Chapter 2 - Comparative advantage. Chapter 2 goes beyond individual decision making to consider trade among both individuals and countries. An important reason for trade is the Principle of Comparative Advantage: by specializing in the production of particular goods and services, people and countries enhance their productivity and raise standards of living.
Chapter 2: Comparative Advantage Explain and apply the Principle of Comparative Advantage Explain and apply the Principle of Increasing Opportunity Cost Identify the factors that shift the menu of production possibilities Explain and apply the role of comparative advantage in international trade Describe why some jobs are more vulnerable to outsourcing than others McGrawHill/Irwin Copyright © 2011 by The McGrawHill Companies, Inc. All rights reserved Exchange and Opportunity Cost • A person has an absolute advantage at a particular task if he or she can perform the task in fewer hours than the other person • A person has a comparative advantage at a particular task if his or her opportunity cost of performing the task is lower than the other person’s opportunity cost 22 The Principle of Comparative Advantage The Principle of Comparative Advantage Everyone does best when each person (or each country) concentrates on the activities for which his or her opportunity cost is the lowest • Two parties have different opportunity costs for two activities – Concentrate on the activities for which you have the lowest opportunity cost • Total value of output increases with specialization and trade 23 Comparative Advantage Example Production Times Web Update Bike Repair Beth 20 minutes 10 minutes Paula 30 minutes 30 minutes • Paula and Beth can each update web pages and repair bikes • Beth has an absolute advantage in both – Comparative advantage drives specialization Opportunity Cost Web Update Bike Repair Beth repairs 0.5 update Paula repair update 24 Comparative Advantage Example Hourly Output Beth Paula Hourly Output Beth Paula Web Update updates Bike Repair repairs updates repairs Web Update updates Bike Repair repairs updates repairs • 16 web updates are ordered – Beth spends half her time at each activity: 12 updates and 24 repairs – Paula produces updates and 12 repairs – Total output 16 updates and 36 repairs • Specialization produces 16 updates and 48 repairs – 12 more repairs for the same inputs! 25 Production Possibilities Curve – Unattainable point – Attainable point • Inefficient point • Efficient point • Scarcity Principle – Give up one good to get another Coffee (lb/day) • A production possibilities curve illustrates the combinations of two goods that can be produced with given resources 24 A Unattainable • Definitions: Combination 16 B Inefficient Combination C D 12 Nuts (lb/day) 26 Susan's Production Possibilities • Two goods: coffee and nuts – Work hours per day • hour of labor – Graph shows options • Negative slope Coffee (lb/day) = pounds of coffee OR = pounds of nuts 24 16 A B C D 12 Nuts (lb/day) 27 Susan's Opportunity Cost • Marginal cost: – coffee • Marginal benefit: nuts • Marginal cost: – nut • Marginal benefit: 16 coffee Loss in nuts Gain in coffee • Opportunity cost of coffee is ½ nut 24 Coffee (lb/day) Loss in coffee Gain in nuts • Opportunity cost of nut is coffee A B 16 C 8 D 12 Nuts (lb/day) 28 Tom's Production Possibilities – Work hours per day • Productivity determines the slope of the PPC – hour of labor • Opportunity cost – Marginal cost: – coffee – Marginal benefit: nuts • Tom's opportunity cost of coffee is nuts • His opportunity cost of nut is ½ coffee 12 Coffee (lb/day) = pounds of nuts OR = pounds of coffee A B C D 16 24 Nuts (lb/day) 29 • PPCs show comparative advantage • Sue's curve is steeper, better for coffee • Tom's curve is flatter, better for nuts • Comparative advantage is a comparison • To get coffee • Sue gives up ẵ nuts Tom gives up nuts Coffee (lb/day) Tom, Meet Susan Susan’s PPC 12 Tom’s PPC Nuts 2(lb/day) 24 210 Gains from Specialization and Trade Coffee (lb/day) 24 Susan and Tom exchange 12 nuts, 12 coffee 12 8 12 Nuts (lb/day) 24 • Preferred diet is half nuts, half coffee – No trade: pounds of coffee and pounds of nuts • Total output is 32 pounds • Specialization gives each person 12 pounds of each good – 48 total pounds 211 Gains from Specialization and Trade Sue's PPC Coffee (lb/day) 24 Trade Trade benefits benefits With Withtrade trade 12 Tom's PPC No Notrade trade 12 Nuts (lb/day) 24 • Benefits increase when differences in opportunity cost increase – Sue's opportunity cost of one pound of nuts increases to coffee – Tom's opportunity cost of one pound of coffee increases to nuts • No trade: 3.4 nuts and 3.4 coffee each • With trade: 12 nuts and 12 coffee each 212 Production Possibilities for an Economy Coffee (1000s of lb/day) • Two goods: coffee and nuts • Multiple people • Different opportunity costs 100 95 A • Intercepts show maximum production of one good • Some resources better at coffee, some better at nuts B C D E 20 20 Nuts (1000s of lb/day) 75 80 77 213 The Principle of Increasing Opportunity Cost • Maximum coffee: 100,000 lb / day Coffee (1000s of lb/day) – Give up 5,000 pounds coffee, get 20,000 pounds of nuts – Give up another 5,000 pounds of coffee, get 10,000 additional pounds of nuts 100 95 90 A B C D E 20 15 20 30 Nuts (1000s of lb/day) 75 80 77 214 Decreasing productivity Re so urc es U sed The Principle of Increasing Opportunity Cost 215 Shifts in PPC Neutral Technical Change Coffee Technical Change in Coffee Coffee Nuts Nuts Coffee Technical Change in Nuts Nuts 216 Comparative Advantage Comparative Advantage Increasing Opportunity Cost Production Possibilities Curve Individual Specialization and Gains from Trade Outsourcing Shift PPC Economy 217 ... – coffee – Marginal benefit: nuts • Tom's opportunity cost of coffee is nuts • His opportunity cost of nut is ½ coffee 12 Coffee (lb/day) = pounds of nuts OR = pounds of coffee A B C D 16 24 ... nuts Coffee (lb/day) Tom, Meet Susan Susan’s PPC 12 Tom’s PPC Nuts 2( lb/day) 24 2 10 Gains from Specialization and Trade Coffee (lb/day) 24 Susan and Tom exchange 12 nuts, 12 coffee 12 8 12 Nuts... cost of one pound of nuts increases to coffee – Tom's opportunity cost of one pound of coffee increases to nuts • No trade: 3.4 nuts and 3.4 coffee each • With trade: 12 nuts and 12 coffee each 2 12