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Introduction to microeconomics

Chapter 2Comparative advantage

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Learning goals1. Understand the principles of trade (bilateral and multilateral) 2. Learn the principle of comparative advantage.3. Show why opportunity cost is the basis for comparative

advantage. 4. Understand the principle of increasing opportunity cost.5. Show how to illustrate the menu of goods and services

produced by an economy is determined.6. Understand what factors change an economy’s menu of

goods and services.7. Show how the transactions of goods and services is a circular

flow of income and expenditures in an economy.

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Our goods and services (Stuff)

• Exchanging goods and services is a basic economic process

• This starts as children when we exchanged less valued items in out lunches for the more valued items in someone else`s lunch

• For bilateral trade, the key is the reciprocity of intersecting values – my valued items must match my partners less valued items.

• For multilateral trade, the group must have reciprocal intersecting values

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Rationale for the fair trade• It seems apparent that trading items that are

less preferred (but valued by someone else) for items you value (but less so by the trading partner) will increase welfare– Example: I will always trade chocolate cake for

apple pie (bilateral)– Example: I can trade cake for licorice with Leslie,

and then I can trade the licorice for apple pie with Jean (multilateral)

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Exchange and Comparative Advantage

• Absolute advantage:– Jill is better at everything than Jack

• Comparative advantage:– Depends on opportunity cost– Jill starts with the activity she is least productive (but still more than

Jack)– She spends no time on that, preferring to work on what she is best at.– The opportunity cost of her time in completing her least productive

activity, is the lost (foregone) gain had she spent that time doing what she is best at.

– Jill continues to eliminate activities in ascending productivity until the gain from switching equals the loss from not.

The marginal gain from switching = marginal loss from not

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Summary

• Absolute advantage – One person has an absolute advantage over

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

• Comparative advantage – 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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TABLE 2.1: Productivity Information for Rikke and Beth

TABLE 2.2: Opportunity Costs for Rikke and Beth

Rikke has comparative advantage in updating webpage

Beth has comparative advantage in repairing bicycle

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Implications

• Gains from trading exist when trading partners each have a comparative advantage in different things.– Poor societies can gain even in trading with rich societies.

It can pay to trade even it do not have an absolute advantage.

– The principle of comparative advantage states that a trading partner should specialize in those areas where they have the lowest opportunity cost (they do not give up a lot in stopping)

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David Ricardo

• English landowner who developed the theory of comparative advantage

• Believed in free trade• Advocated against the Corn Laws

(trade barriers to stop corm imports, thereby enriching land owners at the expense of consumers).

1772 –1823

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Assumptions of free trade argument

• After specialization, we ignore the possibility that the output of one service decreases while the output of the other increases.

• Both before and after specialization, Beth and Rikke each work eight hours per day. Neither is underemployed or unemployed.

• Beth and Rikke produce their services with only their labour. Usually, however, goods and services are produced using at least some machinery and equipment.

• The comparative advantages of Beth and Rikke are static and difficult to change - education can change human skill and change the scenario

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Production Possibilities• The output of an

economy includes many goods and services.

• Let us assume there are only two options

• The production possibility “curve” shows how we can trade off one good for another.

• We assume only one factor of production – labour time

21 The “cost” of 2 kg

of nuts is 1 kg of sugar cane and vice versa

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Problem

If Helen can cut four heads of hair every hour and bake 8 loaves of bread. What does the PPC look like?

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32

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Haircuts per day

Loaves of bread per day

Which are efficient points, which are attainablea. 28 hc/day; 16 loaves/dayb. 16 hc/day; 32 loaves/dayc. 18 hc/day; 24 loaves/day

What would shift the PPC out? What would move it in? Which change results in a parallel movement of the PPC (in or out)

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Unattainable

Attainable and efficient

Attainable and inefficient

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• Susan gives up 2kg nuts/day to get 1 kg of cane

• Tom gives up 1 kg of nuts/day to get 1 kg of cane

• Susan is absolutely more productive than Tom

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Production possibilities in the Susan/Tom economy

• Assumption– Susan and Tom, both work 8 hours per day– Susan can harvest 1.5kg and Tom can harvest 0.75kg of sugar

canes– If they only harvest sugar cane, they can harvest total of

(1.5 +0.75) × 8 = 18kg per day– Susan can harvest 3kg and Tom can harvest 0.75kg of nuts– If they only harvest nuts, they can harvest total of

(3 +0.75) × 8 = 30kg per day• The PPC for the two-person economy is not a straight line

joining the two extreme points.

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The Susan/Tom economy

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The PPC is concave to the origin• Downward sloping (scarcity

principle ands resource constraints)

• Increasing opportunity cost as one move to extremes

• Falling economies of scale (as production rises the marginal productivity falls)

Greater production of one good results in rising opportunity cost of producing more of that good

Concave “in”

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Technology and changes in resources affect PPC

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Events that may affect Canada’s PPC

• Discovery of shale gas– What is shale gas?– Where has it been discovered

• What are the implications for – Manitoba (think Hydro)– Oil sands in Alberta

• What could/should we do about it?

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Circular Flow

firm revenue from sale ofgoods and services

wages paidwages received (labour income)

goods and servicessupplied

household spending on goodsand services (consumer expenditure)

Labour markets (services) and goods/services markets