Comparative Advantage - The Basis for Exchange (Chapter 2)

8/3/2019 Comparative Advantage - The Basis for Exchange (Chapter 2)

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Comparative Advantage:

The Basis of Exchange


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7.2

Exchange and Supply

Basis for exchangePrinciple of comparative advantageProduction possibilities curve

Economic efficiencyPolitical ExchangeRole of middlemenThe Use Money for Exchange


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7.3

Basis for Exchange

W hy do peoples trade? A difference in the comparative advantage (or marginalvalues to be precise) is a precondition for trade to bemutually beneficial.The exchange benefits the two parties just as much asif there had been a magical, costless increase in goodsto the two people.

The following analyses presume costs of transaction arenegligible (this assumption will be relaxed later)


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Example 1: Basis for exchange

Paul is a house painter whose roof needs replacing. Ronis a roofer whose house needs painting.

Although Paul is a painter, he also knows how to installroofing. Ron, for his part, knows how to paint houses.Should Paul roof his own house? Should Ron paint hisown house?

Paul

Ron


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Time required by each to complete each type of job:

Ron has an absolute advantage over Paul at both

painting and roofing, which means that Ron takesfewer hours to perform each task than Paul does.

Painting Roofing

Paul 300 hrs 400 hrsRon 200 hrs 100 hrs

Should Ron do the roofing and painting jobs for bothhouses?


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Time required by each to complete each type of job:

However, Paul has a c omparative advantage overRon at painting, which means that he is relativelymore efficient at painting than Ron is .

Painting Roofing



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Comparative advantage and opportunity cost

To have a comparative advantage at a task

To have a lower opportunity cost of performing it

(is the same as)


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The opportunity cost of painting one house = the numberof roofing jobs he could do during the same time.

Paul s opportunity cost of painting a house is .75 roofing jobs (=300 hrs per painting/400 hrs per roofing).

Ron s opportunity cost of painting a house is 2 roofing jobs (=200 hrs per painting/100 hrs per roofing).

O pportunity Cost for1 Painting

O pportunity Cost for1 Roofing

Paul 0. 75 Roofing 1.2 5 PaintingRon 2 Roofing 0. 5 Painting


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Paul s opportunity cost of painting a house is .75roofing jobs.Ron s opportunity cost of painting a house is 2 roofing

jobs.

Paul thus has a comparative advantage at painting,because his opportunity cost of painting is lower thanRon s.Therefore it makes sense for Paul to do both painting

jobs and leave both roofing jobs for Ron.


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I f each person performed both tasks for himself, thetotal time spent would be 1,000 hours (i.e. 700 hoursfor Paul and 300 hours for Ron).

I n contrast, when each specializes in his comparativeadvantage, these totals fall to 800 hours. Specifically,600 hours for Paul (300 hrs x 2 houses) and 200 forRon (100hrs x 2 houses) , a savings of 200 hours intotal or 100 hours each . This is the gain from

exchange.

Painting Roofing



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Principle of Comparative Advantage

Everyone does best when each person (or country)concentrates on the activities in which he or she isrelatively most efficient .

Concentrates on the activities in which he or she isrelatively most efficient means specialization .

Specialization by comparative advantage provides therationale for market exchange.

By performing only those tasks at which we arerelatively most efficient, we can produce vastly morethan if we each tried to be self-sufficient .


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Sources of Comparative Advantage

I ndividualI nborn talent

EducationTrainingExperience

Non-economic Adoption of a languageI nstitutions

National LevelNatural resourcesCulturalI nstitutions

W hat can we do to change our comparative advantage?


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The Production Possibilities Curve

A graph that describes the maximum amount of onegood that can be produced for every possible level of production of the other good.


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Production Possibilities Curve:One-person economy

Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food.I f Chris is the only person in the economy, describe theeconomy's produ c tion possibilities c urve .

Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120


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Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120

Production Possibilities Curve: All combinations of shelter andfood that can be producedwith Chris s labor.

The absolute value of theslope of the productionpossibility curve is 6/12 =1/2.

For Chris, this means that the opportunity cost of anadditional pound of foodeach week is 1/2 sq yd/wkof shelter.


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Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120

E

C

D

F

A

B

A, B, C, D Attainable and efficient E Attainable but inefficient

F Unattainable


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Production Possibilities Curve:Two-person economy

Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. I f Dana is the only person in the economy, describe the economy'sproduction possibilities curve.

For Dana, the opportunity cost of an additional pound of food each

week is 1 sq yd/wk of shelter.

Food (lb/wk)

Shelter (sq yd/wk)Production Possibilities Curve:

All combinations of shelter andfood that can be producedwith Dana s labor.

4

4

2

2


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For Chris, the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.For Dana, the opportunity cost of an additional poundof food each week is 1 sq yd/wk of shelter.

Thus, Chris has a comparative advantage in producingfood, while Dana has a comparative advantageproducing shelter.

To maximize an economy output, let Chris specialize inproducing food, while Dana in producing shelter.


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To derive the economy's production possibilities curve, let Chrisspecialize in producing food until his full capacity is reached (i.e. 12lb/wk of food). Then, let Dana to produce food after that point.Similarly, Let Dana to produce shelter first until her full capacity is

reached (i.e. 4 sq yd/wk of shelter). Then, let Chris to produceshelter after that point.

Food (lb/wk)

Shelter (sq yd/wk)


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Food (lb/wk)

Shelter (sq yd/wk)

12 16

4

6

8

10Dana works full time makingshelter; Chris works 1/3 weekon shelter, 2/3 week on food.

Dana and Chris, a married couple, have decided to consume, jointly,6 sq yd/wk of shelter and 8 lb/wk of food. How should they dividethe task of producing these quantities?


