AP Macroeconomics

Comparative Advantage

Ricky Ricardo

• Lucy’s Cuban-American husband drumming on the bongo.

David Ricardo

• English economist responsible for promoting comparative advantage as the basis of trade. No relation to Ricky Ricardo.

Absolute Advantage v. Comparative Advantage

• Absolute Advantage– Individual – exists when a person can

produce more of a certain good/service than someone else in the same amount of time.

– National- exists when a country can produce more of a good/service than another country can in the same time period.

• Comparative Advantage– Individual/National- exists when an

individual or nation can produce a good/service at a lower opportunity cost than can another individual or nation

Specialization

• Individuals and Countries can be made better off if they will produce in what they have a comparative advantage and then trade with others for whatever else they want/need.

Example

• Assume David Ricardo and Ricky Ricardo are going to throw a party in exactly one hour. They decide on serving homemade pizzas and cakes. Assume they have like 15 ovens in their apartment and lots of pots and pans. Use the information in the next slide to determine who should produce what.

ExampleBake Cakes

Make Pizza

David Ricardo

2 cakes/hr. 4 pizzas/hr.

Ricky Ricardo

6 cakes/hr. 8 pizzas/hr.

ExampleBake Cakes

Make Pizza

David Ricardo

2 cakes/hr. 4 pizzas/hr.

Ricky Ricardo

6 cakes/hr. 8 pizzas/hr.

Who has the absolute advantage in baking cakes?Who has the absolute advantage in making pizza?

ExampleDavid Ricardo

Ricky Ricardo

Bake Cakes

2 cakes/hr. 6 cakes/hr.

Make Pizza 4 pizzas/hr.

8 pizzas/hr.

Why?Well, because 6 cakes>2 cakes & 8 pizzas>4 pizzas.

ExampleDavid Ricardo

Ricky Ricardo

Bake Cakes

2 cakes/hr. 4 cakes/hr.

Make Pizza 6 pizzas/hr.

8 pizzas/hr.

Who has the comparative advantage in baking cakes?Who has the comparative advantage in making pizza?

Example

Who has the comparative advantage in baking cakes?Who has the comparative advantage in making pizza?

Example

Why?Ricky only gives up 2 pizzas in order to bake a cake, whereas David gives up 3 pizzas in order to bake a cake.

Example

It only cost David 1/3 of a cake to make a pizza, whereas it costs Ricky ½ of a cake to make a pizza.

30

30

12

18

20

10

8

4

Coffee Coffee

Wheat Wheat

Absolute Advantage? Should the U.S. and Absolute Advantage? Should the U.S. and Brazil specialize and trade?Brazil specialize and trade?

Even though the U.S. has an absolute advantage in both goods – it should specialize and trade.

Step 1: Set up the problemStep 2: Identify Production Maximums

Coffee WheatU.S.

Brazil

Step 2: Reduce RatiosStep 3: Identify Opportunity CostStep 4: Compare Costs --- lowest has CA

Coffee: Wheat:

30

Brazil U.S.

30

20 10

1 1

2 1

(1W) (1C)

(1/2 W) (2C)

Step 1: Set up the problemStep 2: Identify production prior to specializationStep 3: Total production in each product prior to specializationStep 4: Identify maximum possible production of each product

with specialization according to comparative advantageStep 5: Compare output before/after specialization and trade

Coffee WheatU.S. Brazil

BeforeAfterGain

12 18

8 4

20 22

20 30

+8

Step 1: Identify original reduced ratios for each countryStep 2: Terms of trade fall between the limits set by the ratiosStep 3: Trading possibilities are the maximums set by the ratios

U.S. 1 C = 1 W

Brazil 2C = 1/2 W

PossiblePossibleTerm ofTerm ofTradeTrade

1.5C = 1W

Both nations benefit from 1.5C traded for 1W. Prior to trade, theU.S. gave up 1W for each coffee. With trade, the U.S. can receive1.5C for each unit of wheat. Before trade, Brazil gave up 2C for eachunit of wheat. With trade, Brazil gives up only 1.5C for each wheat.

