From Opportunity Costs to International Trade

McCaffery © F14, F15a

Topic Slide

Absolute Advantage 2-7

Comparative Advantage 8-13

Comp. Adv. Examples 14-24

International Trade and Comp Adv 25-33

Sample AP style questions 34-41

How to Cheat 42-45

From Opportunity Costs to International Trade

To handle the questions posed by the AP economics exam, we must understand both absolute advantage and comparative advantage.

Some say that the most difficult concept in economics is comparative advantage. Others say that the difference between an economist and a non-economist is understanding comparative advantage. Yikes, sounds like a high risk topic.

Expect 1-3 points on the multiple choice section exam to hinge on knowing absolute and especially comparative advantage. So big deal.

Absolute AdvantageTo understand absolute advantage you

must understand that:You should start with the same quantity of inputs (hours, workers, or financial capital*).Compare the quantity of an output produced by each country, firm, or workerWho can get more out of the same quantity of inputs has the absolute advantage

*Financial capital… economic speak for MONEY.

Absolute AdvantageWith $1000 of financial capital nations A and B

can produce the following quantities of tons of iron or coal.

Iron Coal nation A 20 or 4 nation B 10 or 7Nation A has an absolute advantage in Iron as it can produce 20

tons of Iron with $1000 compared to only 10 tons by Nation B.Nation B has an absolute advantage in Coal as it can produce 7

tons of coal with $1000 while nation A can only produce 4 tons.

Absolute AdvantageMom’s and daughter’s ability to apply

stamps or to seal letters per 2 minute time period Sealings Stampings

Daughter 10 30Mom 20 10Who has the Absolute Advantage?

Daughter applying stampsMom sealing the envelopes

Absolute AdvantageThis is easy as long as the starting

financial capital is the same. Just look at one product and see who can make the most.

When given an AP absolute advantage problem, unless instructed otherwise, assume that the two competitors start with the same quantity of inputs.

Absolute AdvantageAbsolute advantage is how economists

believe trade started and expanded from the beginning of time until 1815.

England produced wool, the Caribbean bananas, and they traded.By 1815 these possibilities were being fully exploited on an ongoing basis.

Comparative AdvantageSeeking additional trade possibilities,

David Ricardo developed the Theory of Comparative Advantage.

This theory rests on measuring the opportunity cost of production for a producer and then comparing that cost with the competitor’s cost.

It is time to start thinking of costs as the opportunity costs they are.

Comparative AdvantageAh, opportunity cost…

our old friend.If a nation with a $1000 of financial

capital can produce one car or 5 computers…this theory says that that one car has a cost to society of 5 computers. Like wise, one computer has a cost of 1/5th of a car.

Comparative AdvantageForget price tags. We are looking to see

what an item costs based upon how much of the other item could have been made instead.

In a way it is the ‘going to the game or Battlestar’ all over again. What did going to the game cost? Battlestar time.

What did that car cost? 5 computers.

Comparative AdvantageIf we go back to the mother and daughter example and use

opportunity cost we will get the same answer as before.Sealing Stamps

Daughter 10 30Mom 20 10

We should first reduce the numbers so they are easier to work with. Sealing Stamps

Daughter 1 3 (divided both by 10)Mom 2 1The cost of a sealed letter for the daughter is 3 stamps. Think about

that a moment. Every letter she doesn’t seal produces enough time to do 3 stamps. Each sealing cost 3 stamps.

Cost of a sealed letter for the mother is only 1/2 stamp.The person with the lowest cost should be sealing the letters. And

that is Mom. No mystery here, she had the absolute advantage, I am showing how to approach a problem using comparative adv.

Comparative AdvantageAgain:

Sealing Stamps Daughter 1 3 Mom 2 1And who should be applying stamps to the letters?Daughter’s cost of a stamp applied is 1/3 of a sealed letter.Mom’s cost is 2 sealed letters.

Obviously, I hope, Mom should out-source the stamping of letters to her daughter. It costs Mom six times as much to stamp a letter as her daughter’s cost.