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Food (lb/wk)

Shelter (sq yd/wk)

12 16

46

8

10 Dana works full time making shelter; Chris works1/3 week on shelter, 2/3 week on food.

Dana has a comparative advantage in producing shelter, but evenif she spends all his time producing shelter, she can make only 4sq yd/wk.

So Chris will have to produce the additional 2 sq yd/wk for them toachieve the desired 6 sq yd/wk.Since Chris is capable of producing 6 sq yd/wk of shelter on hisown, it will take him only 1/3 of a week to produce 2 sq yd.This leaves 2/3 of a week for him to produce food, which is exactlyhow much time he needs to produce the desired 8 lb/wk.


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The Production Possibilities Curve for anEconomy with Many W orkers

Food (lbs/wk)

Clothing (garments/wk)

Produce the initial units of clothing using the resources that are relatively most efficient at clothing production, and onlythen turn to those that are relatively less efficient at clothing production.


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Economic Growth: An Outward Shift in the Economy s PPC

Coffee(1000s of lb/day)

Nuts(1000s of

lb/day)

O riginal PPC

New PPC

Fa c tors S h ifting t h e PPC1. In c reases in produ c tive resour c es

(i.e. labor or c apital)

2. Improvements in knowledge andte c h nology


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Factors That Shift The Economy s ProductionPossibilities Curve

I ncreasing Productive ResourcesI nvestment in new factories and equipment Population growth

I mprovements in knowledge and technologyI ncreasing educationGains from specialization


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Too much specialization?

Specialization boostsproductivity, but it also entails costs.

Variety is one of thefirst casualties.


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Efficiency of specialization and variety

A situation is effi c ient if it results in the largest possible economic surplus.

A situation is ineffi c ient if it fails to achieve the largest possible economic surplus.

Specialization brings additional output.People like more output and also variety in their jobs.There is a trade-off between output and variety.


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Comparative Advantage and I nternational Trade

The same logic that leads the individuals in an economyto specialize and exchange goods with one another alsoleads nations to specialize and trade among themselves.

As with individuals, each trading partner can benefit from exchange, even though one may be moreproductive than the other in absolute terms.


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Economic Naturalist

I f trade between nations is so beneficial, why are free-trade agreements so controversial?


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Common Alleged Reasons to Oppose Free Trade

Learn from the experience during the W orld TradeOrganization ( W TO) meeting in Seattle (1999)Reasons to oppose free trade

Foreign companies engage in dumpingGoods that are produced abroad using unfair laborlaw

use of child labor (sixty-four hours weeks with noovertime pay)

Lower environmental standard abroadclean gasoline programall shrimp sold in American must be caught in netswith turtle escape device


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Political Exchange

Unlike market system, current political system decidesallocation of resources by voting, e.g., election of legislative councilor.

Logrolling is trading political goods for mutual benefit One or more legislators agreeing to vote for anotherlegislator s bill, if the second legislator will vote forthe first one s bill.Example, if Martin Lee, a member of The DemocraticParty, agrees to vote for an Environmental bill onconditional that Tsang Yok-sing, the chairman of theDAB, will vote for a bill for the direct election of thechief executive in 2012.


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Food for Thought

I s logrolling beneficial to society?

Does logrolling protect minority interest?

Do voters want to trade vote for money or goods if theyare allowed to do so? (do you recommend such as asystem?)


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Summary of Free Trade

Free trades are beneficial to both buyers and sellers Any restrictions to free trade reduce social welfareFree trades also allow specialization between nationsand individualsChina and I ndia are successful because of their free-trade policies.


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Role of Middlemen

Middlemen provide useful information about goods andproducts to people and lower information search costs.

Transaction costs are lowered with middlemen

Middlemen could increase transaction volume in society

and benefit both buyers and sellers

Competition between middlemen reduces the spreadbetween buying and selling prices.


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Role of Middlemen

I n a free-entry and exit economy, the equilibrium pricespread equals to the costs of providing middlemen services at the quality wanted by the consumers.

Larger spread attracts more middlemen to enter themarket.


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Realtor Commissions in the US

W hen a home seller wants to sell her home, she istypically required to sign an exclusive agreement with thereal-estate agent (known as the listing agent ). Thelisting agent represents the seller in dealing with allpotential buyers and is typically paid a predetermined fee( } 6% of the home selling price).

I n the U.S., the average sale price for new houses in

June 2005 was US$267,400, indicating the averagerealtor commission fee for selling a new house is approx.US$16,044 (HK$125,143)


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Competition on Realtor Commissions: US

W ith the advance of technology such as internet, manydiscount realtors enter the market and lowers thecommission rates.

From 1991 to 2004, the average commission ratedropped from 6.1% to 5.1%.


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Realtor Commissions in HK

I n Hong Kong, home sellers are not required to sign anexclusive agreement with the real-estate agent. Yet, thereal-estate agent represents the seller in dealing with all

potential buyers.

Both buyers and sellers are required to pay apredetermined fee of 1 % of the home selling price. Yet,

this 1% commission fee could be negotiable too,particularly for luxury home!!!


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Food For Thought

Now, why is the commission rate in HK significantly lowerthan that in the U.S. (2% Vs. 6%)?

Recently, some states in the U.S. require real estateagents to provide minimum services to their customers(buyers or sellers), what are the economic consequencesof such restrictions?

Does consumers benefit with the entry of internet realtors?(hint: internet realtors usually offers rebates toconsumers)


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W hy Money?

W hy is money being used as a medium of exchange?

double coincidence of want?store of value?reduce transaction costs?


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Comparative Advantage - The Basis for Exchange (Chapter 2)