Comparative Advantage Overheads

The Logic of Free Trade Self-sufficiency is nice but …

Advantages of doing things ourselves Good information about quality Will not have any transactions costs Don’t need to depend on others and their foibles Can customize the product Can coordinate production and consumption Can keep information secret Don’t have to worry about enforcing any contracts Don’t have to worry about being exploited

Disadvantages of doing things ourselves May not be able to achieve any economies of scale May not have necessary knowledge, skill or intelligence for task May have limited experience for some tasks May have to keep continually changing tasks

Principle of specialization and exchange Specialization and exchange enable us to enjoy greater production and higher living standards than would otherwise be possible. As a result, all economies have been characterized by high degrees of specialization and exchange. The principle of specialization and exchange applies not just to individuals, but to groups of individuals, such as those living within the boundaries that define cities, counties, states or nations.

International Trade - International trade is trade between nations Exports are goods and services that are produced domestically, but sold abroad. Imports are goods and services that are produced abroad, but consumed domestically.

Absolute and comparative advantage An individual producer has an absolute advantage in the production of a product if he has the ability to produce the good or service using fewer resources than other producers use. Similarly a country has an absolute advantage in the production of a product if it has the ability to produce the good or service using fewer resources than other countries use.

comparative advantage An individual producer has a comparative advantage in the production of a product if she has the ability lower opportunity cost to produce the good or service at a lower opportunity cost than other producers. Comparative advantage country has a comparative advantage Similarly, a country has a comparative advantage in the production of a product if it has the ability lower opportunity cost to produce the good or service at a lower opportunity cost than other countries.

How to measure comparative advantage opportunity cost We measure the opportunity cost of a good, not by the resources used to produce it, other goods but rather by the other goods sacrificed whose production must be sacrificed.

Mutually Beneficial Trade Mutually beneficial trade between any two countries one country is relatively better is possible whenever one country is relatively better at producing a good than the other is at producing the good. relatively better Being relatively better means having the ability lower opportunity cost to produce a good at a lower opportunity cost — that is, at a lower sacrifice of other goods foregone.

Measuring Productivity We often measure productivity in terms of output per unit of input (or other resource) a.labor time or hours b.land c.expenditure or cost

Labor time example Load of washVacuum a room Labor requirement data for White House cleaning Bill.80 hours.40 hours Hillary.75 hours.25 hours This data is input per unit of output

Convert requirement data to output per unit of input data Take the reciprocal of the requirement data Loads per hourRooms per hour Bill1 /.80 = 1.25 loads1 /.40 = 2.5 rooms Hillary1 /.75 = loads1 /.25 = 4 rooms

Mexico U.S. Corn (bu)Peanuts (lbs) $2.50 $4.00 $0.25 $0.50 Corn and peanut example Cost requirement data $ per output

Convert requirement data to output per unit of input data Take the reciprocal of the requirement data Bushels of corn per $Pounds of peanuts per $ U.S.1 / 2.50 = 0.40 bu.1 /.25 = 4 lbs. Mexico1 / 4.00 = 0.25 bu.1 /.50 = 2 lbs (1/4)

Mexico U.S. Corn (bu)Peanuts (lbs) 0.40 bu 0.25 bu 4 lbs 2 lbs Corn and peanut example Output per $

How to determine who has the comparative advantage in what 2.Make an opportunity cost table (agents by goods) 1.Determine the output per per unit of input for each agent 5.The country with the lower opportunity cost has a comparative advantage in the production of each good 3.For each good (column) choose a unit of exchange 4.Determine the opportunity cost of each good in terms of the unit of exchange by dividing the production of the unit of exchange by the production of the other good Output per unit of input data

Example Computation 3.Rooms is unit of exchange for wash Wash is unit of exchange for rooms 5. Bill has the comparative advantage in washing 5a.Hillary has the comparative advantage in room cleaning 4.Fill in comparative advantage table (unit of exchange per unit of good) Hillary BillLoadsRooms Hillary BillLoadsRooms 2 r 3 r 1/2 l 1/3 l

