MBMC Comparative Advantage: The Basis for Exchange Comparative Advantage: The Basis for Exchange.

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Comparative Advantage:

The Basis for Exchange

Comparative Advantage:

The Basis for Exchange

Chapter 2: Comparative Advantage: The Basis for Exchange Slide 2

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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.

Comparative Advantage: The Basis for Exchange

What Do You Think?Do the Nepalese perform their own

services because they are poor or are they poor because they perform their own services?


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Exchange and Opportunity Cost

Should Johnnie Cochran write his own will?Cochran earns more than $1,000 per hourThe cost of having a will prepared is less

than $800


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Absolute AdvantageOne person has an absolute advantage

over another if he or she takes fewer hours to perform a task than the other person


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Comparative AdvantageOne person has a comparative advantage

over another if his or her opportunity cost of performing a task is lower than the other person’s opportunity cost


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The Principle of Comparative AdvantageShould Paula update her own web page?

Time to updateTime to updateweb pageweb page

Time to complete Time to complete bicycle repairbicycle repair

PaulaPaula 20 minutes20 minutes 10 minutes10 minutes

BethBeth 30 minutes30 minutes 30 minutes30 minutes


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Opportunity Cost of Opportunity Cost of updating a web pageupdating a web page

Opportunity Cost of a Opportunity Cost of a bicycle repairbicycle repair

PaulaPaula 2 bicycle repairs2 bicycle repairs 0.5 web page updates0.5 web page updates

BethBeth 1 bicycle repair1 bicycle repair 1 web page update1 web page update


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How many web pages and bicycle repairs can Paula and Beth produce a day if they both work eight-hour days?


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The Principle of Comparative Advantage

If Paula splits her time evenly and both produce 16 web pages

PaulaPaula

BethBeth

Web PagesWeb Pages Bicycle RepairsBicycle Repairs

1212

442424

1212

TotalTotal 1616 3636


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The Principle of Comparative Advantage

If they specialized in their comparative advantage

PaulaPaula

BethBeth

Web PagesWeb Pages Bicycle RepairsBicycle Repairs

00

16164848

00

TotalTotal 1616 4848


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Principle: You can always produce an extra unit of one good at lower opportunity cost through comparative advantage.

That is why the book says (p. 35), that

“The total number of [both] bicycle repairs and web updates accomplished if Paula & Beth both spend part of their time at each activity will always be smaller than … if each specializes [according to] comparative advantage.”

But what about the total number of each?


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Notice, what if they had to achieve more than 16 web updates per day?

Let’s say we need 20 webs a day, and Paula & Beth still have 8 hours a day.

Even if Beth works her full 8 hours on the web, she can only make 16 pages a day.

That would mean Paula would have to work part-time against her comparative-advantage!


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A qualification to Comparative Advantage: a) If there is big enough demand for a good for

which some producer(s) have comparative disadvantage, but an absolute advantage (Paula’s web pages),

b) and that demand can’t be met solely by those producer(s) for whom the good is a comparative advantage, given their limited resources,

Then – The absolute advantage producer(s) of the

good must work against comparative, and with their absolute advantage!


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The Moral – Opportunity Costs (OC) are not constant: they can change and override comparative advantage based solely on labor productivity or some similar measure.


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The OC of Paula producing another bike repair at some point might not be just “0.5 web page updates.”

If we need those pages badly enough, it could be: “you all die.”

Opportunity Cost of Opportunity Cost of updating a web pageupdating a web page

Opportunity Cost of a Opportunity Cost of a bicycle repairbicycle repair

PaulaPaula 2 bicycle repairs2 bicycle repairs 0.5 web page updates0.5 web page updates

BethBeth 1 bicycle repair1 bicycle repair 1 web page update1 web page update


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The Principle of Comparative AdvantageShould Barb update her own web page?

Productivity in Productivity in programmingprogramming

Productivity inProductivity in

bicycle repairbicycle repair

PatPat 2 webs/hr2 webs/hr 1 bike/hr1 bike/hr

BarbBarb 3 webs/hr3 webs/hr 3 bikes/hr3 bikes/hr


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Productivity in Productivity in programmingprogramming

Productivity inProductivity in

bicycle repairbicycle repair

PatPat 2 webs/hr2 webs/hr

OC (web) = 0.5 bikesOC (web) = 0.5 bikes

1 bike/hr1 bike/hr

OC (bike) = 2 websOC (bike) = 2 webs

BarbBarb 3 webs/hr3 webs/hr

OC (web) = 1 bikeOC (web) = 1 bike

3 bikes/hr3 bikes/hr

OC (bike) = 1 webOC (bike) = 1 web


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The Principle of Comparative AdvantageEveryone does best when each person (or

each country) concentrates on the activities for which his or her opportunity cost is lowest


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Economic NaturalistWhere have all the .400 hitters gone?Ted Williams (Red Sox), last man to hit

over 400 in a season (.406, in 1941)


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Sources of Comparative AdvantageIndividual

Inborn talentEducationTrainingExperience


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Sources of Comparative AdvantageNational Level

Natural resourcesCultural institutions


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Economic NaturalistTelevisions and videocassette recorders

were developed and first produced in the United States.

Why did the United States fail to retain its lead in these markets?


