CH. 5 SPECIALIZATION AND COMPARATIVE ADVANTAGE “DO WHAT YOU DO BEST AND TRADE FOR THE REST”

Comparative Advantage Specialization and Comparative Advantage Basic Principle-specialization and trade increase the productivity of a nation’s resources; it pays for a country to specialize and exchange even if that person or nation is more productive than potential trading partners in all economic activities.

Comparative Advantage Specialization and Comparative Advantage Basic Principle Comparative Costs-specialization should take place if there are relative cost differences in the production of different items (if someone else can do something cheaper they should and then trade). A nation (or business or person) has a comparative advantage if it can produce a product at a lower opportunity cost than its partner

Comparative Advantage Specialization and Comparative Advantage Basic Principle Comparative Costs Terms of Trade-the rate of exchange of two products; determined by relative opportunity costs

Comparative Advantage Specialization and Comparative Advantage Basic Principle Comparative Costs Terms of Trade Gains from Specialization & Trade-can improve overall output even when one country can do it all better; has same effect as an increase in resources

I am going to prove that specialization works. I am going to name a state and you tell me what that state specializes in: Idaho Potatoes Florida Oranges Oil or cattle Texas On this slide, click so a state shows. Then ask the students what that state specializes in. When you are finished, ask the students why they don’t grow oranges in Alaska? I will be willing to bet you a buck, the one student will say that they CAN”T grow oranges in Alaska. You say, I will bet you a MILLION dollars I can grow oranges in Alaska. Can you grow oranges in Alaska? Yes. It just COSTS more. So why are oranges grown in Florida? Because it is cheaper. Michigan Automobiles Nevada Any illegal activity that you can think of

Absolute Advantage Absolute and Comparative Advantage Betty types 120 w.p.m. with 0 errors Jim types 60 w.p.m. with 0 errors Who should do the typing, Betty or Jim? Betty. Why? Betty can type ABSOLUTELY faster than Jim can. What type of advantage does Betty have over Jim? On the next eight slides, you will be giving the students an relatively easy question relating to absolute and comparative advantage. Just click each slide and have the students answer each question. Absolute Advantage

I forgot to tell you--Betty is a lawyer. A lawyer earns $60 an hour. A secretary earns $6 an hour. Betty is the lawyer. According to the information given, that makes Jim-- A secretary. A 600-word document has to be typed, how long does it take each person to type this document?

How long does it take Betty to type this document? 5 minutes 600 divided by 120 = 5 How long does it take Jim to type this document? 10 minutes 600 divided by 60 = 10

How much would it cost each one to type this 600-word document? Betty $5 Betty receives $60 an hour or $1 per minute. It takes her 5 minutes to type the document. Jim $1 Jim receives $6 an hour or $1 for every 10 minutes. It takes him 5 minutes to type the document.

We know that it takes Betty 5 minutes to type the document, and it takes Jim 10 minutes to type the document. We also know that it costs Betty $5 to type the document, and it costs Jim $1 to type the document. According to this information, who should do the typing? Jim

Comparative Advantage Why should Jim do the typing? Because he has a-- Comparative Advantage One entity can produce something at a LOWER MARGINAL OPPORTUNITY PRODUCTION COST than another entity

Five minutes ago you told me that Betty should do the typing; now you are telling me that Jim should do the typing. Why? Because Jim has the comparative advantage. Which is more important in economics-- absolute or comparative advantage? Comparative Advantage

Comparative Advantage Take absolute advantage and KICK it out the window. The more important of the two is-- Comparative Advantage

Which country has the absolute advantage in the production of Maple Man-hours required U.S. Canada Maple Syrup 5 8 Copper Wire 6 7 The next four slides are another example of absolute and comparative advantage. When the students are done writing this in their notebooks, (click) ask them which country has the absolute advantage in the production of Maple Syrup? In Copper Wire? The U.S. has the absolute advantage in Maple Syrup because it can produce Maple Syrup ABSOLUTELY faster than Canada can (5-man hours compared to 8 in Canada). Which country has the absolute advantage in the production of copper wire? The U.S. has the absolute advantage in the production of copper wire because it can produce Copper Wire ABSOLUTELY faster than Canada can (6-man hours compared to 7 for Canada). Does this mean that the U.S. should produce ALL the Maple Syrup and ALL the Copper Wire and the Canadians should just hang out? (click to next slide) Which country has the absolute advantage in the production of Maple Syrup? In Copper Wire?

