Basic Economic Concepts Unit 1 Comparative and Absolute Advantage

Comparative v Absolute Advantage Advantages are looked at to determine what and how (should) people/nation’s trade – who has the advantage in production of goods/services Advantages are looked at to determine what and how (should) people/nation’s trade – who has the advantage in production of goods/services Absolute Advantage: idea that given the exact same resources and creating the exact same goods/services, one person/nation can create more than the other Absolute Advantage: idea that given the exact same resources and creating the exact same goods/services, one person/nation can create more than the other If a person/nation has the absolute advantage in production, should they still trade? If a person/nation has the absolute advantage in production, should they still trade?

Comparative Advantage Comparative advantage says that given the same resources and producing the same goods, one person/nation will produce with a lower opportunity cost than the other. Comparative advantage says that given the same resources and producing the same goods, one person/nation will produce with a lower opportunity cost than the other. Example: John and Jane both make shirts and jeans. They have the exact same resources in the same amounts. Example: John and Jane both make shirts and jeans. They have the exact same resources in the same amounts. John can make 200 shirts with his resources or 100 jeans or some combination of the two John can make 200 shirts with his resources or 100 jeans or some combination of the two Every time John makes a pair of jeans, what is his opportunity cost? Every time John makes a pair of jeans, what is his opportunity cost? What/how much does he give up when he makes the pair of jeans? What/how much does he give up when he makes the pair of jeans? What is his opportunity cost of producing a shirt? What is his opportunity cost of producing a shirt? Jane can make 150 shirts or 70 jeans Jane can make 150 shirts or 70 jeans What is Jane’s opportunity cost of producing a pair of jeans? What is Jane’s opportunity cost of producing a pair of jeans? What is Jane’s opportunity cost of producing a shirt? What is Jane’s opportunity cost of producing a shirt?

Hint: computing comparative advantage John has a production ratio of 1 pair of jeans to 2 shirts (can make 100 jean or 200 shirts) – 1J:2S John has a production ratio of 1 pair of jeans to 2 shirts (can make 100 jean or 200 shirts) – 1J:2S This means that if he makes 1 pair of jeans, he gives up the opportunity to make 2 shirts This means that if he makes 1 pair of jeans, he gives up the opportunity to make 2 shirts His opportunity cost is then 2 shirts His opportunity cost is then 2 shirts What about the shirts? If the ratio is 1J:2S what is the 1 shirt ratio? Divide both sides by 2 (this gives you the one shirt number) What about the shirts? If the ratio is 1J:2S what is the 1 shirt ratio? Divide both sides by 2 (this gives you the one shirt number) ½ J:1S ½ J:1S His opportunity cost of 1 shirt is half a pair of jeans His opportunity cost of 1 shirt is half a pair of jeans

Comparison: John v Jane John (100J or 200S) John (100J or 200S) Opportunity cost of 1J is 2S Opportunity cost of 1J is 2S Opportunity cost of 1S is ½ J Opportunity cost of 1S is ½ J Jane (70J or 150S) – 70:150 Jane (70J or 150S) – 70:150 Opportunity cost of 1J is 2.14S (divide both sides by 70) Opportunity cost of 1J is 2.14S (divide both sides by 70) Opportunity cost of 1S is.46J Opportunity cost of 1S is.46J Who has the greater opportunity cost in producing jeans? Who has the greater opportunity cost in producing jeans? Who has the greater opportunity cost in producing shirts? Who has the greater opportunity cost in producing shirts?

What does the comparison tell you? Comparative advantage leads to specialization and trade!!!!!!!!! Comparative advantage leads to specialization and trade!!!!!!!!! John has the comparative advantage (lower OC) in producing jeans (gives up only 2S compared to Jane’s 2.14S) John has the comparative advantage (lower OC) in producing jeans (gives up only 2S compared to Jane’s 2.14S) Jane has the comparative advantage (lower OC) in producing shirts (gives up.46S compared to John’s ½ S) Jane has the comparative advantage (lower OC) in producing shirts (gives up.46S compared to John’s ½ S) What should they do then? Each should specialize in producing the item they have the comparative advantage in and trade with each other. What should they do then? Each should specialize in producing the item they have the comparative advantage in and trade with each other. They will be better off with trade They will be better off with trade

Specialization Specialization means focusing on only one good or service and becoming an expert in its production Specialization means focusing on only one good or service and becoming an expert in its production Examples? Examples? Specialization leads to trade between nations and everyone is made better off Specialization leads to trade between nations and everyone is made better off

Trade People and nations trade to make themselves better off People and nations trade to make themselves better off Would you trade with someone if the trade makes you worse off then before you traded? Would you trade with someone if the trade makes you worse off then before you traded? Comparative advantage tells us how to trade and make each other better off Comparative advantage tells us how to trade and make each other better off