1. Lecture 19 The Principle of Comparative Advantage
Microeconomics 1000
Lecture 19 The Principle of Comparative Advantage

2. Key Points for today
Interdependence and trade increase the quality of life for everyone.
Productivity can be measured in (i) absolute advantage or (ii) comparative advantage.
The gains from trade are based on comparative advantage, not absolute advantage.
Trade makes everyone better off because it allows people and countries to specialize in those activities in which they have a comparative advantage.
The principle of comparative advantage applies to countries as well as people.

3. The principle of Comparative Advantage
The only result in the whole of the social sciences that is true and non-trivial.
(Paul Samuelson)

4. Gains from trade
We started this course by noting that if trade is voluntary and agents are rational, both parties must gain from trade
We then proceeded to measure such gains, using the notion of willingness to pay
The approach was partial equilibrium in nature
Now we take a fresh look at the problem from a general equilibrium perspective.

5. Interdependence and the Gains from Trade
How do we satisfy our wants and needs?
We can be economically self-sufficient (primitive economies, Robinson Crusoe…).
We can specialize and trade with others, leading to economic interdependence (modern economies).
Why is interdependence the norm?
What determines the pattern of trade? 3

6. Interdependence and the Gains from Trade
Why is interdependence the norm?
Interdependence occurs because people are better off when they specialise and trade with others.
What determines the pattern of trade?
Patterns of trade are based upon differences in productivity, factor endowments and preferences.
The Ricardian model focuses on the first determinant of the pattern of trade, namely differences in productivity

7. The Ricardian model Only two goods: corn and cloth
Only two people: a corn farmer (called Mr. C) and a cloth producer (called Mr. B)
Fixed labour supply: each works 240 days per year
What should each produce (that is, why does Mr. C grows corn and Mr. B produces cloth)?
Why should they trade?

8. Table 1 The Productivity of Mr. B and Mr. C
Number of days of work to produce 1 ton of corn
Number of days of work to produce 1 cloth
Mr. B 8 24
Mr. C 12 60
Copyright © South-Western

9. Production Possibilities
Self-Sufficiency
By ignoring each other:
Each consumes what they each produce.
The production possibilities frontier is also the consumption possibilities frontier.
Without trade, economic gains are diminished. 8

10. Figure 1 The Production Possibilities Curve of Mr. B
(a) Mr B’s
Production Possibilities Frontier
Corn 30 10
If there is no trade,
Mr. B chooses
this production and
consumption. A 8 7
Cloth
Copyright©2003 Southwestern/Thomson Learning

11. Figure 2 The Production Possibilities Curve of Mr. C
(a) Mr C’s
Production Possibilities Frontier
Corn
If there is no trade,
Mr. C chooses
this production and
consumption. 20 4 C 10 2
Cloth
Copyright©2003 Southwestern/Thomson Learning

12. Specialization and Trade
Mr. B and Mr. C Specialize and Trade
Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other.

13. Table 2 Autarky: A Summary
Without trade: production and consumption
Corn
Cloth
Mr. B 8 7
Mr. C 10 2
Copyright © South-Western

14. Trade
Suppose the price of cloth in terms of corn is 4 (i.e. 4 tons of corn per unit of cloth)
Later we shall ask what determines the price
However, notice 4 is greater than the slope of Mr.B’s production possibility frontier, and lower than the slope of Mr. C’s production possibility frontier

15. Figure 3 How Trade Expands the Set of Consumption Opportunities
(a) Mr B’s
Production and ConsumptionPossibilities Frontier
Corn 40
If there is trade,
Mr. B chooses
this production and
consumption. 30 10 A 7
Cloth
Copyright©2003 Southwestern/Thomson Learning

16. Figure 4 How Trade Expands the Set of Consumption Opportunities
(a) Mr C’s
Production and Consumption Possibilities Frontier
Corn
If there is trade,
Mr. C chooses
this production and
consumption. 20 4 C 10 2
Cloth
Copyright©2003 Southwestern/Thomson Learning