Kick it out the window! Man-hours required U.S. Canada Maple Syrup 5 8 Copper Wire 6 7 Ask the students what you asked them to do with ABSOLUTE ADVANTAGE. Kick it out the window! What did I tell you to do with Absolute Advantage?

More importantly, which country has the Comparative Advantage in Maple Man-hours required U.S. Canada Maple Syrup 5 8 Copper Wire 6 7 More important is Comparative Advantage. Now which country should produce the Maple Syrup and which country should produce the Copper Wire? The correct answer is the U.S. should produce the Maple Syrup and Canada should produce the Copper Wire. (Some students will say the opposite because Maple Syrup is produced in Canada. Tell them this isn’t reality—this is economics). Click on next slide. More importantly, which country has the Comparative Advantage in Maple Syrup? In Copper Wire? And Why?

Canada saves one-man hours Man-hours required U.S. Canada U.S. 2 1 Maple Syrup 5 8 Copper Wire 6 7 2 x = 10 Canada 1 2 + 2 x + = 14 Let’s say that the U.S. and Canada are STUPID! Each country decides to produce its OWN Maple Syrup and its OWN Copper Wire. How many man hours would it take the U.S. to produce one barrel of Maple Syrup + one mile of Copper Wire? 11. How many man hours would it take Canada? 15. But we learned from Adam Smith that both countries should SPECIALIZE and then TRADE. Say that the U.S. should specialize in Maple Syrup, and instead of producing just one barrel of Maple Syrup, it produces two barrels. And say that Canada should specialize in the production of Copper Wire, and instead of producing one mile of Copper Wire, it produces two miles. How many man hours does each country save? One-man hour. Now what should the U.S. do with one of its barrels of Maple Syrup and what should Canada do with one of its miles of Copper Wire? Trade. Through specialization and trade, are both countries better off? Yes. Isn’t this what Adam Smith is telling us in The Wealth of Nations? 11 15 U.S. saves one-man hour Canada saves one-man hours

Production Possibilities Curve/Frontier -

Ireland Puerto Rico Crystal Rum Crystal Rum A B C 1 million 0 700,000 30,000 0 100,000 A B C 80,000 0 40,000 40,000 0 80,000

Ireland Puerto Rico Crystal Rum Crystal Rum A B C 1 million 0 700,000 A 80,000 B 40,000 C C 30,000 100,000 Rum 40,000 80,000 Rum Ireland Puerto Rico Crystal Rum Crystal Rum A B C 1 million 0 700,000 30,000 0 100,000 A B C 80,000 0 40,000 40,000 0 80,000

Crystal Crystal A 1 million B 700,000 A 80,000 B 40,000 C C 30,000 100,000 Rum 40,000 80,000 Rum Ireland Puerto Rico Which country has the absolute advantage in the production of Crystal? In the production of Rum? What did I tell you to do with absolute advantages? KICK IT OUT THE WINDOW!!!

Which country has the comparative advantage in Crystal? In Rum? 1 million B 700,000 A 80,000 B 40,000 C C 30,000 100,000 Rum 40,000 80,000 Rum Ireland Puerto Rico Which country has the comparative advantage in Crystal? In Rum?

There are___steps in figuring out which country has Crystal Crystal A 1 million B 700,000 A 80,000 B 40,000 C C 30,000 100,000 Rum 40,000 80,000 Rum Ireland Puerto Rico There are___steps in figuring out which country has the comparative advantage. 5

1. Know the definition of comparative advantage Crystal Crystal A 1 mil. B 700,000 A 80,000 B 40,000 C C 100,000 Rum 30,000 40,000 80,000 Rum Ireland Puerto Rico 1. Know the definition of comparative advantage One entity can produce something at a LOWER MARGINAL OPPORTUNITY COST than another entity. 2. Set up a table: Ireland Puerto Rico 1 Rum = __Crystal 1 Rum = __Crystal 1 Crystal = __ Rum 1 Crystal = __Rum 3. Go to the Xtremes (X and Y Games)

