Comparative advantage Today: An introduction to the advantages of trade

Becky’s linear production possibilities curve

Becky’s linear production possibilities curve What points are attainable? What points are efficient?

Attainable and efficient points Any point on the production possibility curve These points are efficient, since additional production of one good necessarily means that another good has lower production Attainable points F/B define an attainable point to be “any combination of goods that can be produced using currently available resources” (p. 43)

Back to Becky Efficient points: w, x, y, z, v Attainable points: t, w, x, y, z, v Unattainable point: u

Next, let’s look at a two-person economy Suppose that Barbara and Sherry have the Production Possibility Curves (PPCs) as shown

Next, let’s look at a two-person economy Barbara can do one of the following: Copy 50 tests if she does not type letters Type 25 letters and copy no tests Something in between

Next, let’s look at a two-person economy Sherry can do one of the following: Copy 25 tests and do nothing else Type 50 letters and do nothing else Something in between

Opportunity cost How much of one activity needs to be given up in order to do one more of the other? Example: Barbara could type one less letter in order to copy two more tests

Absolute advantage and comparative advantage “One person has an absolute advantage over another if he or she takes fewer hours to perform a task than the other person” (F/B p. 36) Comparative advantage “One person has a comparative advantage over another if his or her opportunity cost of performing a task is lower than the other person’s opportunity cost” (F/B p. 37)

New example Productivity in pizza production Productivity in salad production Greg 20 pizzas cooked per hour 10 salads made per hour David 16 pizzas cooked per hour 4 salads made per hour

Drop units to save space Notice that Greg has absolute advantage in producing both pizzas and salads Productivity in pizza production Productivity in salad production Greg 20 / hour 10 / hour David 16 / hour 4 / hour However, we will see that each person has a comparative advantage in producing one of the goods

Comparative advantage Before we can determine comparative advantage, we must ask about each person “how much of ____ must I give up in order to produce an additional ____?” In other words, we need to determine the opportunity cost of making one more pizza or one more salad for both Greg and David

Opportunity cost table Opportunity cost of cooking a pizza Opportunity cost of making a salad Greg ½ salad 2 pizzas David ¼ salad 4 pizzas Note that the two numbers in each row are mathematical inverses of each other

Comparative advantage Opportunity cost of cooking a pizza Opportunity cost of making a salad Greg ½ salad 2 pizzas David ¼ salad 4 pizzas To find comparative advantage for each person, find the lowest number in each column

Comparative advantage Opportunity cost of cooking a pizza Opportunity cost of making a salad Greg ½ salad 2 pizzas David ¼ salad 4 pizzas David has comparative advantage in cooking pizzas Greg has comparative advantage in making salads

Some things to note Absolute advantage The same person could have absolute advantage in everything Comparative advantage in a two-person, two-good economy Each person will almost always have comparative advantage in exactly one of the two goods

From Greg and David to a big economy To produce an efficient point in an economy, each good needs to be produced with lowest opportunity cost All units in this graph in millions

From Greg and David to a big economy Notice that opportunity cost of pizzas increases from A to C Opportunity cost increases as more is produced All units in this graph in millions

Changes in a production possibilities curve Some factors that can shift a production possibilities curve Change in population War Investment in buildings, machines, and other forms of capital Research and development in technology

From comparative advantage to trade Recall that Greg had comparative advantage at making salads, while David’s was making pizzas Greg could make more salads than he wants to eat and trade them for pizzas from David Both can be made better off with trade

International trade In the real world, trade is more complex than simple two-good economies When trade becomes more open between countries, there are typically millions of winners and often only thousands of losers Prices go down for goods on average The few displaced workers must find an alternate form of work, typically at a lower wage

International trade We will examine more about international trade in the next lecture For more on international trade, read Ch. 9 Think about how trade benefits your everyday life Example: You could speculate about the price of gas if OPEC countries stopped producing oil