Example Computation 3.Peanuts is unit of exchange for corn Corn is unit of exchange for peanuts 4.Fill in comparative advantage table (unit of exchange per unit of good) Mexico USA CornPeanuts Mexico USACornPeanuts 10 p 8 p 1/10 c 1/8 c

Example Computation 3.Peanuts is unit of exchange for corn Corn is unit of exchange for peanuts 5. Mexico has the comparative advantage in corn 5a.USA has the comparative advantage in peanuts 4.Fill in comparative advantage table (unit of exchange per unit of good) Mexico USACornPeanuts Mexico USACornPeanuts 10 p 8 p 1/10 c 1/8 c

Using input per unit of output data Determining comparative advantage Using cost per unit of output data

Output per unit of input data We want the most possible Input (cost) per unit of output data We want the least possible Most output per unit of input Least input per unit of output

What does Bill give up to do a load of wash? Bill gives up 2 rooms to do a load of wash 1 load of wash costs two rooms Hillary Bill WashRooms Hours per task Washing takes twice the resources of rooms

Hillary Bill 1 Load1 Room Opportunity Cost of: 2 rooms

What about Hillary? Hillary gives up 3 rooms to do a load of wash 1 load of wash costs three rooms Hillary Bill WashRooms Hours per task Washing takes 3 times the resources of rooms

Hillary Bill 1 Load1 Room Opportunity Cost of: 2 rooms 3 rooms

Who has the lowest opportunity cost for washing? Hillary Bill 1 Load1 Room 2 rooms 3 rooms Bill has a comparative advantage in washing

What does Bill give up to vacuum a room? Bill gives up 1/2 load of wash to vacuum a room 1 room costs ½ load of wash Hillary Bill LoadsRooms Hours per task Vacuuming takes ½ as long as washing

Hillary Bill 1 Load1 Room Opportunity Cost of: 2 rooms 3 rooms ½ load

What does Hillary give up to vacuum a room? Hillary gives up 1/3 load of wash to vacuum a room 1 room costs 1/3 load of wash Hillary Bill WashRooms Hours per task Vacuuming takes 1/3 as long as washing

Hillary Bill 1 Load1 Room Opportunity Cost of: 2 rooms 3 rooms ½ load 1/3 load

Bill has a comparative advantage in washing Hillary has a comparative advantage in vacuuming

How to determine who has the comparative advantage in what 2.Make an opportunity cost table (agents by goods) 1.Determine the input per per unit of output for each agent 5.The country with the lower opportunity cost has a comparative advantage in the production of each good 3.For each good (column) choose a unit of exchange 4.Determine the opportunity cost of each good in terms of the unit of exchange by dividing the input use of each good by the input use of the unit of exchange Input per unit of output data

Example Computation 3.Peanuts is unit of exchange for corn Corn is unit of exchange for fish 5. Mexico has the comparative advantage in corn production 5a.U.S. has the comparative advantage in peanut production 4.Fill in comparative advantage table (unit of good per unit of exchange) Mexico U.S.CornPeanuts Mexico U.S.CornPeanuts 10 p 8 p 1/10 c 1/8 c

Time for a break and review

Specialization and Gains from Trade If individuals/countries specialize according to their comparative advantage, a more efficient use of given resources occurs. As a result, the output of at least one good rises, without decreasing that of any other good.

The rate of substitution between outputs Opportunity cost Hillary Bill LoadsRooms 2 rooms 3 rooms ½ load 1/3 load If Bill cleans 1 less room, he washes 1/2 more load of laundry. If Bill cleans 2 less rooms, he washes 1 more load of laundry. (1 less room) x (½ load per room) = ½ more loads of laundry (2 less rooms) x (½ load per room) = 1 more loads of laundry

The rate of substitution between outputs If Bill does 1 more load of laundry, he cleans 2 less rooms. If Bill does 2 more loads of laundry, he cleans 4 less rooms. (1 more load) x (2 rooms per load) = 2 less rooms (2 more loads) x (2 rooms per load) = 4 less rooms Opportunity cost Hillary Bill LoadsRooms 2 rooms 3 rooms ½ load 1/3 load

