AP Macroeconomics Comparative Advantage

Ricky Ricardo Lucy’s Cuban- American husband drumming on the bongo.

David Ricardo English economist responsible for promoting comparative advantage as the basis of trade. No relation to Ricky Ricardo.

Absolute Advantage v. Comparative Advantage Absolute 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.

Example Assume David Ricardo and Ricky Ricardo are going to throw a party in exactly one hour. They decide on serving homemade pizzas and cakes. Assume they have like 15 ovens in their apartment and lots of pots and pans. Use the information in the next slide to determine who should produce what.

Example Bake CakesMake Pizza David Ricardo 2 cakes/hr.4 pizzas/hr. Ricky Ricardo 6 cakes/hr.8 pizzas/hr.

Example Bake CakesMake Pizza David Ricardo 2 cakes/hr.4 pizzas/hr. Ricky Ricardo 6 cakes/hr.8 pizzas/hr. Who has the absolute advantage in baking cakes? Who has the absolute advantage in making pizza?

Example David Ricardo Ricky Ricardo Bake Cakes2 cakes/hr.6 cakes/hr. Make Pizza4 pizzas/hr.8 pizzas/hr. Why? Well, because 6 cakes>2 cakes & 8 pizzas>4 pizzas.

Example David Ricardo Ricky Ricardo Bake Cakes2 cakes/hr.4 cakes/hr. Make Pizza6 pizzas/hr.8 pizzas/hr. Who has the comparative advantage in baking cakes? Who has the comparative advantage in making pizza?

Example Who has the comparative advantage in baking cakes? Who has the comparative advantage in making pizza?

Example Why? Ricky only gives up 2 pizzas in order to bake a cake, whereas David gives up 3 pizzas in order to bake a cake.

Example It only cost David 1 / 3 of a cake to make a pizza, whereas it costs Ricky ½ of a cake to make a pizza.

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.

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

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 Coffee Wheat U.S. Brazil Before After Gain

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 U.S. 1 C = 1 W Brazil 2C = 1/2 W Possible Term of Trade 1.5C = 1W

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. U.S. 1 C = 1 W Brazil 2C = 1 W Trading Possibilities: Possible Term of Trade 1C < 1W < 2C 1.5C = 1W

Should the U.S. and Brazil specialize and trade? Why: Efficiency Argument and Output Argument efficient use 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 trade

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 ApplesPears Tom105 Sam62

Absolute Advantage? Acres to produce one unit of each. Who has the absolute advantage in apples and pears? Sam ApplesPears Tom105 Sam62

Explanation Acres to produce one unit of each. 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. ApplesPears Tom105 Sam62

Input or Output problem? Number caught per day. Output problem TroutBass Tom46 Sam2412

Absolute Advantage? Number caught per day. Which guy has the absolute advantage in the production of each product? Sam TroutBass Tom46 Sam2412

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. TroutBass Tom46 Sam2412

Input or Output Problem? Days to produce one unit of each. Input problem CarsPlanes XYZ Corp.810 QKFX Corp.1512

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. CarsPlanes XYZ Corp.810 QKFX Corp.1512

Absolute Disadvantage? Days to produce one unit of each. Which corporation has an absolute disadvantage in the production of both products? QKFX CarsPlanes XYZ Corp.810 QKFX Corp.1512

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. CarsPlanes XYZ Corp.810 QKFX Corp.1512

Input or Output Problem? To produce the following from one ton of olives. Output problem Canned Olives Olive Oil Zaire6010 Colombia248

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 Zaire6010 Colombia248

Absolute Advantage? To produce the following from one ton of olives. Which nation has the absolute advantage in both products? Zaire Canned Olives Olive Oil Zaire6010 Colombia248

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 Zaire6010 Colombia248