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Comparative Advantage and Production Possibilities

The Production Possibilities CurveA graph that describes the maximum

amount of one good that can be produced for every possible level of production of another good.


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The Production Possibilities CurveAssume

A small economy thato Produces only two goods - coffee and nutso Has only one worker who works 6 hrs/day


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Susan’s Production Possibilities

0

Coffee(lb/day)

Nuts(lb/day)

Opportunity Cost (OC)1. OC nuts = Loss in

coffee/gain in nuts = 2

2. OC coffee = Loss in nuts/gain in coffee = 1/2

16

8

4 8

24

Production Possibilities Curve: Allcombinations of coffee and nuts thatcan be produced with Susan’s labor

A

B

C

D

12


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Susan’s Production Possibilities

The scarcity principle: Having more of one good generally means having less of another good.

Coffee(lb/day)

Nuts(lb/day)

A

B

C

D

24

0

16

8

4 8 12


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Attainable and Efficient Points on Susan’s Production Possibilities

Nuts(lb/day)

A

B

Combination F: Unattainable

C

Combination E: Inefficient

D

Combinations A, B, C, and D: Efficient

Coffee(lb/day)

24

0

16

8

4 8 12


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The Production Possibilities CurveAttainable Point

Any combination of goods that can be produced using currently available resources

Unattainable PointAny combination that cannot be produced using

currently available resources


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The Production Possibilities CurveEfficient Point

Any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other


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The Production Possibilities CurveInefficient Point

Any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other


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Tom’s Production Possibilities

0

Nuts(lb/day)

How Individual Productivity Affects the Slope and Position of the Production Possibilities Curve

Tom’s Production Possibilities Curve for a 6 hour day

Coffee(lb/day)

4

8

8 16

A

B

C

D

12Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor

24


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Individual Production Possibilities Curves Compared

Nuts(lb/day)0

12

24

Tom’s Production Possibilities Curve

Tom has an absolute and comparative advantage in

picking nuts

24

12

Susan’s Production Possibilities Curve

Susan has an absolute and comparative advantage in picking coffee

Coffee(lb/day)


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Production Without Specialization

Nuts(lb/day)0

12

24

12 24


Assume: Susan and Tom allocate their time so each person’s output is half nuts and half coffee

Tom’s Output = 2 hrs picking nuts = 8 lbs 4 hrs picking coffee = 8 lbs

Susan’s Output = 2 hrs picking coffee = 8 lbs4 hrs picking nuts = 8 lbs

Total Output = 16 lbs each

8

8

BTom’s Production Possibilities Curve

Coffee(lb/day)


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Production With Specialization

Nuts(lb/day)0

12

24

12 24


Tom’s comparative advantage is in nuts so he specializes in nuts and produces 24 lbs

Susan’s comparative advantage is in coffee so she specializes in coffee and produces 24 lbs

Susan gives Tom 12 lbs of coffee for 12 lbs of nuts

E

Tom’s Production Possibilities Curve

Coffee(lb/day)


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The gains from specialization grow larger as the difference in opportunity cost increasesFor Example

Susan: 5 lb coffee/hr 1lb nuts/hr

Tom: 1 lb nuts/hr 5 lb coffee/hr

Comparative Advantageand Production Possibilities


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The gains from specialization grow larger as the difference in opportunity cost increasesWithout Specialization

Tom: 5 hrs coffee = 5 lb 1 hr nuts = 5 lb

Susan: 1 hr coffee = 5 lb 5 hrs nuts = 5 lb

Total: 10 lb 10 lb



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The gains from specialization grow larger as the difference in opportunity cost increasesWith Specialization

Tom: 30 lb coffee 0 lb nuts

Susan: 0 lb coffee 30 lb nuts

Total: 30 lb 30 lb

Comparative Advantageand Production Possibilities


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Production PossibilitiesCurve For a Large Economy

Nuts(1000s of lb/day)

Assume: An economy that produces only two goods, coffee and nuts

100

80

Why would the Production Possibilities Curve have

an outward bow?

Coffee(1000s of lb/day)

E

AB

C

D

1520

9095

20 30 75

77


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Principle of Increasing Opportunity Cost (“The Low-Hanging-Fruit Principle”)

In expanding the production of any good, first employ those resources with the lowest opportunity costs, and only later turn to resources with higher opportunity costs.



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Economic Growth: An Outward Shift in the Economy’s PPC

Coffee(1000s of lb/day)

Nuts(1000s of lb/day)

Original PPC

New PPC

Factors Shifting the PPC1. Increases in productive resources

(i.e., labor or capital)

2. Improvements in knowledge and technology


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Factors That Shift The Economy’s Production Possibilities Curve

Increasing Productive ResourcesInvestment in new factories and equipment Population growth

Improvements in Knowledge and TechnologyIncreasing educationGains from specialization


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Why have countries Like Nepal been So slow to specialize?Low population densityIsolation

Some factors that may limit specialization in other countries:LawsCustoms


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Can we have too much specialization?

What do you think?What are the costs of specialization?


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Comparative Advantage and International Trade

Economic NaturalistIf trade between nations is so beneficial,

why are free-trade agreements so controversial?

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End ofChapterEnd of

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MBMC Comparative Advantage: The Basis for Exchange Comparative Advantage: The Basis for Exchange.

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