The rate of substitution between outputs If Hillary does 1 more load of laundry, she cleans 3 less rooms (1 more load) x (3 rooms per load) = 3 less rooms If Hillary cleans 2 more rooms, she washes 2/3 less loads of laundry (2 more rooms) x (1/3 load per room) = 2/3 more loads of laundry Opportunity cost Hillary Bill LoadsRooms 2 rooms 3 rooms ½ load 1/3 load

Now adjust tasks and see what happens Opportunity cost Hillary Bill LoadsRooms 2 rooms 3 rooms ½ load 1/3 load Bill does 2 more loads of laundry and Hillary does 2 less loads (2 more loads) x (2 rooms per load) = 4 less rooms (Bill) (2 less loads) x (3 rooms per load) = 6 more rooms (Hillary) Net impact is 2 more rooms vacuumed

Now adjust tasks and see what happens Opportunity cost Mexico U.S. CornPeanuts US grows 1,000 less bu corn and Mexico grows 1,000 more bu corn (1,000 less bu corn) x (10 lbs per bu) = 10,000 more lbs of peanuts (1,000 more bu) x (8 lbs per bushel) = 8,000 less lbs of peanuts Net impact is 2,000 more lbs of peanuts 10 p 8 p 1/10 c 1/8 c

Another example Opportunity cost Mexico U.S. CornPeanuts US grows 10,000 less corn and Mexico grows 100,000 less peanuts (10,000 less bu corn) x (10 lbs per bu) = 100,000 more lbs of peanuts (100,000 less lbs) x (1/8 bushels per pound) = 12,500 more corn Net impact is 2,500 more bushels of corn 10 p 8 p 1/10 c 1/8 c

A third example Opportunity cost Mexico U.S. CornPeanuts US grows 4,000 more corn and Mexico grows 40,000 more peanuts (4,000 more bu corn) x (10 lbs per bu) = 40,000 less lbs of peanuts (40,000 more lbs) x (1/8 bushel per pound) = 5,000 less corn Net impact is 1,000 less bushels of corn 10 p 8 p 1/10 c 1/8 c Oops!!

Helpful note on finding tradeoffs The tradeoff in the US is 1 bushel corn for 10 pounds of peanuts Suppose we produce 3,000 less bushels of corn in the US How much will peanuts rise?

Helpful note on finding tradeoffs The tradeoff in the Mexico is 1 bushel corn for 8 pounds of peanuts Suppose we want 30,000 less lbs of peanuts How much will corn rise?

If countries specialize according to their comparative advantage, a more efficient use of given resources occurs. The world output of at least one good rises, without decreasing that of any other good.

With the opening of trade, there will be a net increase in world output. Gains from trade Therefore, international trade flows can be arranged so that no country would have less of anything, while each country would some of the gain in total output.

Mexico U.S. CornPeanuts World Production Gain U.S. Mexico Corn Peanuts Loss from exports (-) Gain from imports (+) Mexico U.S. CornPeanuts Opportunity cost 10 p 8 p 1/10 c 1/8 c US imports 100 corn and exports 900 peanuts /100 = 9 so the US is trading 9 for 1

Mexico U.S. CornPeanuts World Production Gain U.S. Mexico Corn Peanuts Loss from exports (-) Gain from imports (+) Mexico U.S. CornPeanuts Opportunity cost 10 p 8 p 1/10 c 1/8 c US imports 11 corn and exports 98 peanuts /11 = the US is trading for 1

Mexico U.S. CornPeanuts World Production Gain U.S. Mexico Corn Peanuts Loss from exports (-) Gain from imports (+) Mexico U.S. CornPeanuts Opportunity cost 10 p 8 p 1/10 c 1/8 c US imports 45 corn and exports 360 peanuts /45 = 8 so the US is trading 8 for 1

As long as the opportunity costs differ, specialization and trade can be beneficial to all involved. This remains true regardless of whether the parties involved are nations, state, countries, or individuals. It remains true even if one party holds an all-around absolute advantage or disadvantage.

