©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 2: Comparative Advantage.

©2012 The McGraw-Hill Companies, All Rights Reserved

1

Chapter 2: Comparative Advantage


2

Learning Objectives: Understand

1. The Principle of Comparative Advantage

2. The Principle of Increasing Opportunity Cost (also called the Low-Hanging-Fruit Principle)

3. Factors that shift the menu of production possibilities

4. The role of comparative advantage in international trade


3

Do It Yourself?

Joe Jamail, a highly successful Lebanese-American trial attorney, employs another attorney to write his will Writing your own will Opportunity cost of 2 hours Hiring someone to spend 4 hours

on your will Making the right economic choice

Do It Yourself only whenOpportunity cost < hired cost

2 hours

$10,000+

$3,200

Priceless


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Production Advantages: Previous Example

From the previous example: Jamail has an absolute advantage at

preparing his will Because he can perform that task than

another lawyer Other lawyer has a comparative

advantage at preparing the will Because his opportunity cost of

performing that task is lower than Jamail’s


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Production Advantages

Definitions Absolute advantage

Lowest production cost one person has an absolute advantage over

another if he or she takes fewer hours to perform a task than the other person

Comparative advantage Lower opportunity cost than someone else one person has a comparative advantage over

another if his or her opportunity cost of performing a task is lower than the other person’s opportunity cost


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The Principle of Comparative Advantage

The Principle of Comparative AdvantageEveryone does best when each concentrates

on the activity with the lowest opportunity cost

Opens doors for specialization have you ever met an engineer who is also a medical

doctor? Or a mechanic who is also a professor? defines the basis for trade

among people and countries


7

Comparative Advantage Example

Production Times

Web Update Bike Repair

Ayden 20 minutes 10 minutes

Ghadah 30 minutes 30 minutesAyden and Ghadah can each update web pages and repair bikes but Ayden has an absolute advantage in both

Because it takes Ayden less time to perform each task

• In an 8 hour day, we can translate this into quantities

Production Output


Ayden 24 48

Ghadah 16 16


8


Opportunity Cost


Ayden 2 repairs 0.5 update

Ghadah 1 repair 1 update

Production Output


Ayden 24 48

Ghadah 16 16


9


Production Times


Ayden 20 minutes 10 minutes

Ghadah 30 minutes 30 minutes

Hourly Output Web Update Bike Repair

Ayden 3 updates 6 repairs

Ghadah 2 updates 2 repairs


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Assume that 16 web updates are ordered Ayden spends half his time at each activity: 12

updates and 24 repairs Ghadah produces the remaining 4 updates and

spends the last 6 hours of the day making 12 repairs Total output 16 updates and 36 repairs

If specialization occurs then:16 updates and 48 repairs 12 more repairs for the same inputs!


Ayden 3 updates 6 repairs

Ghadah 2 updates 2 repairs


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Another Example

This table shows output per hour Principle of Comparative Advantage

is the same Look at opportunity cost per unit


Rasha 2 updates 1 repair

Amr 3 updates 3 repairs

Opportunity Cost


Rasha ½ repair 2 updates

Amr 1 repair 1 update


12

The Principle of Comparative Advantage

Two parties have different opportunity costs for two activities Concentrate on the activities of your

lowest opportunity cost Identify the task with which the person or

country has a comparative advantage in Total value of output increases with

specialization • By specializing on producing tasks with which a

person or a country has a comparative advantage, the opportunity for trade exists


13

Sources of Comparative Advantage

Where does comparative advantage come from? At the individual level

Talent• Education, training and experience

At the national level Natural resources Cultures or societal norms

• Languages• Institutions

- Value placed on craftsmanship- Support for entrepreneurship


14

Moroccan Track & Field

What has happened to Moroccan Track and Field?

Moroccan athletes won gold medals in the following Olympics games:

1984: 2 gold medals 1988: 1 gold medal 1992: 1 gold medal 2004: 2 gold medals

Ethiopians specialized in 10,000-meter competition, thus showing unsurpassed domination.


15

Pearl Diving in the Gulf

What happened to pearl diving in the Arabian Gulf?

Pearls from the Gulf are known to be the finest in the world.

Arabian Gulf had comparative advantage in pearl diving due to arid climate which made sea-related activities the only economically-viable options.

Global economic depression of 1930s reduced global demand for pearls, coinciding with the introduction of Japanese cultured pearls.

Cultured pearls were mass produced according to specific shape, size, and quality, thereby reducing costs and virtually destroying the natural pearl industry.


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Production Possibilities Curve (PPC)

A graph of the combinations of two goods that can be produced with given level of resources

Definitions Unattainable point Attainable point

Inefficient point Efficient point

Scarcity Principle Give up one good to get

another Nuts (kg/day)

A

B

UnattainableCombination

C

Inefficient Combination

DC

offe

e (

kg/d

ay)

24

16

8

4 8 12


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Fatima’s Production Possibilities

Two goods: coffee and nuts Work 6 hours per day Has nimble fingers

better for picking coffee

1 hour of labor= 4 kg of coffee OR= 2 kg of nuts

Graph shows options Negative slope

Cof

fee

(kg/

day)

Nuts (kg/day)