Comparative AdvantageTo expand international trade

comparative advantage was needed after 1815.

This next slide is a conundrum without comparative advantage.

Comparative AdvantageHere is a situation where absolute advantage says

mutually beneficial trade* is not possible. With the same financial capital the nations can produce these tons per month of…Wool or Copper Nation C 10 5 Nation D 30 10

Nation D has an absolute advantage in both items. So it appears that mutually beneficial trade* is not possible. But mutually beneficial trade is possible using comparative advantage.

Comparative Advantage Wool CopperNation C 2 1 (10 and 5)Nation D 3 1 (30 and 10)

1 copper costs 2 wool in C and 3 wool in D.Nation C, even though it has no absolute advantage is the

low cost producer of copper.Nation D has the comparative advantage in Wool as it only

costs 1/3rd copper per wool while in C it costs 1/2 copper. Previously thought impossible to have both of these nations

benefit from trade, with comparative advantage mutually beneficial trade between C and D is shown to be possible.

*Mutually Beneficial tradeTrue economists know that trade

causes some people to gain and others to suffer, often by losing their jobs.

Often the benefit is diffuse, benefiting many a small amount while the pain is highly localized and severe, but affecting a much smaller number.

The AP exam has not examined this aspect.

*Mutually Beneficial tradeTo determine if a trade is mutually

beneficial all the pain and suffering as well as all the benefit must be taken into account. Only if benefit > pain is it beneficial.

If the benefit from the trade isn’t large enough to alleviate the pain in both countries, then it can not truly be a mutually beneficial trade.

The AP exam has not examined this aspect.

Comparative AdvantageHere is another different format for the set-up: Nation E Nation F

Bikes 4 3Skates 12 6 REDUCE ! (divide E by 4, F by 3) always pick a number for each nation that works easilyNation E Nation F

Bikes 1 1 Skates 3 2Don’t cheat…look and calculate the opportunity costs.1 bike can cost 3 skates or 2 skates. Produce bikes where it

costs less, in Nation F. 1 skate can cost 1/3 or 1/2 bike…make them in Nation E.

Comparative AdvantageSo far all the examples have been shown

in ‘quantity of finished output’.Some problems you will encounter will be

in one of the following:Hours to make each unit, Quantity of inputs to make a unit, Price to buy…For simplicity I suggest converting these

problems into the finished output.

Comparative AdvantageLet’s use dollars and work it out. Here are

costs to produce (or buy) in two countries.Nation G Nation H

Hats $40 ea. $50 ea. Coats $80 ea. $150 ea.REDUCE and Convert…you can use $80 in G and $150 in H. In

G how much will $80 buy, in H how much will $150 buy? The dollar amounts do not have to be the same for both nations. Nation G Nation HHats 2 3Coats 1 1

Solve using opportunity costs… here comes another

Comparative AdvantageHere are the hours to produce something:

Hammer SawNation I 10 hours 20 hoursNation J 6 hours 18 hours REDUCE/Convert (use 20 hrs in I, 18 hrs in J)

Nation I 2 hammers or 1 sawNation J 3 hammers or 1 saw

Now a problem with uglier numbers

Comparative Advantage Washer Dryer

Nation K 50 hours 75 hoursNation L 30 hours 50 hours

REDUCE/ Convert I will use 75 hrs in K, 50 hrs in LNation K 1.5 washers 1 dryerNation L 1.67 washers 1 dryer

Who should make washers? L as they can get 1.67 washers for every dryer

not made. That is more than K’s 1.5 per dryer.Who should make dryers? K as it only costs them 1.5 washers < L’s 1.67.

Comparative AdvantageNation K 1.5 washers 1 dryerNation L 1.67 washers 1 dryer

Have you noticed that when you can reduce so both nations have a ONE for one of the outputs all you have to do is choose the larger number of the none one output for the producer of that output.