Time for another break

Mexico U.S. CornPeanuts World Production Gain U.S. Mexico Corn Peanuts Loss from exports (-) Gain from imports (+) Mexico U.S. CornPeanuts Opportunity cost 10 p 8 p 1/10 c 1/8 c The US is trading 100 bu corn for 900 lbs peanuts Terms of trade

The U.S. is exporting 900 pounds of peanuts and importing 100 bushels of corn. This exchange ratio is known as the terms of trade. The US is exchanging 900 lbs peanuts for 100 bu corn

With different terms of trade, the benefits of specialization and exchange would be apportioned in different manner. The exchange ratio in this example is 9 to 1 terms of trade More formally, the terms of trade is the ratio at which a country can trade domestically produced products for foreign-produced products. (900/100) = 9

Bounds on the terms of trade What is the most the US will pay for a bushel of corn in terms of peanuts? No more than what it can transform peanuts into corn domestically.

Bounds on the terms of trade What is the least Mexico will take for a bushel of corn in terms of peanuts? No more than what it can transform corn into peanuts domestically.

Corn and Peanuts US CountryOpportunity Cost of a Bushel of Corn 1 bu. corn costs 10 lbs. of peanuts Mexico 1 bu. corn costs 8 lbs. of peanuts What if Mexico asks for 5 lbs of peanuts per bushel? What if Mexico asks for 15 lbs of peanuts per bushel? Will Mexico ask only 5 lbs of peanuts for a bushel of corn? NO!!!

Bounds on the terms of trade The U.S. will not trade peanuts for corn for more than 10 pounds for 1 bushel Mexico will not trade peanuts for corn at less than 8 pounds for 1 bushel

Another Little Break

Analysis of Comparative Advantage using PPF’s Output Combinations of Peanuts & Corn - US PeanutsCorn 0 10, , ,000 8,000 40,000 6,000

Peanuts Corn PPF_US This is a linear PPF which we can see by plotting it

We can find the slope of the PPF using two of the points In particular, use the first two points in the set CornPeanuts 10, ,000 The implication is that the US gains 1 corn for 10 peanuts

Peanuts Corn PPF_US We can see this slope graphically -20,

The US produces 10,000 corn when it produces no peanuts So the intercept in the line describing the PPF is 10,000 The equation for the PPF is then given by corn = (- 1/10) peanuts + 10,000

Some example points corn = (- 1/10) peanuts + 10,000 (20,000) corn = (- 1/10) (20,000) + 10,000 corn = - 2, ,000 corn = 8,000 (40,000) corn = (- 1/10) (40,000) + 10,000 corn = - 4, ,000 corn = 6,000

Given a change in peanuts we can get the change in corn  corn = slope *  peanuts 8,000 20,000 6,000 40,000 CornPeanuts  corn = (-1 / 10) * (40, ,000)  corn = (-1 / 10) * (20,000)  corn = -2,000  corn  peanuts

Peanuts Corn PPF_US Graphically -40,

Now consider Mexico Output Combinations of Corn & Peanuts - Mexico CornPeanuts 8, , ,000 6,000 16,000 2,500 44,000 3,000 40,000

Peanuts Corn The linear PPF PPF_Mexico

We can find the slope of the PPF using two of the points In particular, use the second two points in the set CornPeanuts 0 64, ,000 16,000 6,000 16,000 The implication is that Mexico gains 1 corn for 8 peanuts

Peanuts Corn Graphically PPF_Mexico -20,

Mexico produces 8,000 corn when it produces no peanuts So the intercept in the line describing the PPF is 8,000 The equation for the PPF is then given by corn = (- 1/8) peanuts + 8,000

Given a change in peanuts we can get the change in corn  corn = slope *  peanuts 6,000 16,000 2,500 44,000 CornPeanuts  corn = (-1 / 8) * (16, ,000)  corn = (-1 / 8) * (- 28,000)  corn = 3,500  corn  peanuts

Production Possibility Frontier Peanuts Corn Combine the diagrams PPF_US PPF_Mexico

Production Possibility Frontier Peanuts Corn PPF_US PPF_Mexico The US gets more peanuts for corn compared to Mexico