17. Table 2 The gains from trade: A Summary
With trade:
Corn
production consumption
Cloth
Mr. B
buys 10
7 ½
sells 2 ½
Mr. C 10
sells 10 ½
buys 2 ½
Copyright © South-Western

18. THE PRINCIPLE OF COMPARATIVE ADVANTAGE
Differences in the costs of production determine who should produce what
Two ways to measure differences in costs of production:
The number of days required to produce a unit of output (for example, one ton of corn).
The opportunity cost of sacrificing one good for another.

19. Absolute Advantage
The comparison among producers of a good according to their productivity—absolute advantage
Describes the productivity of one person, firm, or nation compared to that of another.
The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. 13

20. Mr. B has an absolute advantage in the production of both goods
Mr. B needs only 8 days to produce a ton of corn, whereas Mr. C needs 12 days.
Mr. B needs only 24 days to produce a unit of cloth, whereas Mr. C needs 60 days.
Mr. B has an absolute advantage in the production of both goods 13

21. Opportunity Cost and Comparative Advantage
Compares producers of a good according to their opportunity cost.
Whatever must be given up to obtain some item
The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. 14

22. Comparative Advantage and Trade
Who has the absolute advantage?
Mr. B or Mr. C?
Who has the comparative advantage? 15

23. Table 3 The Opportunity Cost of Meat and Potatoes
1 ton of corn unit of cloth
Mr. B units of cloth /3 tons of corn
Mr. C units of cloth /5 tons of corn

24. Comparative Advantage and Trade
Mr. B’s opportunity cost of a unit of cloth is 1/3 tons of corn, whereas Mr. C’s opportunity cost of a unit of cloth is only 1/5 tons of corn.
Mr. B’s opportunity cost of a ton of corn is 3 units of cloth, whereas Mr. C’s opportunity cost of a ton of corn is 5 units of cloth.
So, Mr. B has a comparative advantage in the production of cloth but Mr. C has a comparative advantage in the production of corn.

25. Comparative Advantage and Trade
Comparative advantage and differences in opportunity costs are the basis for specialized production and trade.
Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. 16

26. Comparative Advantage and Trade
Benefits of Trade
Trade can benefit everyone in a society because it allows people to specialise in activities in which they have a comparative advantage. 17

27. How is price determined?
If one agent is much more productive, or works longer hours, than the other, the “small” agent will specialise whereas the “big” agent will produce both goods
In this case, the relative price of the two goods equal will reflect the relative productivity of the big agent
If the two agents are more or less the same size, both may fully specialise
In this case, equilibrium prices will depend on demand

28. COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE
Suppose that instead of Mr. B and Mr. C we have two countries, B and C
Country B is more productive in the production of both goods
Would all the production take place in country B?
No, country B will specialise in the production for which it has a comparative advantage
Country C will specialise in the production of the good for which it has a comparative advantage

29. International trade
Trade will occur, benefiting both countries
Imports—goods produced abroad and sold domestically
Exports—goods produced domestically and sold abroad
Note, all countries have a comparative advantage!

30. Free trade Each country has many citizens with different interests.
International trade can make some individuals worse off, even as it makes the country as a whole better off.

31. Summary
Each person consumes goods and services produced by many other people both in our country and around the world.
Interdependence and trade are desirable because they allow everyone to enjoy a greater quantity and variety of goods and services.

32. Summary
There are two ways to compare the ability of two people, or two countries, producing a good.
The person who can produce a good with a smaller quantity of inputs has an absolute advantage.
The person with a smaller opportunity cost has a comparative advantage.

33. Summary
The gains from trade are based on comparative advantage, not absolute advantage.
Trade makes everyone better off because it allows people to specialize in those activities in which they have a comparative advantage.
The principle of comparative advantage applies to countries as well as people.