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Chapter 2 Comparative Advantage
Learning Objectives
1.
The Principle of Comparative Advantage2.
The Principle of Increasing Opportunity Cost3.
Factors that shift the menu of production possibilities
4.
The role of comparative advantage in international trade
5.
Why some jobs are more vulnerable to outsourcing than others
Do It Yourself?
Joe, a highly successful trial attorney, employs another attorney to write his will
Writing your own willOpportunity cost of 2 hoursHiring someone to spend 4 hours on your willMaking the right economic choice
Do It Yourself only whenOpportunity cost < hired cost
2 hours$10,000+
$3,200
Priceless
Production Advantages
DefinitionsAbsolute advantage
Lowest production costComparative advantage
Lower opportunity cost than someone elseThe principle of comparative advantage
Every one does best when each concentrates on activity with the lowest opportunity cost
The Principle of Comparative Advantage
Two parties have different opportunity costs for two activities
Concentrate on the activities of your lowest opportunity costTotal value of output increases with specialization and trade
Comparative Advantage ExampleProduction Times
Web Update Bike Repair
Paula 20 minutes 10 minutesBeth 30 minutes 30 minutes
Paula and Beth can each update web pages and repair bikes
Paula has an absolute advantage in both
Comparative Advantage Example
Production Times Web Update Bike Repair
Paula 20 minutes 10 minutesBeth 30 minutes 30 minutes
Opportunity Cost Web Update Bike Repair
Paula 2 repairs 0.5 updateBeth 1 repair 1 update
Comparative Advantage Example
Production Times Web Update Bike Repair
Paula 20 minutes 10 minutesBeth 30 minutes 30 minutes
Hourly Output Web Update Bike RepairPaula 3 updates 6 repairsBeth 2 updates 2 repairs
Comparative Advantage Example
16 web updates are orderedPaula spends half her time at each activity: 12 updates and 24 repairsBeth produces 4 updates and 12 repairsTotal output 16 updates and 36 repairs
Specialization produces 16 updates and 48 repairs
12 more repairs for the same inputs!
Hourly Output Web Update Bike RepairPaula 3 updates 6 repairsBeth 2 updates 2 repairs
Another Example
Principle of Comparative Advantage is the same
Look at opportunity cost per unitPat updates web pages and Barb repairs bikes
Hourly Output
Web Update Bike Repair
Pat 2 updates 1 repairBarb 3 updates 3 repairs
Opportunity Cost
Web Update Bike Repair
Pat ½
repair 2 updatesBarb 1 repair 1 update
Sources of Comparative Advantage
TalentNatural resourcesCultures or societal norms
LanguagesInstitutions
Value placed on craftsmanshipSupport for entrepreneurship
Production Possibilities Curve
A graph of the combinations of two goods that can be produced with given resourcesDefinitions
Unattainable pointAttainable point
Inefficient pointEfficient point
Scarcity PrincipleGive up one good to get another Nuts (lb/day)
A
B
Unattainable
Combination
C
Inefficient Combination
DC
offe
e (l
b/da
y)
24
16
8
4 8 12
Susan's Production Possibilities
Two goods: coffee and nutsWork 6 hours per day
1 hour of labor= 4 pounds of coffee OR= 2 pounds of nutsGraph shows options
Negative slope, which is constant
Cof
fee
(lb/d
ay)
Nuts (lb/day)
16
8
4 8
24 A
B
C
D12
Susan's Opportunity CostOpportunity cost of 1 nut is 2 coffee
Opportunity cost of 1 coffee is ½ nutC
offe
e (lb
/day
)
Nuts (lb/day)
16
8
4 8
24 A
B
C
D12
Tom's Production PossibilitiesWork 6 hours per day1 hour of labor
= 4 pounds of nuts OR= 2 pounds of coffee
Tom's opportunity cost of 1 coffee is 2 nutsHis opportunity cost of 1 nut is ½ coffee
Nuts (lb/day)
Cof
fee
(lb/
day)
4
8
8 16
A
B
C
D
12
24
Tom, Meet SusanPPCs show comparative advantageSue's curve is steeper, better for coffeeTom's curve is flatter, better for nuts
Nuts (lb/day)
12
24
Tom’s PPC
24
12
Susan’s PPC
Cof
fee
(lb/
day)
Tom, Meet SusanTo get 1 coffee, Sue gives up ½ nuts and Tom gives up 2 nutsTo get 1 nut, Sue gives up 2 coffees and Tom ½ coffee.Sue has CA in coffee and Tom in production of nuts.
Nuts (lb/day)
12
24
Tom’s PPC
24
12
Susan’s PPC
Cof
fee
(lb/
day)
Gains from Specialization and Trade
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 advantageTrade to get what you want
Gains from Specialization and Trade
Suppose preferred diet equal amount of coffee and nutsNo trade: 8 pounds of coffee and 8 pounds of nuts
Total output is 32 pounds
Susan and Tom exchange
12 nuts, 12 coffee
8
8
Nuts (lb/day)
12
24
24
12
Cof
fee
(lb/
day)
Gains from Specialization and Trade
Benefits increase when differences in opportunity cost increase
Susan and Tom exchange
12 nuts, 12 coffee
8
8
Nuts (lb/day)
12
24
24
12
Cof
fee
(lb/
day)
Specialization gives each person 12 pounds of each good →48 total pounds
Production Possibilities for an EconomyTwo goods: coffee and nutsIncreasing opportunity cost, given by the slope of PPC.Some resources better at coffee, some better at nuts
Nuts (1000s of lb/day)
100
80Cof
fee
(10
00s
of lb
/day
)
E
A B C
D1520
9095
20 30 7577
The Principle of Increasing Opportunity Cost
Maximum coffee: 100,000 lb / dayGive up 5,000 pounds coffee, get 20,000 pounds of nutsGive up another 5,000 pounds of coffee, get an 10,000 additional pounds of nuts
Nuts (1000s of lb/day)
100
80Cof
fee
(10
00s
of lb
/day
)
E
A B C
D1520
9095
20 30 7577
The Principle of Increasing Opportunity Cost
Dec
reas
ing
prod
uctiv
ity
Reso
urce
sUs
ed
The Dynamic Economy
A PPC represents current choicesChanges in choices occur over time due to
More resourcesInvestment in capital Population growth
Improvements in technologyMore specialization: start-up and switching costs
Increases in knowledge
Shifts in PPC
Nuts
Cof
fee
Neutral Technical Change
Nuts
Cof
fee
Technical Change in Nuts
Technical Change in Coffee
Nuts
Cof
fee
Some Countries Resist Specialization
Specialization is easier whenPopulation density passes a thresholdMarkets are connected
Transportation for goodsCommunications for services
Legal framework supports businessFinancial markets enable start-ups
Comparative Advantage and International Trade
Principle of Comparative Advantage and gains from trade apply worldwide
Potentially large gains from trading with different and distant countries
Controversial tradeBenefits the society broadlyCosts are concentrated
Some industriesPeople who lose their jobs e.g., outsourcing, loss of manufacturing etc.
Comparative Advantage
Comparative Advantage
Specialization and Gains from Trade
Increasing Opportunity
Cost
Shift PPC
Production Possibilities
CurveIndividualEconomy
Outsourcing