Now consider some initial production point for each country CountryCornPeanuts Mexico3,00040,000 US6,00040,000 Total9,00080,000

Production Possibility Frontier ,00038,00040,00042,00044,000 Peanuts Corn PPC_Mexico US Corn Graphically we can see this point as follows PPC_US Mexico Corn

Now decrease US corn production by 1 unit Production Possibility Frontier ,99039,99540,00040,00540,01040,01540,020 Peanuts Corn Initial Corn Less Corn PPF_US  peanuts = + 10

Now increase Mexican corn production by 1 unit Production Possibility Frontier ,98439,98839,99239,99640,00040,004 Peanuts Corn PPC_Mexico Initial Corn More Corn  peanuts = - 8

Initial Subsequent CornPeanuts Mexico U.S. Total 3,00040,000 6,00040,000 9,00080,000 3,00139,992 5,99940,010 9,00080,002 Putting it all together

By growing one less bushel of corn in the U.S. and one more bushel in Mexico, there is a net gain of 2 pounds of peanuts. What have we learned?

Now drop US corn production by 1000 CountryCornPeanuts US6,00040,000  corn = (-1 / 10) *  peanuts = (-1 / 10) *  peanuts = (-1 ) *  peanuts =  peanuts

Now increase Mexican corn production by 1000 CountryCornPeanuts  corn = (-1 / 8) *  peanuts 1000 = (-1 / 8 ) *  peanuts 8000 = (-1 ) *  peanuts =  peanuts Mexico2,50044,000

Corn stays the same In the US,  peanuts = Summarizing In Mexico,  peanuts = In Total,  peanuts = 2000

CountryCornPeanuts Mexico4,00032,000 US5,00050,000 Total9,00082,000 Total Production Total9,00080,000 Previously

Mexico US Total CornPeanuts 9,00080,000 CornPeanuts ,000 80,002 CornPeanuts ,000 88,004 CornPeanuts , Consider a variety of alternative production points Corn stays the same, peanuts increase by 10,

Practice Problem Output Combinations of Cotton and Sugar CottonSugar 100, ,000 USCuba CottonSugar 30, ,000

Practice Problem Initial Outputs of Cotton and Sugar 60,00010,000 USCuba CottonSugar 10,00010,000 Final Outputs of Cotton and Sugar ?5,000 USCuba CottonSugar ?15,000

For the US For Cuba Outputs of Cotton and Sugar CottonSugar USCuba CottonSugar 60,00010,000 10,00010,000 Initial Final 80,0005, ,000

Consumption beyond the frontier 9 pounds of peanuts for 1 bushel of corn Suppose terms of trade are 9 pounds of peanuts for 1 bushel of corn. Any time the U.S. stops producing a bushel of corn, it gets 10 pounds of peanuts. It can trade 9 of these for a bushel of corn and have 1 left over to bring it outside the frontier.

Any time Mexico stops growing a pound of peanuts it can produce 1/8 of a bushel of corn. It can trade this for 9 pounds of peanuts and be better off. So if Mexico stops growing 8 pounds of peanuts, it will have a bushel of corn to trade. Consumption beyond the frontier

If opportunity costs differ and countries specialize according to their comparative advantage, according to their comparative advantage, As a result, both countries are better off they can consume combinations of goods that lie outside that lie outside their production possibilities frontiers.

Convert domestic currency into the foreign currency and then compare prices. Turning potential gains into actual gains Exchange rates will adjust so that trade occurs. Buy at the lowest price and sell at the highest price.

Provisos Costs of trading Sizes of countries Size of market Market power Increasing opportunity cost and a concave PPF Barriers to trade

Sources of Comparative Advantage Capital stock Physical Experience Natural resources Human

Objections to free trade Alternative groups in society are made better and worse off

Exports Good for domestic producers Bad for domestic consumers

Good for domestic consumers Imports Bad for domestic producers

Compensation principle With free trade the gainers can compensate the losers such that everyone is better off

Barriers to trade Tariffs Quotas Clever rules

The End