1. Know the definition of comparative advantage Crystal Crystal A 1 mil. B 700,000 A 80,000 B 40,000 C C 100,000 Rum 30,000 40,000 80,000 Rum Ireland Puerto Rico 1. Know the definition of comparative advantage Ireland Puerto Rico 1 Rum = __Crystal 1 Rum = __Crystal 1 Crystal = ____ Rum 1 Crystal = __Rum 2. Set up a table: 10 1 1/10 1 3. Go to the Xtremes (X and Y Games) 4. Fill in the blanks (starting with Puerto Rico first) 5. Circles and Arrows

We decided that Ireland should produce ALL the crystal and 1 million B 700,000 A 80,000 B 40,000 C C 100,000 Rum 30,000 40,000 80,000 Rum Ireland Puerto Rico We decided that Ireland should produce ALL the crystal and Puerto Rico should produce ALL the rum. How much crystal should Ireland produce? 1 million cases How much rum should Puerto Rico produce? 80,000 barrels Should Ireland just hold onto its cases of crystal and Puerto Rico just hold onto its barrels of rum? NO! What should each country do after specialization? Trade

Ireland Puerto Rico IRELAND PUERTO RICO Crystal Crystal A 1 million B 700,000 A 80,000 B 40,000 C C 30,000 100,000 Rum 40,000 80,000 Rum Ireland Puerto Rico Consumes Consumes after specialization before Trade Produces Trades and Trade (Point B) Gain from Trade IRELAND C 1 million -175,000 R 0 +35,000 825,000 700,000 +125,000 35,000 30,000 + 5,000 PUERTO RICO C 0 R 80,000 +175,000 175,000 40,000 +135,000 -35,000 45,000 40,000 +5,000

Ireland Puerto Rico IRELAND PUERTO RICO Crystal Crystal A 1 million 175,000 D Crystal Crystal A 1 million D 825,000 700,000 A B 80,000 40,000 B 35,000 C 45,000 C 30,000 100,000 Rum 40,000 80,000 Rum Ireland Puerto Rico Consumes Consumes after specialization before Trade Produces Trades and Trade (Point B) Gain from Trade IRELAND Plot this column C 1 million -175,000 R 0 +35,000 825,000 700,000 +125,000 35,000 30,000 + 5,000 PUERTO RICO C 0 R 80,000 +175,000 175,000 40,000 +135,000 -35,000 45,000 40,000 +5,000

175,000 D Crystal Crystal A 1 million D 825,000 700,000 A B 80,000 40,000 B 35,000 C 45,000 C 30,000 100,000 Rum 40,000 80,000 Rum Ireland Puerto Rico Which country is obviously better off through this specialization and trade--Ireland or Puerto Rico? Both Countries are!!! Both countries are now outside their own production capabilities. Through specialization and trade all parties are better off.

Micro Economics 1999 Question 2

line XZ in the figure above. Country B can produce 100 bushels of Wheat Country B 100 Country A Z Y 100 300 Cloth 2. Assume that Countries A and B have equal amounts of resources and identical technologies. Country A can produce 100 bushels of wheat or 100 yards of cloth or any combination, as shown by the line XZ in the figure above. Country B can produce 100 bushels of wheat or 300 yards of cloth or any combination, as shown by the line XY in the figure above.

(a) Which country has an absolute advantage in the production of Wheat Country B 100 Country A Z Y 100 300 Cloth (a) Which country has an absolute advantage in the production of wheat and which has an absolute advantage in the production of cloth? Explain how you determined your answer. Neither country or both countries has the absolute advantage in the production of wheat. Both countries can produce 100 bushels of wheat. Country B has the absolute advantage in the production of cloth. It can produce absolutely more cloth (300) than Country A (100). Absolute advantage is which entity can produce absolutely more than another entity.

(b) Which country has a comparative advantage in the production of wheat and which country has the comparative advantage in the production of cloth? Explain how you determined your answer. Wheat Country B 100 Country A Z Y 100 300 Cloth A B 1 1W = __ C 1C = __W 3 1W = __C 1C = __W 1 1/3 Country A has the comparative advantage in wheat and Country B has the comparative advantage in cloth because they can both produce those items at a lower marginal opportunity production cost.

Country B should import the wheat because Country A C) With specialization and trade, which country will import wheat? Explain why. Wheat Country B 100 Country A Z Y 100 300 Cloth A B 1 1W = __ C 1C = __W 3 1W = __C 1C = __W 1 1/3 Country B should import the wheat because Country A has a comparative advantage in wheat and should produce all the wheat.