Comparative Advantage and Gains from Trade

Overview Principle Five: Trade can make everyone better off Voluntary exchange between people must be mutually beneficial…otherwise one side would cancel the deal. Logic of specialization and exchange is clear for individuals: self-sufficiency would be hard. Do you grow your own food or make your own clothes?

The Production Possibilities Frontier The Production Possibilities Frontier: illustrates the different quantities of two goods an economy can produce given the available factors of production and current state of technology. The Production Possibilities Frontier can be used to illustrate: a) the concept of opportunity cost b) the concept of economic efficiency c) the concept of gains from trade

The Production Possibilities Frontier Agricultural Goods Points along the frontier are efficient. Point B is inefficient Point D is unattainable given current technology Movement from Point A to Point C demonstrates opportunity cost. Opportunity cost of 300 more units high tech goods is 800 units of agricultural goods 3,000 2,800 A D 2,000 C 1,000 B 200 1,000 500 800 High Tech Goods

Shifts in The Production Possibilities Frontier Agricultural Goods A technological advance in high tech goods shifts the production possibilities outward. As a result, more of both goods can be produced. 3,000 2,200 B 2,000 A 800 900 1,000 1,500 High Tech Goods

Production Possibilities Frontier and Gains from Trade The production possibilities frontier can also be used to analyze gains from trade. Consider two men on a deserted island: Gilligan and Skipper. Each has 6 hours a day to secure food. Gilligan is better at collecting coconuts. Skipper is better at fishing.

Productivity Table Coconuts Fish Gilligan Per hour: 2 1 In 6 hours: 12 6 Skipper Per hour: 1 2 In 6 hours: 6 12

. . . Gilligan’s PPF Coconuts Fish Gilligan likes to consume an equal number of fish and coconuts. 12 Without trade, his PPF allows him to consume four of each . 4 . 4 6 Fish

. . . Skipper’s PPF Coconuts 6 4 12 4 Fish Skipper also likes to consume an equal number of fish and coconuts. . . 6 Without trade, his PPF allows him to consume four of each 4 . 4 12 Fish

Opportunity Costs Gilligan: Skipper: One more fish = 2 fewer coconuts One more coconut = .5 fewer fish Skipper: One more fish = .5 fewer coconuts One more coconut = 2 fewer fish

The Benefits of Exchange If the men specialize in what they do best, trade will make them better off: Coconuts Fish Gilligan Produce: Trade: Consume: Skipper 12 0 - 6 + 6 6 6 0 12 + 6 - 6 6 6

Gilligan’s Exchange w/ Skipper Coconuts With trade, Gilligan specializes in collecting coconuts…. . 12 …and trades away six coconuts for six fish… …after which he has more of both goods. . 6 Without trade, his PPF allows him to consume four of each 4 . 4 6 Fish

Skipper’s Exchange w/ Gilligan Coconuts Without trade, his PPF allows him to consume four of each With trade, Skipper specializes in catching fish…. . …and trades away six fish for six coconuts. . 6 …after which he has more of both goods. 4 . 4 6 12 Fish

The Principle of Comparative Advantage: An Overview Differences in the costs of production determine the following: Who should produce what How much should be traded for each product In the previous example, Gilligan could produce coconuts at a lower cost and the Skipper could produce fish at a lower cost. Two ways to measure differences in costs of production: The number of hours required to produce a unit of output (for example, one fish or one coconut). The opportunity cost of sacrificing one good for another.

Comparative Advantage Comparative Advantage: The comparison among producers of a good according to their opportunity cost. In the previous example: Gilligan’s opportunity cost of producing one more fish was two coconuts. Skipper’s opportunity cost of one more fish was .5 coconuts. Thus, Skipper has a comparative advantage in producing fish. Skipper’s opportunity cost of producing one more coconut was 2 fish. Gilligan’s opportunity cost of one more coconut was .5 fish. Thus, Gilligan has a comparative advantage in producing coconuts.

Absolute Advantage Absolute Advantage: The comparison among producers of a good according to their productivity. In the previous example: Gilligan required only 30 minutes to produce one coconut whereas the Skipper required one hour: Gilligan had an absolute advantage in collecting coconuts Skipper required only 30 minutes to produce one fish whereas Gilligan required an hour: Skipper had an absolute advantage in fishing

Opportunity Cost and Comparative Advantage When trading partners have absolute advantage in opposite goods, benefits of exchange are pretty clear… Gilligan (coconuts) and Skipper (fish) Colombia (coffee) and Chile (fish) Saudi Arabia (oil) and New Zealand (sheep) …but what if one trading partner has an absolute advantage in everything? Is trade still worthwhile? Enter: Maryanne

Productivity Table Coconuts Fish Gilligan Per hour: 2 1 In 6 hours: 12 6 Maryanne Per hour: 3 3 In 6 hours: 18 18

Absolute Advantage and Gains from Trade Maryanne has an absolute advantage over Gilligan in the production of both goods She is better off than he is in the absence of trade Can Maryanne profit from trading with a bozo like Gilligan? Can Gilligan benefit from trade, too? YES

. . . Maryanne’s PPF Coconuts 18 9 9 18 Fish Maryanne also likes to consume an equal number of fish and coconuts. . Without trade, her PPF allows her to also consume nine of each 9 . 9 18 Fish

The Benefits of Exchange Coconuts Fish Gilligan Produce: Trade: Consume: Maryanne 12 0 - 7 + 5 = 5 = 5 3 15 + 7 - 5 = 10 = 10

Gilligan’s Exchange w/ Maryanne Coconuts With trade, Gilligan specializes in collecting coconuts…. . 12 …and trades away seven coconuts for five fish… …after which he has more of both goods. . 5 Without trade, his PPF allows him to consume four of each 4 . 4 5 6 Fish

Maryanne’s Exchange w/ Gilligan Coconuts . With trade, Maryanne moves toward a specialization in fishing…. 18 …and trades away five fish for seven coconuts… . 10 …after which she has more of both goods. 9 . . 3 9 10 15 18 Fish

Comparative Advantage and Gains from Trade The benefits of trade ultimately come from comparative (not absolute) advantage Everyone has a comparative advantage in something, so opportunities for exchange are everywhere Even when a person or a country has an absolute advantage in everything, they can still benefit from trade due to comparative advantage.

International Trade Trade at international prices allows a nation to consume beyond its PPF Manufacturing goods Production and consumption in the absence of trade . Consumption with trade . Production with trade . International trade line Agricultural goods