16

8

4 8

24 A

B

C

D12


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Fatima’s Opportunity Cost

Moving from A to B: Marginal cost : – 8 coffee Marginal benefit: 4 nuts

Loss in coffeeGain in nuts

• Opportunity cost of 1 nut is

2 coffee

Moving from C to A: Marginal cost: – 8 nut Marginal benefit: 16 coffee

Loss in nutsGain in coffee

• Opportunity cost of 1 coffee is ½ nut

Cof

fee

(kg/

day)

Nuts (kg/day)

16

8

4 8

24 A

B

C

D12


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PPC and Opportunity Cost

Hints: Since Fatima’s PPC is a straight line, its slope is

constant The absolute value of the slope of Fatima’s PPC is

the ratio of its vertical intercept to its horizontal intercept:

(24 kg of coffee/day)/(12 kg of nuts/day) = (2 kg of coffee)/(1 kg of nuts) This ratio means that Fatima’s opportunity cost of an additional kg of nuts is 2 kg of coffee

To say that Fatima’s opportunity cost of an additional kg of nuts is 2 kg of coffee is thus equivalent to saying that her opportunity cost of a kg of coffee is ½ kg of nuts.


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Kamal 's Production Possibilities

Work 6 hours per day Productivity determines the slope of the PPC 1 hour of labor

= 4 kg of nuts OR= 2 kg of coffee

Opportunity cost Marginal cost: – 4 coffee Marginal benefit: 8 nuts Tom's opportunity cost of

1 coffee is 2 nuts His opportunity cost of

1 nut is ½ coffee Nuts (kg/day)

Cof

fee

(kg

/day

)4

8

8 16

A

B

C

D

12

24


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Kamal meets Fatima

PPCs show comparative advantage Fatima's curve is

steeper, better for coffee

Kamal's curve is flatter, better for nuts

Comparative advantage is a comparison

To get 1 coffee Fatima gives up ½ nuts Kamal gives up 2 nuts

Nuts (kg/day)

12

24

Kamal’s PPC

24

12

Fatima’s PPC

Cof

fee

(kg

/day

)


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Gains from Specialization and Trade

Without trade, each person can consume along his production possibilities curve What you produce determines what you

consumeWith trade, each person's consumption

can be greater than production Produce according to comparative

advantage Trade to get what you want


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Fatima and Kamal

exchange12 nuts, 12

coffee

8

8

Nuts (kg/day)

12

24

24

12

Cof

fee

(kg

/day

)

Preferred diet is half nuts, half coffee

No trade: 8 kg of coffee and 8 kg of nuts Total output is 32

pounds Specialization gives

each person 12 kg of each good

48 total kg


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Benefits increase when differences in opportunity cost increase

Fatima's opportunity cost of nuts increase to 6 coffee

Kamal's opportunity cost of coffee increases to 6 nuts

No trade: 3.4 nuts and 3.4 coffee each

With trade: 12 nuts and 12 coffee each

Trade benefit

s

Trade benefit

s

No trade

No trade

24

244

4

12

Fatima's PPC

12

Cof

fee

(kg/

day)

Nuts (kg/day)

Kamal's PPC

With tradeWith trade


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Production Possibilities for an Economy

Two goods: coffee and nuts

Multiple people Different opportunity

costs

Intercepts show maximum production of one good

Some resources better at coffe, some better at nuts

Nuts (1000s of kg/day)

100

80

Cof

fee

(10

00s

of k

g/da

y)

E

A B C

D1520

9095

20 30 7577


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The Principle of Increasing Opportunity Cost

Maximum coffee: 100,000 kg / day Give up 5,000 kg coffee, get 20,000 kg of nuts (A

B) Give up another 5,000 kg of coffee, get an 10,000

additional kg of nuts (B C)

Nuts (1000s of kg/day)

100

80

Cof

fee

(10

00s

of k

g/da

y)

E

A B C

D1520

9095

20 30 7577


27


Dec

reas

ing

prod

uctiv

ity

Res

ourc

es U

sed


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PPC is bow-shaped because of increasing opportunity cost Also known as the “low-hanging-fruit principle”

1st: It is easier to pick the low-hanging-fruit 2nd: if the fruit picker does not want to pick

the whole tree then it is still a better choice since the high-hanging-fruit are more difficult to get to

3rd: if the fruit picker wants to pick the whole tree then it is still a better choice since he can enjoy some fast revenue from the sales of the easy to pick sooner


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The Dynamic Economy

What shifts the PPC? A PPC represents current choices

Changes in choices occur over time due to

• More resources- Investment in capital - Population growth

• Improvements in technology- More specialization: start-up and switching

costs• Increases in knowledge


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Shifts in PPC

Nuts

Cof

fee

Neutral Technical Change

Nuts

Cof

fee

Technical Change in Nuts

Technical Change in Coffee

Nuts

Cof

fee


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Some Countries Resist Specialization

Specialization is easier when Population density passes a threshold Markets are connected

Transportation for goods Communications for services

Legal framework supports business Financial markets enable start-ups


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Too Much Specialization?

Imagine this: Your hair stylist only cuts blonde hair A professor for each chapter! Seven bookstores, each open a

different day of the week A grocery store for every type of food


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Comparative Advantage and International Trade

Principle of Comparative Advantage and gains from trade apply worldwide Potentially large gains from trading

with different and distant countriesControversial trade

Benefits the society broadly Costs are concentrated

Some industries People who lose their jobs

©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 2: Comparative Advantage.

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Transcript of ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 2: Comparative Advantage.