Fred & Kate A story of Comparative Advantage

Specialization  Specialization: when individuals, businesses, or nations do what they are best at  Comparative Advantage: producing a good at a lower opportunity cost than another person, business, nation

Fred & Kate Fred and Kate are stranded on a deserted island and consume two products, coconuts and fish. In a day, Fred can either gather two coconuts or catch six fish, wile Kate can gather one fish or one coconut.

Kate Coconuts Fish All 6 days on coconuts 5 days coconuts, 1 day fish 4 days coconuts, 2 days fish 3 days coconuts, 3 days fish 2 days coconuts, 4 days fish 1 day coconuts, 5 days fish All 6 days on fish 6 day production schedule Fred Coconuts Fish All 6 days on coconuts 5 days coconuts, 1 day fish 4 days coconuts, 2 days fish 3 days coconuts, 3 days fish 2 days coconuts, 4 days fish 1 day coconuts, 5 days fish All 6 days on fish

Self-Sufficient Fred and Kate each work 6 days a week. Fred’s ideal self-sufficient output is 4 coconuts and 24 fish Kate ideal self-sufficient output is 1 coconut and 5 fish Both prefer to consume more fish than coconutsBoth prefer to consume more fish than coconuts

Benefit of Trade One day while searching for coconuts, Fred and Kate discover each other on the island. They decide to specialize and trade. They decide to trade 1 coconut for 2 fish.

1 coconut= 2 fish 1.Who should specialize in catching fish? Fred, because he has the lowest opportunity cost in terms of coconuts 2. How much will each produce is they specialize? Fred=36 fish Kate=6 coconuts 3. How much will each end up with then they trade? Fred=26 fish, 5 coconuts Kate=10 fish, 1 coconut 4. Did both Fred and Kate benefit from trade?

Yes!

Comparative Advantage The ability of one person or nation to produce a good at a lower opportunity cost than another person or nation  Fred has a comparative advantage in producing fish because his opportunity cost of fish is one-third coconut per fish, compared to 1 coconut per fish for Kate.  Kate has a comparative advantage in harvesting coconuts because her opportunity cost of coconuts is 1 fish per coconut, compared to 3 fish per coconut for Fred.

Specialization Advantages of Specialization  Increases productivity through division of labor  Repetition the more times a worker performs a task, the more proficient he becomes  Continuity worker does not waste time switching tasks  Innovation gains insight leading to better production methods

TIGER WOODS AND WEEDS APPLYING THE CONCEPTS #4: What is the rationale for specialization and exchange? Should Tiger Woods whack his own weeds? The swinging skills that make Tiger Woods one of the world’s best golfers also make him a skillful weed whacker. His large estate has a lot of weeds, and it would take the best gardener 20 hours to take care of all of them. With his powerful and precise swing, Tiger could whack down all the weeds in just one hour. Since Tiger is 20 times more productive than the best gardener, should he take care of his own weeds? We can use the principle of voluntary exchange to explain why Tiger should hire the less productive gardener. Suppose Tiger earns $1,000 per hour playing golf— either playing in tournaments or giving lessons. For Tiger, the opportunity cost of weed whacking is $1,000—the income he sacrifices by spending an hour cutting weeds rather than playing golf. If the gardener charges $10 per hour, Tiger could hire him to take care of the weeds for only $200. By switching one hour of his time from weed whacking to golf, Tiger earns $1,000 and incurs a cost of only $200, so he is better off by $800. Tiger Woods specializes in what he does best, and then buys goods and services from other people. A P P L I C A T I O N

Comparative Advantage & International Trade  Imports: a good or service produced in a foreign country and purchased by US residents  Exports: A good or service produced in the US and sold to another country  Countries take advantage of comparative advantage to produce a product at a lower cost

Comparative Advantage & International Trade Is outsourcing bad for an economy?  Loss of jobs resulting from outsourcing are a part of a healthy economy  Jobs lost to outsourcing are partly offset by jobs gained by insourcing  Cost savings from outsourcing lead to lower prices and more output for firms

CANDY CANE MAKERS MOVE TO MEXICO FOR CHEAP SUGAR APPLYING THE CONCEPTS #1: Does the protection of one domestic industry harm another? About 90 percent of the world’s candy canes are consumed in the United States, and until recently most were produced domestically. Domestic firms used their superior access to consumers to dominate the market. In recent years, the domestic production of candy canes has decreased. In 2003, Spangler Candy Company of Bryan, Ohio, shifted half its production to Mexico because the cost of sugar, the key ingredient in candy, is only $0.06 per pound in Mexico, compared to $0.21 in the United States. Since 1998, the Chicago area, the center of the U.S. confection industry, has lost about 3,000 candy-production jobs. Why is the price of sugar in the United States so high? The government protects the domestic sugar industry from foreign competition by restricting sugar imports. As a result, the supply of sugar in the United States is artificially low and the price is artificially high. In this case, the protection of jobs in one domestic industry reduces jobs in another domestic industry. A P P L I C A T I O N

GOLD FARMING FOR WORLD OF WARCRAFT APPLYING THE CONCEPTS #2: What is the role of opportunity cost in the development of markets? As an example of a market that results from comparative advantage, consider the market for virtual currency. Firms in China pay workers (called gold farmers) to play the online game World of Warcraft (WoW). In the game, workers earn virtual currency in the form of gold coins by killing monsters. In the real world, firms pay the workers a piece rate of about $ per coin, which translates into a wage of about $0.30 per hour. The firm sells the coins to an online retailer for about $0.03 per coin, and the retailer then sells the coins to consumers for about $0.20 per coin. The consumers in this market are WoW gamers in the United States, who are willing to pay cash for game shortcuts—they use the purchased coins to buy the equipment and magic spells required to battle virtual monsters and move to the next level of the game. Let’s look at this exchange in terms of opportunity cost. Suppose a gamer in the United States is roughly half as productive as a gold farmer in earning gold in the game, getting 12 coins per hour. The gamer can either spend an hour to earn 12 coins or take a shortcut by paying $0.20 per coin, or $2.40. If the gamer’s opportunity cost is greater than $2.40 per hour, buying the coins is sensible. A P P L I C A T I O N