Lecture 19 The Principle of Comparative Advantage Microeconomics 1000 Lecture 19 The Principle of Comparative Advantage

Key Points for today Interdependence and trade increase the quality of life for everyone. Productivity can be measured in (i) absolute advantage or (ii) comparative advantage. The gains from trade are based on comparative advantage, not absolute advantage. Trade makes everyone better off because it allows people and countries to specialize in those activities in which they have a comparative advantage. The principle of comparative advantage applies to countries as well as people.

The principle of Comparative Advantage The only result in the whole of the social sciences that is true and non-trivial. (Paul Samuelson)

Gains from trade We started this course by noting that if trade is voluntary and agents are rational, both parties must gain from trade We then proceeded to measure such gains, using the notion of willingness to pay The approach was partial equilibrium in nature Now we take a fresh look at the problem from a general equilibrium perspective.

Interdependence and the Gains from Trade How do we satisfy our wants and needs? We can be economically self-sufficient (primitive economies, Robinson Crusoe…). We can specialize and trade with others, leading to economic interdependence (modern economies). Why is interdependence the norm? What determines the pattern of trade? 3

Interdependence and the Gains from Trade Why is interdependence the norm? Interdependence occurs because people are better off when they specialise and trade with others. What determines the pattern of trade? Patterns of trade are based upon differences in productivity, factor endowments and preferences. The Ricardian model focuses on the first determinant of the pattern of trade, namely differences in productivity

The Ricardian model Only two goods: corn and cloth Only two people: a corn farmer (called Mr. C) and a cloth producer (called Mr. B) Fixed labour supply: each works 240 days per year What should each produce (that is, why does Mr. C grows corn and Mr. B produces cloth)? Why should they trade?

Table 1 The Productivity of Mr. B and Mr. C Number of days of work to produce 1 ton of corn Number of days of work to produce 1 cloth Mr. B 8 24 Mr. C 12 60 Copyright © 2004 South-Western

Production Possibilities Self-Sufficiency By ignoring each other: Each consumes what they each produce. The production possibilities frontier is also the consumption possibilities frontier. Without trade, economic gains are diminished. 8

Figure 1 The Production Possibilities Curve of Mr. B (a) Mr B’s Production Possibilities Frontier Corn 30 10 If there is no trade, Mr. B chooses this production and consumption. A 8 7 Cloth Copyright©2003 Southwestern/Thomson Learning

Figure 2 The Production Possibilities Curve of Mr. C (a) Mr C’s Production Possibilities Frontier Corn If there is no trade, Mr. C chooses this production and consumption. 20 4 C 10 2 Cloth Copyright©2003 Southwestern/Thomson Learning

Specialization and Trade Mr. B and Mr. C Specialize and Trade Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other.

Table 2 Autarky: A Summary Without trade: production and consumption Corn Cloth Mr. B 8 7 Mr. C 10 2 Copyright © 2004 South-Western

Trade Suppose the price of cloth in terms of corn is 4 (i.e. 4 tons of corn per unit of cloth) Later we shall ask what determines the price However, notice 4 is greater than the slope of Mr.B’s production possibility frontier, and lower than the slope of Mr. C’s production possibility frontier

Figure 3 How Trade Expands the Set of Consumption Opportunities (a) Mr B’s Production and ConsumptionPossibilities Frontier Corn 40 If there is trade, Mr. B chooses this production and consumption. 30 10 A 7 Cloth Copyright©2003 Southwestern/Thomson Learning

Figure 4 How Trade Expands the Set of Consumption Opportunities (a) Mr C’s Production and Consumption Possibilities Frontier Corn If there is trade, Mr. C chooses this production and consumption. 20 4 C 10 2 Cloth Copyright©2003 Southwestern/Thomson Learning

Table 2 The gains from trade: A Summary With trade: Corn production consumption Cloth Mr. B 0 10 buys 10 7 ½ sells 2 ½ Mr. C 10 sells 10 0 2 ½ buys 2 ½ Copyright © 2004 South-Western

THE PRINCIPLE OF COMPARATIVE ADVANTAGE Differences in the costs of production determine who should produce what Two ways to measure differences in costs of production: The number of days required to produce a unit of output (for example, one ton of corn). The opportunity cost of sacrificing one good for another.

Absolute Advantage The comparison among producers of a good according to their productivity—absolute advantage Describes the productivity of one person, firm, or nation compared to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. 13

Mr. B has an absolute advantage in the production of both goods Mr. B needs only 8 days to produce a ton of corn, whereas Mr. C needs 12 days. Mr. B needs only 24 days to produce a unit of cloth, whereas Mr. C needs 60 days. Mr. B has an absolute advantage in the production of both goods 13

Opportunity Cost and Comparative Advantage Compares producers of a good according to their opportunity cost. Whatever must be given up to obtain some item The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. 14

Comparative Advantage and Trade Who has the absolute advantage? Mr. B or Mr. C? Who has the comparative advantage? 15

Table 3 The Opportunity Cost of Meat and Potatoes 1 ton of corn 1 unit of cloth Mr. B 3 units of cloth 1/3 tons of corn Mr. C 5 units of cloth 1/5 tons of corn

Comparative Advantage and Trade Mr. B’s opportunity cost of a unit of cloth is 1/3 tons of corn, whereas Mr. C’s opportunity cost of a unit of cloth is only 1/5 tons of corn. Mr. B’s opportunity cost of a ton of corn is 3 units of cloth, whereas Mr. C’s opportunity cost of a ton of corn is 5 units of cloth. So, Mr. B has a comparative advantage in the production of cloth but Mr. C has a comparative advantage in the production of corn.

Comparative Advantage and Trade Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. 16

Comparative Advantage and Trade Benefits of Trade Trade can benefit everyone in a society because it allows people to specialise in activities in which they have a comparative advantage. 17

How is price determined? If one agent is much more productive, or works longer hours, than the other, the “small” agent will specialise whereas the “big” agent will produce both goods In this case, the relative price of the two goods equal will reflect the relative productivity of the big agent If the two agents are more or less the same size, both may fully specialise In this case, equilibrium prices will depend on demand

COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE Suppose that instead of Mr. B and Mr. C we have two countries, B and C Country B is more productive in the production of both goods Would all the production take place in country B? No, country B will specialise in the production for which it has a comparative advantage Country C will specialise in the production of the good for which it has a comparative advantage

International trade Trade will occur, benefiting both countries Imports—goods produced abroad and sold domestically Exports—goods produced domestically and sold abroad Note, all countries have a comparative advantage!

Free trade Each country has many citizens with different interests. International trade can make some individuals worse off, even as it makes the country as a whole better off.

Summary Each person consumes goods and services produced by many other people both in our country and around the world. Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.

Summary There are two ways to compare the ability of two people, or two countries, producing a good. The person who can produce a good with a smaller quantity of inputs has an absolute advantage. The person with a smaller opportunity cost has a comparative advantage.

Summary The gains from trade are based on comparative advantage, not absolute advantage. Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage. The principle of comparative advantage applies to countries as well as people.