U.S. 1 C = 1 W

Brazil 2C = 1 W

Trading Possibilities:Trading Possibilities:

PossiblePossibleTerm ofTerm ofTradeTrade

1C < 1W < 2C

1.5C = 1W

Should the U.S. and Brazil specialize and trade?Should the U.S. and Brazil specialize and trade?

Why: Efficiency Argument and Output ArgumentMore efficient useefficient use of scarce global resources • The U.S. gives up 1 coffee for each wheat / Brazil gives up 2 coffees for each wheat --- The U.S. gives up less to produce wheat.• Brazil gives up ½ wheat for each coffee / U.S. gives up 1 wheat for each coffee --- Brazil gives up less to produce coffee.Gains from trade --- more can be produced from the same resources• 8 additional units of wheat can be produced through specialization and8 additional units of wheat can be produced through specialization and tradetrade

Distinguishing:

Input/Output Problems

Distinguishing input from output problems.

• An OUTPUT problem presents the data as products produced given a set of resources. (ex. Number of pens produced)

• An INPUT problem presents the data as amount of resources needed to produce a fixed amount of output. (ex. Number of labor hours to produce 1 bushel)

• When identifying absolute advantage, input problems change the scenario from who can produce the most to who can produce a given product with the least amount of resources.

Which type of problem?• Acres to produce one unit of each.

• Input problem

Apples Pears

Tom 10 5

Sam 6 2

Absolute Advantage?• Acres to produce one unit of each.

• Who has the absolute advantage in apples and pears?

Sam

Apples Pears

Tom 10 5

Sam 6 2

Explanation• Acres to produce one unit of each.

• Sam has an absolute advantage in both pears and apples because he can produce 1 unit of each in fewer acres than Tom. Absolute advantage in INPUT problems is based on using the LEAST amount of resources to produce the given unit(s) of product.

Apples Pears

Tom 10 5

Sam 6 2

Input or Output problem?• Number caught per day.

Output problem

Trout Bass

Tom 4 6

Sam 24 12

Absolute Advantage?• Number caught per day.

• Which guy has the absolute advantage in the production of each product?

Sam

Trout Bass

Tom 4 6

Sam 24 12

Explanation:• Number caught per day.

• Sam has an absolute advantage in catching both trout and bass as he can

catch more of each than Tom in one day’s time.

Trout Bass

Tom 4 6

Sam 24 12

Input or Output Problem?• Days to produce one unit of each.

• Input problem

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Explanation:• Days to produce one unit of each.

• This is an input problem as it refers to how many days (work days for labor) will

be needed to produce 1 unit. The problem is phrased in terms of resources used

rather than products produced.

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Absolute Disadvantage?• Days to produce one unit of each.

• Which corporation has an absolute disadvantage in the production of

both products?QKFX

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Explanation:• Days to produce one unit of each.

• XYZ has an absolute advantage in producing both cars and planes because it

can produce 1 unit of each in less time (days) than QKFX. This means that QKFX

has an absolute disadvantage in producing both products. QKFX uses more

days to produce both products.

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Input or Output Problem?• To produce the following from one

ton of olives.

Output problem

Canned Olives

Olive Oil

Zaire 60 10

Colombia 24 8

Explanation?• To produce the following from one ton

of olives.

• This is an output problem because it is the number produced (output in

canned olives and olive oil) from a given unit of resources (1 ton of olives)

Canned Olives

Olive Oil

Zaire 60 10

Colombia 24 8

Absolute Advantage?• To produce the following from one

ton of olives.

• Which nation has the absolute advantage in both products?

Zaire

Canned Olives

Olive Oil

Zaire 60 10

Colombia 24 8

Explanation:• To produce the following from one ton

of olives.

• Zaire has an absolute advantage in producing both products because it can produce more given the unit of

resources available (1 ton of olives).

Canned Olives

Olive Oil

Zaire 60 10

Colombia 24 8