Above: Who should make washers? 1.67. (L)

Comparative Advantage Washer Dryer

Nation K 50 hours 75 hoursNation L 30 hours 50 hours

The numbers you choose to use to reduce are up to you. A constant 50 hours for both nations works well too.

Washer DryerNation K 1 1.5Nation L 1.67 1

To my mind awkward, but it does work.

International Trade and Opportunity Costs

McCaffery © F14, F15

Comp Adv for International TradeThe examples we just used gave the

ratios (slope) of output for a PPC, 4 coal or 3 iron. Rather than deal with curved PPC concepts let’s stick with straight line PPC and not curved ones.

here are few as examples.

Comp Adv for International Trade

cars

200

100

0

cars

20

10

0trucks trucks

0 10 20 30 40 50 0 10 20 30 40

Nation G Nation H

Here is the table for the graphs above

Nation G Nation H

Cars 200 15

Trucks 50 10

Comp Adv for International Trade Nation G Nation H

Cars 200 15

Trucks 50 10

REDUCE use maybe 50 in G, and 10 in H, get either cars or trucks to one.

Nation G Nation H

Cars 4 1.5

Trucks 1 1I find that if you can get one output type of both nations equal to one, as above, it makes the solving much easier.

Comp Adv for International Trade

Nation G Nation H

Cars 4 1.5

Trucks 1 1

Who has the comparative advantage in trucks? (H)

How do we know? Look at the cost. Do you want to pay 4 cars for a truck or 1.5 cars for a truck?

Who should be producing cars? (G) In return for giving up a truck you can either get 1.5 cars or 4 cars. If I were trading, I would want to give up a truck and get 4 cars.

So let’s specialize, G in cars, H in trucks.

Comp Adv for International Trade

cars

200

100

0

cars

20

10

0

trucks trucks

0 10 20 30 40 50 0 10 20 30 40

Nation G Nation H

If nation G specialized in cars, and made 200 and traded them all, what would they expect in return?In their own nation they would expect 1 truck for every 4 cars, so trading 200 cars for at least 50 trucks.Through trading they would expect to do even better than that. But wait Nation H can only produce 15 cars.

Comp Adv to International trade

What answer does the AP exam expect? The maximum output of the trading partner, or the theoretical maximum?

ANSWER: the theoretical answer (50).

Don’t say, “Oh, they can’t make or don’t want that many.” Or, “Trucks are more valuable than cars…”

At least as of 2014.

Comp Adv and Trade RangesNation G Nation H

Cars 4 1.5

Trucks 1 1

Forgetting about the collateral damage of lost jobs…what is the range of mutually beneficial trade?

Nation H would be happy trading ONE truck and getting anything more than 1.5 cars in return. They can get 1.5 cars at home.

Nation G would be happy paying anything less than 4 cars per truck.So one way to look at the mutually beneficial trade range is in cars per

truck. And any where between 1.5 and 4 cars per truck is mutually beneficial.

Comp Adv and Trade RangesNation G Nation H

Cars 4 (1) 1.5 (1)

Trucks 1 (.25) 1 (.667)

What would a nation want for each car it sent over seas?

Nation G would be the manufacturer. And they would want more than .25 truck in return for each car (less than 4 cars for 1 truck).

What would nation H be willing to pay for each car? Anything less than .667 trucks per car would be good for them.

So the mutually beneficial trade range for cars as measured in trucks is 1 car for anywhere between .667 trucks and .25 trucks.

Questions

Question 1

Before specialization and trade, the domestic opportunity cost of producing 1 ton of grain in Alpha and in Beta is which of the following?

