Comparative Advantage and Comparative Advantage and the Gains from Tradethe Gains from Trade

OutlineOutline

I. Assumptions

II. Absolute Advantage

A. Definition

B. Example

III. Comparative Advantage

A. Definition

B. Example

OutlineOutline

IV. Specialization

A. Definition

B. Example

V. Terms of Trade

A. Definition

B. Example

AssumptionsAssumptions

• Let’s say that the crew on Gilligan’s Island finds another nearby island of native folk who also produce radios and huts

• Both the crew and the islanders have 7 people and the same resources.

• Linear PPF– Allows us to calculate per-unit opportunity cost only

once (since linear PPF’s have constant opportunity cost)

The Crew’s PPFThe Crew’s PPF

Huts

0

120

60

30

90

28147 21

The opportunity cost ofmaking a radio is 6 huts.Thus the opportunity costof making a hut is 1/6 ofa radio.

Radios

The Islander’s PPFThe Islander’s PPF

Huts

0

120

60

30

90

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The opportunity cost ofmaking a radio is 9 huts.The opportunity cost ofmaking a hut is 1/9 of aradio.

Radios

Absolute AdvantageAbsolute Advantage

• Absolute Advantage - an economy’s ability to produce more of a good than another country can produce with the same quantity of resources.

• In this case, the crew has the absolute advantage in radios AND the absolute advantage in huts since they can make more of both (though it is possible to have the absolute advantage in only one good).

Comparative AdvantageComparative Advantage

• Comparative Advantage - an economy’s ability to produce a good at a lower opportunity cost than another economy.

Comparative AdvantageComparative Advantage

• The crew’s opportunity cost of making a radio is 6 huts, the islanders opportunity cost of making a radio is 9 huts, so the crew has the comparative advantage in radios

• The crew’s opportunity cost of making a hut is 1/6 of a radio, the islanders opportunity cost of making a hut is 1/9 of a radio, so the islanders have the comparative advantage in making huts

A Note on Comparative A Note on Comparative AdvantageAdvantage

With two economies, it is impossible for one country to have a comparative advantage in both goods.

TradeTrade

• Now both islands are considering trade.

• Each island will produce the good in which they have the comparative advantage - why?– because they can produce it cheaper. It only

costs the crew 6 huts to make a radio, while it costs the islanders 9 huts!

SpecializationSpecialization

• Specialization - each country will produce only the good in which it has a comparative advantage.

• So, if the crew makes radios and the islanders make huts, how do they decide upon a trading arrangement that is best for both of them?

The IslandersThe Islanders

• The islanders will trade huts for radios.

• They want radios as cheaply as possible

• What is the most they will “pay” for a radio?– 9 huts. Because if a radio cost 10 huts, they

would be better off not making 9 huts and making the radio themselves.

The CrewThe Crew

• Since the crew is making radios, they are buying huts.

• They want to get as many huts as possible for one of their radios.

• What is the least they would be willing to accept for a radio?– 6 huts. If they were offered 5 huts for a radio, they

would be better off not making a radio and producing 6 huts themselves

Terms of TradeTerms of Trade

• The islanders will pay anything less than 9 huts for a radio

• The crew will accept no more less than 6 huts for a radio

• So anywhere between 6 and 9 huts per radio makes both islands happy

Why is it better to trade?Why is it better to trade?

• Let’s go back to the PPFs.

• If the crew made all radios and traded 6 of them for 48 huts, and islanders made all huts and traded 48 for 6 radios (a terms of trade of 8 huts per radio), we will see that such a trade will allow each island to consume outside of their PPF!

• Both islands win through free trade!

The Crew’s PPFThe Crew’s PPF

Huts

0

120

60

30

90

28147 21 Radios

The CrewConsumes This Much

The Islander’s PPFThe Islander’s PPF

Huts

0

120

60

30

90

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This is the consumptionpoint for the islanders

Radios

NotesNotes• It is possible for a country to have an absolute

advantage and still benefit from trade.– Benefits from trade depend upon there being a

comparative advantage.

• Terms of Trade will be agreed upon by both countries as long as they are between each countries opportunity cost.– Must be able to trade for less than you can produce

yourself.