Chapter 2 (Briefly) The Principle of Comparative Advantage

Generalize or Specialize? People do all of their own tasks People are “jack-of-all-trades” People are self-sufficient Specialize People do different tasks and trade to satisfy their wants People are more productive/efficient People produce greater output

Comparative Advantage A person has a comparative advantage in producing a particular good or service if That person is relatively more efficient at producing it than producing other goods and services Questions: What is the opportunity cost of producing?

Absolute vs. Comparative Advantage A person has an absolute advantage over another if That person takes fewer hours to perform a task than the other person A person has a comparative advantage over another if That person’s opportunity costs of performing the task is lower than the other person’s opportunity cost

Principle of Comparative Advantage Everyone does best when each person (or each country) concentrates on the activities for which his or her opportunity cost is lowest Output is increased when we all focus on those tasks in which we are relatively more productive; together we can produce vastly more than if we were all self-sufficient

Sources of Comparative Advantage Individuals Possibly inborn talent More often due to education, training, or experience Countries Difference in natural resources Difference in cultures--incentives of institutions

Efficient and Inefficient Efficient 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 Inefficient 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

Principle of Increasing Opportunity Cost AKA “The Low Hanging-Fruit Principle” In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs

Gains from Specialization Specialization produces gains for all, even when one person enjoys an absolute advantage in both tasks Specialization Uses differences in individual skills Deepens skills via practice Breaks tasks into simple steps multiplies the productivity of workers

Gains from Specialization This is one of the most important explanations of the difference in income levels across societies

Even Specialization Has Costs Most people enjoy variety in the work they do Increased specialization means less variety Overspecialization results in repetitive tasks

Comparative Advantage and International Trade Each trading partner can benefit from trade, even if one partner is absolutely more productive Without trade, the opportunity cost of producing is higher than it would be if trade occurrence, hence output is lower

Volume of Trade The volume of international trade has grown substantially over time Most nations produce less than a small fraction of the total supply of any good or service, which allows these nations to benefit from the differences in domestic opportunity costs and global opportunity costs

Why Trade Barriers? If exchange is beneficial, why does anyone oppose it? International trade does increase the total value of all goods and services, but certain industries may be harmed E.G. Concerns over NAFTA (1994) U.S. consumers would benefit from lower prices But, some thought that the U.S. would lose some unskilled jobs to Mexico, which, however, has not been shown

Naturalist Question Why did Schuhmann decide to build his own shed instead of hiring someone to do it? Notes: Schuhmann is not even remotely close to having any kind of comparative advantage in building things, and he is well aware of this. Schuhmann built the shed during the summer (the whoooole summer) when he was not teaching, but could have been consulting.

Naturalist Question Why do great chefs go out to eat? Assume: The great chef has the ability to cook all meals for herself The chef can sell the meals she cooks

Comparative Advantage and International Trade Economic Naturalist If trade between nations is so beneficial, why are free-trade agreements so controversial?

Exercise Jane can produce 50 pizzas or 100 hamburgers per day, while Sam can produce 30 pizzas or 90 hamburgers per day. Jane has an absolute advantage in the production of pizzas, but not hamburgers, and has a comparative advantage in the production of pizzas. absolute advantage in the production of hamburgers, but not pizzas, and has a comparative advantage in the production of hamburgers. absolute advantage in the production of hamburgers, and pizzas, as well as a comparative advantage in the production of hamburgers. absolute advantage in the production of hamburgers, and pizzas, as well as a comparative advantage in the production of pizzas. absolute advantage in the production of hamburgers, and pizzas, as well as a comparative advantage in the production of hamburgers and pizzas.

Example of Comparative Advantage and Mutual Gains from Trade Assume that Lara and Leah can spend the day either washing cars or mowing lawns. The table below shows how much of each task they could accomplish in one day if they spent the whole day doing just that task. For example, Lara could wash 20 cars or mow 5 lawns in one day. ______________________________________________ Lara Leah Cars washed 20 15 Lawns mowed 5 3 Question: Use the principle of comparative advantage to illustrate how specialization can make them more productive than they can be alone.

CA and Trade cont’d… Steps: 1. Calculate the opportunity cost of each activity for each person. Lara The opportunity cost of mowing 5 lawns is washing 20 cars.  the opportunity cost of mowing 1 lawn is washing 4 cars.  the opportunity cost of washing 1 car is mowing ¼ of a lawn. Leah The opportunity cost of mowing 3 lawns is washing 15 cars.  the opportunity cost of mowing 1 lawn is washing 5 cars.  the opportunity cost of washing 1 car is mowing 1/5 of a lawn.

CA and Trade cont’d… 2. Use the opportunity costs to see who has comparative advantage (lower opp cost) in each good, and therefore who should specialize in each good. Lara has a lower opportunity cost for mowing lawns so she has the comparative advantage in lawns (she gives up only 4 cars while Leah gives up 5 cars). Leah has a lower opportunity cost for washing cars so she has the comparative advantage in cars (she gives up only 1/5 of a lawn while Lara gives up ¼ of a lawn).  Lara should specialize in mowing lawns and Leah should specialize in washing cars.

CA and Trade cont’d… Use the opportunity costs of each good to figure out how much they would be willing to pay or accept in a trade. Since Lara is doing all the lawn mowing and Leah is doing all the car washing, we can see that Lara will trade some lawns for Leah’s car washing. Questions: a) how many lawns would Lara be willing to mow for Leah if Leah washes one car for Lara? b) how many lawns would Leah accept as a trade for each car she washes for Lara?

CA and Trade cont’d… Answers: a) Lara would mow up to ¼ of a lawn, but not more, for each car that Leah washes for her (because this is her opportunity cost or what she would have to give up if she washed a car herself). b) Leah would accept anything above 1/5 of a lawn, but not less, for each car that she washes for Lara. Notice that there is a “window” of opportunity for trade. Any amount of lawns between ¼ and 1/5 will be acceptable to both Lara and Leah and make them both better off.

Example of a mutually beneficial trade: Suppose Lara mows 6 lawns for Leah. What is the most that Leah would pay Lara (in car washes) for these 6 lawns?  Leah will pay up to 30 cars for this because for her the opportunity cost of 1 lawn is 5 cars, so the opportunity cost of 6 lawns is 30 cars. What is the least that Lara will accept for these 6 lawns?  Lara will accept anything greater than 24 cars for this because for her the opportunity cost of 1 lawn is 4 cars, so the opportunity cost of 6 lawns is 24 cars.

Example of a mutually beneficial trade: If Leah gives Lara 27 cars for the 6 lawns (or any other number between 24 and 30) then they will both be better off. Lara gets 27 cars washed at a “price” of only 6 lawns – if she were to wash 27 cars herself she would have to give up 6.75 lawns (27 x 0.25) – she is therefore better off by ¾ of a Lawn. Leah gets 6 lawns mowed at a “price” of only 27 cars – if she were to mow 6 lawns herself she would have to give up 30 cars (6 x 5) – she is therefore better off by 3 cars.

Another one … Suppose that Alex and Brandon are trapped on a desert island where the only food available is fish and coconuts. Each of the two individuals can spend their time catching fish or gathering coconuts. The table below shows how much of each task they could accomplish in one hour if they spent the whole hour doing just that task. For example, Alex could catch 4 fish or collect 12 coconuts in one hour. ______________________________________________ Alex Brandon Fish Caught 4 2 Coconuts collected 12 10

Fish and Coconuts … Questions: Who has the comparative advantage in each good? Illustrate a mutually beneficial trade based on the principle of comparative advantage.