mobilization

Trade costs are:◦ Specific◦ Personal◦ Clearly understood◦ Easy to identify and use as a rallying cry for

political mobilization