Comparative Advantage FRQ - 2010B #1; 2008 #3 AP Macroeconomics Comparative Advantage FRQ - 2010B #1; 2008 #3

David Ricardo English economist responsible for promoting comparative advantage as the basis of trade

Absolute Advantage v. Comparative Advantage Individual – exists when a person can produce more of a certain good/service than someone else in the same amount of time. National- exists when a country can produce more of a good/service than another country can in the same time period. Comparative Advantage Individual/National- exists when an individual or nation can produce a good/service at a lower opportunity cost than can another individual or nation

Specialization Individuals and Countries can be made better off if they will produce in what they have a comparative advantage and then trade with others for whatever else they want/need. How will specialization within a country influence the factors of production?

Example Bake Cakes Make Pizza Juniors 2 cakes/hr. 6 pizzas/hr. Seniors

Absolute Advantage? Should the U.S. and Brazil specialize and trade? 30 12 18 20 10 8 4 Coffee Wheat Absolute Advantage? Should the U.S. and Brazil specialize and trade? Even though the U.S. has an absolute advantage in both goods – it should specialize and trade.

Determine Comparative Advantage Step 1: Set up the problem Step 2: Identify Production Maximums Coffee Wheat U.S. Brazil 30 1 (1W) 30 1 (1C) 20 2 (1/2 W) 10 1 (2C) Step 2: Reduce Ratios Step 3: Identify Opportunity Cost Step 4: Compare Costs --- lowest has CA Coffee: Wheat: Brazil U.S.

Gains From Trade: Coffee Wheat U.S. Brazil Before After Gain 12 18 8 4 20 22 Before After Gain 20 30 +8 Step 1: Set up the problem Step 2: Identify production prior to specialization Step 3: Total production in each product prior to specialization Step 4: Identify maximum possible production of each product with specialization according to comparative advantage Step 5: Compare output before/after specialization and trade

(Trading Possibilities) Terms of Trade (Trading Possibilities) U.S. 1 C = 1 W Brazil 2C = 1/2 W Possible Term of Trade 1.5C = 1W Step 1: Identify original reduced ratios for each country Step 2: Terms of trade fall between the limits set by the ratios Step 3: Trading possibilities are the maximums set by the ratios Terms are mutually beneficial

(Trading Possibilities) Terms of Trade (Trading Possibilities) U.S. 1 C = 1 W Brazil 2C = 1 W Possible Term of Trade 1.5C = 1W 1C < 1W < 2C Trading Possibilities: Both nations benefit from 1.5C traded for 1W. Prior to trade, the U.S. gave up 1W for each coffee. With trade, the U.S. can receive 1.5C for each unit of wheat. Before trade, Brazil gave up 2C for each unit of wheat. With trade, Brazil gives up only 1.5C for each wheat. Terms are mutually beneficial

Yes!!!!!!!! Should the U.S. and Brazil specialize and trade? Why: Efficiency Argument and Output Argument More efficient use of scarce global resources The U.S. gives up 1 coffee for each wheat / Brazil gives up 2 coffees for each wheat --- The U.S. gives up less to produce wheat. Brazil gives up ½ wheat for each coffee / U.S. gives up 1 wheat for each coffee --- Brazil gives up less to produce coffee. Gains from trade --- more can be produced from the same resources 8 additional units of wheat can be produced through specialization and trade

Input/Output Problems Distinguishing: Input/Output Problems

Distinguishing input from output problems. An OUTPUT problem presents the data as products produced given a set of resources. (ex. Number of pens produced) An INPUT problem presents the data as amount of resources needed to produce a fixed amount of output. (ex. Number of labor hours to produce 1 bushel) When identifying absolute advantage, input problems change the scenario from who can produce the most to who can produce a given product with the least amount of resources.

Which type of problem? Acres to produce one unit of each. Input problem Apples Pears Tom 10 5 Sam 6 2

Absolute Advantage? Acres to produce one unit of each. Who has the absolute advantage in apples and pears? Sam Apples Pears Tom 10 5 Sam 6 2

Explanation Acres to produce one unit of each. Apples Pears Tom 10 5 Sam has an absolute advantage in both pears and apples because he can produce 1 unit of each in fewer acres than Tom. Absolute advantage in INPUT problems is based on using the LEAST amount of resources to produce the given unit(s) of product. Apples Pears Tom 10 5 Sam 6 2

Input or Output problem? Number caught per day. Output problem Trout Bass Tom 4 6 Sam 24 12

Absolute Advantage? Number caught per day. Which guy has the absolute advantage in the production of each product? Sam Trout Bass Tom 4 6 Sam 24 12

Explanation: Number caught per day. Sam has an absolute advantage in catching both trout and bass as he can catch more of each than Tom in one day’s time. Trout Bass Tom 4 6 Sam 24 12

Input or Output Problem? Days to produce one unit of each. Input problem Cars Planes XYZ Corp. 8 10 QKFX Corp. 15 12

Explanation: Days to produce one unit of each. This is an input problem as it refers to how many days (work days for labor) will be needed to produce 1 unit. The problem is phrased in terms of resources used rather than products produced. Cars Planes XYZ Corp. 8 10 QKFX Corp. 15 12

Absolute Disadvantage? Days to produce one unit of each. Which corporation has an absolute disadvantage in the production of both products? QKFX Cars Planes XYZ Corp. 8 10 QKFX Corp. 15 12

Explanation: Days to produce one unit of each. XYZ has an absolute advantage in producing both cars and planes because it can produce 1 unit of each in less time (days) than QKFX. This means that QKFX has an absolute disadvantage in producing both products. QKFX uses more days to produce both products. Cars Planes XYZ Corp. 8 10 QKFX Corp. 15 12

Input or Output Problem? To produce the following from one ton of olives. Output problem Canned Olives Olive Oil Zaire 60 10 Colombia 24 8

Explanation? To produce the following from one ton of olives. This is an output problem because it is the number produced (output in canned olives and olive oil) from a given unit of resources (1 ton of olives) Canned Olives Olive Oil Zaire 60 10 Colombia 24 8

Which nation has the absolute advantage in both products? To produce the following from one ton of olives. Which nation has the absolute advantage in both products? Zaire Canned Olives Olive Oil Zaire 60 10 Colombia 24 8

Explanation: To produce the following from one ton of olives. Zaire has an absolute advantage in producing both products because it can produce more given the unit of resources available (1 ton of olives). Canned Olives Olive Oil Zaire 60 10 Colombia 24 8

FRQ – 2003 #3 Assume that two countries, Atlantis and Xanadu, have equal amounts of resources. Atlantis can produce 30 cars or 10 tractors or any combination, as shown by the line MN in the figure above. Xanadu can produce 20 cars or 40 tractors or any combination, as shown by the line PQ in the figure above. (a) Which country has an absolute advantage in the production of tractors? Explain how you determined your answer. (b) Which country has a comparative advantage in the production of cars? Using the concept of opportunity cost, explain how you determined your answer. (c) If the two countries specialize and trade with each other, which country will import cars? Explain why. (d) If the terms of trade are such that one car can be exchanged for one tractor, explain how Atlantis will benefit from such trade