Absolute Advantage, Comparative Advantage, Specialization, and Trade

AP Macroeconomics and AP Microeconomics

Ms. Flora

Why do nations trade?

• “You could say…that globalization, driven not by human goodness but by the profit motive, has done far more good for far more people than all the foreign aid and soft loans ever provided by well-intentioned governments and international agencies.”

Paul Krugman, “The Magic Mountain,” New York Times, January 23, 2001

Adam Smith, The Wealth of Nations(often called the Father of Modern Economics)

It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. The farmer attempts to make neither the one nor the other, but employs those different artificers…

What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we can make it, better buy it of them with some part of the produce of our own industry;…. (Book IV, Section ii, 12)

Why do nations trade?

• Nearly all economic theory suggest that the benefits of international trade far exceed the costs.

• So let’s investigate the basic ideas that support the case for international trade.

Why do nations trade?

This is what McConnell and Brue, 16th edition, page 96, says about trade….

“Specialization and international trade increase the productivity of a nation’s resources and allow for greater total output than would otherwise be possible. “

Important Terms to Know

• Specialization: Division of labor into specific tasks and roles intended to increase the productivity of workers.

• Globalization: Name for the process of increasing the connectivity and interdependence of the world's markets and businesses.

• Imports: Goods and services purchased from other countries

• Exports: Goods and services sold to other countries

The Circular-Flow Diagram

Firms Households

Market for Factors of Production

Market for Goods and Services

SpendingRevenue

Wages, rent, interest & profit

Income

Important Terms to Know• Leakages: flows out of the circular flow when

resource income is received and not spent directly on purchases from domestic firms– Imports are a leakage

• Injections: added spending in the circular flow that does not come out of current resource income– Exports are an injection

Important Terms to Know

• If exports = imports, the Circular Flow is in balance. (the amount of money leaving the country through import buying equals the amount of money entering the country through export selling)

• Usually it is not balanced.– A trade deficit occurs when imports are greater than

exports.– A trade surplus occurs when exports are greater than

imports– News Release: U.S. International Trade in Goods and Servi

ces

United States Balance of Trade

The Circular-Flow Diagram in an Open Economy

(Showing Income Flows)

Firms Households

Market for Factors of Production

Market for Goods and Services

SpendingRevenue

Wages, rent, interest & profit

Income

ForeignExchange

Market

Imports $

Exports $

So…Why do nations trade?Absolute Advantage

• Individual – exists when a person can produce more of a certain good/service than someone else in the same amount of time (or can produce a good using the least amount of resources.)

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

So….Is Absolute Advantage the only basis for trading?

What if a person or a nation has an absolute advantage in producing

everything….would there still be a reason to specialize and trade?

Yes!It’s all about comparative advantage.

Comparative Advantage

A person or a nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than can a trading partner.

Comparative advantage as the basis for trade is one of the most

important ideas in economics and also one of the least intuitive.

Comparative Advantage

• Comparative advantage is the basis for all trade between individuals, regions, and nations.

• A person or nation will specialize in the production of a product for which it has a lower opportunity cost and trade to obtain those products for which its opportunity cost is higher.

Specialization and Trade

• Gains from trade are based on comparative advantage, not absolute advantage

• Specialization and trade increase productivity within a nation and increase a nation’s output and standard of living.

• Everyone can benefit when people trade with one another. Not only can people enjoy a greater quantity of goods and services, but they can also enjoy a greater variety of goods.

BakeCakes

MakePizza

Ms.Gray

2 cakes/hr. 6 pizzas/hr.

Mr.Pinson

4 cakes/hr. 8 pizzas/hr.

Who has the absolute advantage in producing cakes? Mr. PinsonWho has the absolute advantage in producing pizza? Mr. PinsonSo, would Mr. Pinson be better off if he specializes and trades?

Mr. Pinson Ms. Gray

Pizza Pizza

Cake Cake

BakeCakes

MakePizza

Ms.Gray

2 cakes/hr.(1c = 3p)

6 pizzas/hr.(1p = 1/3c)

Mr.Pinson

4 cakes/hr.(1c = 2p)

8 pizzas/hr.(1p = 1/2c)

Mr. Pinson should specialize and trade if he has acomparative advantage (lower opportunity cost)in the production of one of the products.

Mr. Pinson has a lower opportunity cost in producing cakes; therefore, he should specialize in the production of cakes. Ms. Gray has a lower opportunity cost in producing pizza; therefore, she should specialize in the production of pizza.

Terms of trade?

BakeCakes

Pinson will specialize in cakes.

Make Pizza Gray will specialize in pizzas.

Ms. Gray 1c = 3pFor one cake, Gray would be willing to pay anything up to 3 pizzas.

1p = 1/3cFor one pizza, Gray will want more than 1/3 cakes.

Mr. Pinson 1c = 2pFor one cake, Pinson will want more than 2 pizzas.

1p = 1/2cFor one pizza, Pinson would be willing to pay anything up to ½ cake.

