McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Comparative Advantage and Trade 2-1

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-2 Economic Growth In the Past Two Thousand Years $6,000 $5,000 $4,000 $3,000 $2,000 $1, Per capita income (in 1990 dollars) WHY?

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. The Economics of Babe Ruth 2-3

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Babe Ruth Statistics Boston Red Sox Pitcher * *Means New York Yankee Right Fielder led the *.300 league * *.393* *

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. Comparative Advantage Comparative Advantage—the relatively most productive use of a resource Hitting was the Babe’s comparative advantage  Very good pitcher—played every 4-5 days  Great hitter—played every day and changed the game forever Specialized—pitched a total of only 5 games after

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-6 Production Possibilities Without Trade Production Possibilities Curves for Pakistan and Belgium What does each country do best? Hint: Think opportunity costs Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan A B E D

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-7 Specialization and Trade Specialization and Trade How could they get to point C where each country can consume 2,000 tons of fabric and 2 tons of chocolate? Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan A B C E D

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-8 Specialization and Comparative Advantage For Pakistan the opportunity cost of one ton of chocolate is 4000 yards of textiles. For Belgium the opportunity cost of one ton of chocolate is 250 yards of textiles. Belgium has the comparative advantage in chocolate and specializes producing 4 tons (point E). Pakistan has the comparative advantage in textiles and specializes producing 4000 yards (point D) Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan A B C E D

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-9 Comparative Advantage and the Combined PPC Chocolate (in tons) Textiles (in thousands of yards) Belgium Pakistan H (4,4) F (0,5) G (5,0) Note how much more they can have if they specialize and trade The combined PPC is the curve connecting points F, H, and G.. C (2,2)

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved U.S. Textile Production and Trade Two hundred years ago, the U.S. had a comparative advantage in textile production. Now countries with cheaper labor, such as Bangladesh, have the comparative advantage in textiles. The gains from trade are higher wages for workers in Bangladesh and lower-priced cloth for U.S. consumers.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Comparative Advantage Review Suppose that the U.S. can produce 100 computer chips or 100 video games in one hour. Japan can produce 40 computer chips or 80 video games in one hour. What is the opportunity cost of computer chips in each country? In which product should each country specialize? The U.S. is more efficient in producing both computer chips and video games. Can the U.S. benefit by trading with Japan?

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved In the U.S. the opportunity cost of 1 video game is 80/80 = 1 computer chip. In Japan the opportunity cost of 1 computer chip is 80/40 = 2 video games. U.S. should specialize in computer chips. Produces 100 per hour Japan should specialize in video games. Produces 80 per hour They agree to trade 1 computer chip for 1.5 video games U.S. gets video games for 2/3 of a computer chip Japan gets computer chips for 1.5 video games Both countries have reduced their opportunity costs

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Comparative Advantage and Outsourcing Outsourcing : The relocation of production once done in the U.S. to foreign countries. Outsourcing occurs because of comparative advantage  What is the comparative advantage of countries such as India and China?  What is the comparative advantage of the U.S.? What economic activities are being outsourced?

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved. 2-14Globalization Globalization: The increasing integration of economies, cultures, and institutions across the world. The positive effect of globalization is that it provides larger markets than the domestic economy. The negative effect is that it results in increased competition.

McGraw-Hill/Irwin Copyright  2008 by The McGraw-Hill Companies, Inc. All rights reserved Law of One Price Wages of similar workers in one country will not differ significantly from the wages of workers in another institutionally similar country. If the U.S. loses its comparative advantage based on technology and institutional structure, U.S. wages will decrease relative to wages in many other countries.