Alpha Beta(A) 1 ton of steel 1 ton of steel(B) 1 ton of steel 2 tons of steel(C) 2 tons of steel 1 ton of steel(D) 1 ton of steel 0.5 ton of steel(E) 0.33 ton of steel 1.5 tons of steel

Question 2

The theory of comparative advantage implies that Alpha would find it advantageous to(A) export grain and import steel(B) export steel and import grain(C) export both grain and steel and import nothing(D) import both grain and steel and export nothing(E) trade 1ton of grain for 0.5 ton of steel

Question 3

At what real exchange ratio, also referred to as the terms of trade, between grain (G) and steel (S) would both Alpha and Beta find it mutually advantageous to specialize and trade?(A) 1 Grain for 3.0 Steel(B) 1 Grain for 1.5 Steel(C) 1 Grain for 1.0 Steel(D) 1 Grain for 0.5 Steel(E) There is no real exchange ratio that would enable both countries to benefit, since Alpha has an absolute advantage in both goods.

Question 4

Interesting way to display output possibilities and absolutely correct. Country A when doing 24 computers can do zero cars, hence 24 - 0.

The table below shows the production alternatives of Country U and Country V for producing checkers and chess with equal amounts of resources that are fully and efficiently employed.

Country Checkers Chess U 18 0

0 9

V 30 0 0 10

Which of the following is true according to the data in the table?(A) Country U has an absolute and comparative advantage in the production of checkers. (B) Country V has an absolute and comparative advantage in the production of checkers.(C) Country V should import checkers and export chess.(D) Since Country V has an absolute advantage in the production of both goods, it will not trade with Country U.(E) Neither country can benefit from trade.

Question 5

Here is a good all-round hint for AP questions: Anything that gets in the way of mutually beneficial trade is BAD. Trade is GOOD.

If two nations specialize according to the law of comparative advantage and then trade with each other, which of the following would be true?

(A) A smaller number of goods would be available in each trading nation. (B) Total world production of goods would decrease. (C) Everyone within each nation would be better off. (D) Each nation would increase its consumption possibilities. (E) One nation would gain at the expense of the other nation.

Question 6The table below indicates the number of labor hours required in Countries

S and T to produce one unit of guns or one unit of butter.Country Guns Butter S 25 hours 75 hours T 12 hours 24 hours

Given this information, which of the following statements is correct?A. S has a comparative advantage in the production of both

guns and butter.B. T has a comparative advantage in the production of both guns

and butterC. S has a comparative advantage in gun production, whereas Y has a

comparative advantage in butter production.

D. T has a comparative advantage in gun production, whereas S has a comparative advantage in butter productionE. Neither country has a comparative advantage in the

production of either good

Answers 1 - 61. (b) Here is a test taking hint. If you can see that 20 to 20 equals 1 to

1, then only (a) and (b) can be correct. Forget the other options.

2. (a) Here is a trick for when both PPCs are on the same graph, slide one of the lines until in or out until it crosses the other. The line with the highest output intersect should make that product.

3. (b) Internal opportunity costs for the two nations are 1:1 and 1:2, so the mutually beneficial trade range is anywhere between these.

4. (b) Other than an odd but absolutely correct way of displaying output (Country U at 18 checkers can do zero chess) this is traditional approach.

5. (c) Well here is a case where they ignore the pain of lost employment. I warned you that they would.

6. (c) Here it is with hours to produce. I don’t know how you were taught to deal with, but my method is to change hours to produce to output.

Comparative AdvantageWhen instruction is done on this topic, if

you still don’t ‘get it’, don’t sweat it. You will get many wrong on the AP exam, and this topic will be a few of them. Better to move on than get frustrated. You can get a 4 without this.Good bye, and good luck,Wayne iNWI

How to “cheat” next.

How to cheat #1If given two graphs…redraw using two lines

with the same slopes but draw them so they cross as I have done below.

Then read either axis. Who should be producing S? The red line (nation) is better. Producing T? The Blue line nation can do more. This works. Always get it into output, not hours or tons or dollars.

How to cheat #2If given numbers…get the data into

OUTPUT, not hours, tons, or money. Then cross multiply and take the pair which yields the larger number.

Yep…it works. It shows no understanding of what is happening. The AP people are aware of this trick and try to design problems to make using this difficult.

How to cheat #2Oddly, the numbers 200 and 300

from the previous slide represent nothing that I know of. All we care about is which is larger.

So long, and good luck,Wayne iNWI