How to Handle a Comparative Advantage Problem

on the AP Exam

1. The question will have information about two people or nations producing two of the same products. This information will be given to you in a Production Possibilities table or on a Production Possibilities curve or maybe a word problem form.

2. Ask what type of problem: Output or input?

2. Determine which nation or person has the absolute advantage in producing each of the two goods or services.

3. Determine which nation or person has the comparative advantage in producing each of the two goods or services.

– For each nation, determine the opportunity cost of producing one unit of each good.

– Identify the nation who has the lowest opportunity cost of producing one unit of each good. That nation has the comparative advantage.

4. Determine the terms of trade. Each country will specialize in the production of the good in

which it has the comparative advantage and will export that good. It will import the other good. The terms of trade will be whatever is mutually beneficial to the two countries. (They will want to be better off after trade than before trade.)• If the country exports Good A, it will want more of

Good B than it would get before specialization.• If the country imports Good A, it will want to pay

less in terms of Good B than it would have to pay before specialization and trade.

Tom’s PPF Hank’s PPF

Q of Coconuts Q of Coconuts

Q of Fish Q of Fish

30

40

20

10

9

28

8

6

Will the Castaways Gain From Trade?

Coconuts Fish

Tom

Hank

Will the Castaways Gain From Trade?

Coconuts Fish

Tom 1 C = 1 1/3 F

1 F = ¾ C

Hank 1 C = ½ F 1 F = 2 C

Tom has the lower opportunity cost in fishing and Hank has the loweropportunity cost gathering coconuts. Therefore, Tom should specialize in fishing and Hank should specialize in gathering coconuts.

Tom’s PPF Hank’s PPF

Q of Coconuts Q of Coconuts

Q of Fish Q of Fish

30

40

20

10

9

28

8

6

11

31

9

9

After specialization and trade, Tom and Hank can consume outside their PPCs.

5 10 15 20 25 30 35 40 45 5 10 15 20 25 30 35 40 45

45

40

35

30

25

20

15

10

5

45

40

35

30

25

20

15

10

5

Coffee

Wheat Wheat

Coffee

United States Brazil

Will the U.S. and Brazil Gain From Trade?

Coffee Wheat

U.S

Brazil

Benefits from Specialization and Trade

• Specialization and trade increase productivity and the standard of living within a nation.

• Because of specialization and trade, there will be a larger global output of goods and services.

• Everyone can benefit when people trade with one another. Not only can people enjoy a greater quantity of goods and services, but they can also enjoy a greater variety of goods.

So….if economists all agree that free trade is

such a great idea, why do so many people have

problems with the idea?

Costs of Specialization and Trade

• Domestic jobs are lost.• Domestic income is lost.• National security.• Nations “dumping” goods trying to drive out

domestic competition.• Other nations don’t treat their workers fairly.

Barriers to Trade

• Tariffs: a tax on imports• Quotas: a restriction on the amount of

imports

• General Agreements on Tariffs and Trade (GATT)

• North American Free Trade Agreement (NAFTA)

• World Trade Organization

Trade agreements regulate international trade between two or more nations. An agreement may cover all imports and exports, certain categories of goods, or a single category. The United States is currently engaged in some 320 trade agreements with various nations.

Trade Agreements

Corn SunscreenMexico 300 150

France 200 150

1. Type of problem (output or input)?: 2. Which nation has the absolute advantage in

producing corn? Sunscreen?3. Which nation has the comparative advantage in

the production of each good? (What is the opportunity cost for each nation of producing one unit of corn and sunscreen ?)

4. What would be a favorable term of trade?

Wheat ClothUnited States 1 hour 2 hoursCanada 3 hours 4 hours

1. What type of problem is this? (output/input)2. Who has the absolute advantage in producing

wheat? In producing cloth?3. Who has the lowest opportunity cost producing

wheat? In producing cloth?4. Favorable terms of trade?

Alpha BetaGuns

Guns

Butter Butter

400 300

200100

Significance of “guns and butter?”

Labor Hours Needed toProduce a Unit of:

Wheat Cloth

Portugal 10 20

England 20 60

In order to produce one ton of output, Mexico and the USA must use the following amount of resources (in acres of land).

Soybeans Avocados

Mexico 16 8

USA 8 6

Given a fixed amount of resources, Mexico and the USA can choose between the following alternatives.

Soybeans Avocados

Mexico 15 60

USA 30 90

Chapter 6 Table 6.5

Mankiw, question 4, page 60 Pat and Kris are roommates. They spend

most of their time studying (of course), but they leave some time for their favorite activities; making pizza and brewing root beer. Pat takes 4 hours to brew a gallon of root beer and 2 hours to make a pizza. Kris takes 6 hours to brew a gallon of root beer and 4 hours to make a pizza.

What is each roommate’s opportunity cost of making a pizza? Who has the comparative advantage in making pizza?

Root beer(hours to make)

Pizza(hours to make)

Kris 16 8

Pat 4 2