1. Comparative and Absolute Advantage

2. In the movie, Castaway, the Tom Hanks character had to do everything himself
For the rest of us, labor is shared

3. Law of Comparative Advantage
The individual (or country) with the lowest opportunity cost of producing a particular good should specialize in producing that good.

4. Specialization Focusing on a specialty
Individuals and/or firms concentrate on producing a limited number of products/activities

5. Comparative & Absolute Advantage
Comparative Advantage:
The ability to produce something at a lower opportunity cost than other producers face
Absolute Advantage:
The ability to produce something with fewer resources than other producers use

6. Opportunity Costs and Efficiency
Before Specialization
Hours Worked
Production and Consumption
Alaskan 4
5 pounds of salmon
1 pound of coffee
Brazilian
1 pound of salmon
5 pounds of coffee
After Specialization
Hours Worked
Production
Consumption
Alaska 8
10 pounds Salmon
5 pounds of salmon
5 pounds of coffee
Brazilian
10 pounds Coffee

7. Trade
Trade enables each Alaskan to consume an additional 4 pounds of coffee per day, and each Brazilian to consume an extra 4 pounds of fish per day.
Each group specializes in the form of production in which it enjoys a comparative advantage, and Alaskans and Brazilians both gain from trade.

8. Opportunity Costs and Efficiency
Before Specialization
Hours Worked
Production and Consumption
Alaskan 4
5 pounds of salmon
1 pound of coffee
Brazilian
1 pound of salmon
5 pounds of coffee
After Specialization
Hours Worked
Production
Consumption
Alaska 8
10 pounds Salmon
5 pounds of salmon
5 pounds of coffee
Brazilian
10 pounds Coffee

9. An example
Suppose a lawyer, who charges $250 an hour, types twice as fast as her secretary, whose wage is $12 an hour.
She still gains by hiring the secretary.
Despite her absolute advantage in typing, the lawyer’s comparative advantage lies in practicing law.

10. Comparative Advantage in Early America
“Cash crops did not grow well in the Northern soil and climate, but they did in the south. Southerners reaped huge profits from cotton and tobacco by the 1790s.
The South had very little incentive to industrialize, but the North did. As a result, the North and South developed two distinct economies, including very different agricultural systems.”

11. Comparative Advantage in Early America
What was the comparative advantage for the North?
What was the comparative advantage for the South?
---The Americans

12. Comparative Advantage in Early America
What was the comparative advantage for the North? Industry
What was the comparative advantage for the South? Cotton and Tobacco production
---The Americans

13. Cost-Benefit Analysis in Early America
Opportunity Cost: Value of the next best alternative
Choices: slavery or wage labor
North: Why did the benefits of wage labor
exceed the opportunity cost of slavery?
South: Why did the benefits of slavery
exceed the opportunity cost of wage labor?

14. Factors that influenced the choice
Climate
Market
Wages
Fixed Costs

15. Relatively high wages made renting labor expensive
Climate and market promoted large production practices (farms) in the South and small production practices (industry) in the North.
Relatively high wages made renting labor expensive
Fixed costs of overseeing and possessing slaves
Larger firm size lowers average fixed cost
Minimum average cost for slave production occurs at larger firm size.

16. Trade was beneficial to both the north and the south, but separated them from each other
Northern farmers traded with Northern manufacturers
Southern farmers traded with European manufacturers

17. Northern farmers traded with Northern manufacturers
This facilitated the growth of Northern industry
Relative wealth in industry ownership
Southern farmers traded with European manufacturers
This facilitated growth of Southern plantation system
Relative wealth in plantation ownership
Less industrial growth in South

18. The “American System”
Tariff (tax) imposed in 1816 on imported manufactured goods from Europe
This was designed to make North and South more interdependent
Lobbied for by Northern Manufacturers
Ushered in the circular flow of income and expenditure
One person’s spending becomes another’s income

19. Tariff of 1816
Shifted Southern trade with Europe to Southern trade with the North
Strengthened Northern Manufacturing
Limited competitors
Influenced outcome of Civil War

20. Practice:
Under current conditions, we can produce either 120 autos OR 3 boats, therefore: 120A = 3 B.
Dividing both sides by 3 yields: 120/3 = 3/3 or 40A = 1B
40A = 1B is the number of autos given up to produce one boat or the opportunity cost of one boat

21. To Find Which Nation has the Comparative Advantage
Find opportunity costs for both nations
Compare each product’s opportunity cost from nation to nation
Nation with the lowest opportunity cost has the comparative advantage

22. example
Country A must give up 3 units of product X for every unit of product Y
Country B must give up only 2 units of product X for every unit of product Y
both countries would benefit if country B specialized in the production of Y and country A specialized in the production of X.
B could then exchange one unit of y for between two and three units of x (before trade, for only two units of x), and A could receive between one-third and one-half unit of y (before trade, only one-third unit of y) for every unit of x.
This is true even though B may be absolutely less efficient than A in the production of both commodities.

23. Importance of Comparative Advantage
To benefit from free trade, a nation does not have to be the lowest cost producer in the world
A nation only has to have the lowest opportunity cost
Remember, opportunity cost is what you give up to do something

24. Where did the theory of Comparative Advantage originate?
David Ricardo, early 1800’s
attributed the cause and benefits of international trade to the differences among countries in the relative opportunity costs  of producing the same commodities.
The theory of comparative advantage provides a strong argument in favor of free trade and specialization among countries.
The issue becomes much more complex, however, as the theory’s simplifying assumptions are replaced by more-realistic parameters.