Comparative Advantage

1. Comparative Advantage Overheads

2. The Logic of Free Trade Self-sufficiency is nice but …

3. Advantages of doing things ourselves Good information about quality Don’t need to depend on others and their foibles Can customize the product Can coordinate production and consumption Can keep information secret Don’t have to worry about enforcing any contracts Don’t have to worry about being exploited Will not have any transactions costs

4. Disadvantages of doing things ourselves May not be able to achieve any economies of scale May not have necessary knowledge, skill or intelligence for task May have limited experience for some tasks May have to keep continually changing tasks

5. Principle of specialization and exchange Specialization and exchange enable us to enjoy greater production and higher living standards than would otherwise be possible. As a result, all economies have been characterized by high degrees of specialization and exchange. The principle of specialization and exchange applies not just to individuals, but to groups of individuals, such as those living within the boundaries that define cities, counties, states or nations.

6. International Trade - International trade is trade between nations Exports are goods and services that are produced domestically, but sold abroad. Imports are goods and services that are produced abroad, but consumed domestically.

7. Absolute and comparative advantage An individual producer has an absolute advantage in the production of a product if he has the ability to produce the good or service using fewer resources than other producers use. Similarly a country has an absolute advantage in the production of a product if it has the ability to produce the good or service using fewer resources than other countries use.

8. Comparative advantage An individual producer has a comparative advantage in the production of a product if she has the ability to produce the good or service at a lower opportunity cost than other producers. Similarly, a country has a comparative advantage in the production of a product if it has the ability to produce the good or service at a lower opportunity cost than other countries.

9. How to measure comparative advantage We measure the opportunity cost of a good, not by the resources used to produce it, but rather by the other goods whose production must be sacrificed.

10. Mutually Beneficial Trade Mutually beneficial trade between any two countries is possible whenever one country is relatively better at producing a good than the other is at producing the good. Being relatively better means having the ability to produce a good at a lower opportunity cost — that is, at a lower sacrifice of other goods foregone.

11. Measuring Productivity We often measure productivity in terms of output per unit of input (or other resource) a. labor time or hours b. land c. expenditure or cost

12. Labor time example Labor requirement data for White House cleaning Load of wash Vacuum a room Bill .80 hours .40 hours Hillary .75 hours .25 hours This data is input per unit of output

13. Convert requirement data to output per unit of input data Take the reciprocal of the requirement data Loads per hour Rooms per hour Bill 1 / .80 = 1.25 loads 1 / .40 = 2.5 rooms Hillary 1 / .75 = 1.333 loads 1 / .25 = 4 rooms

14. Corn (bu) Peanuts (lbs) $0.25 $2.50 U.S. $4.00 $0.50 Mexico Corn and peanut example Cost requirement data $ per output

15. Convert requirement data to output per unit of input data Take the reciprocal of the requirement data Bushels of corn per $ Pounds of peanuts per $ U.S. 1 / 2.50 = 0.40 bu. 1 / .25 = 4 lbs. Mexico 1 / 4.00 = 0.25 bu. 1 / .50 = 2 lbs (1/4)

16. Corn (bu) Peanuts (lbs) 4 lbs 0.40 bu U.S. 2 lbs Mexico 0.25 bu Corn and peanut example Output per $

17. How to determine who has the comparative advantage in what Output per unit of input data 1. Determine the output per per unit of input for each agent 2. Make an opportunity cost table (agents by goods) 3. For each good (column) choose a unit of exchange 4. Determine the opportunity cost of each good in terms of the unit of exchange by dividing the production of the unit of exchange by the production of the other good 5. The country with the lower opportunity cost has a comparative advantage in the production of each good

18. Example Computation Loads Loads Rooms Rooms 1.25 2.5 Bill Bill 1.33 4 Hillary Hillary 2 r 1/2 l 3 r 1/3 l • Rooms is unit of exchange for wash • Wash is unit of exchange for rooms 4. Fill in comparative advantage table (unit of exchange per unit of good) 5. Bill has the comparative advantage in washing 5a. Hillary has the comparative advantage in room cleaning

19. Example Computation Corn Peanuts Corn Peanuts 4 0.40 USA USA 0.25 2 Mexico Mexico 1/10 c 10 p 8 p 1/8 c • Peanuts is unit of exchange for corn • Corn is unit of exchange for peanuts 4. Fill in comparative advantage table (unit of exchange per unit of good)

20. Example Computation Corn Corn Peanuts Peanuts USA USA 4 0.40 Mexico Mexico 0.25 2 1/10 c 10 p 8 p 1/8 c • Peanuts is unit of exchange for corn • Corn is unit of exchange for peanuts 4. Fill in comparative advantage table (unit of exchange per unit of good) 5. Mexico has the comparative advantage in corn 5a. USA has the comparative advantage in peanuts

21. Determining comparative advantage Using input per unit of output data Using cost per unit of output data

22. Output per unit of input data We want the most possible Most output per unit of input Input (cost) per unit of output data We want the least possible Least input per unit of output

23. Wash Rooms Bill Hours per task Hillary What does Bill give up to do a load of wash? 0.8 0.4 0.75 0.25 Bill gives up 2 rooms to do a load of wash 1 load of wash costs two rooms Washing takes twice the resources of rooms

24. 1 Load 1 Room Opportunity Cost of: 2 rooms Bill Hillary

25. Wash Rooms Bill Hours per task Hillary What about Hillary? 0.8 0.4 0.75 0.25 Hillary gives up 3 rooms to do a load of wash 1 load of wash costs three rooms Washing takes 3 times the resources of rooms

26. 1 Load 1 Room Opportunity Cost of: 2 rooms Bill 3 rooms Hillary

27. 1 Load 1 Room Bill Hillary Who has the lowest opportunity cost for washing? 2 rooms 3 rooms Bill has a comparative advantage in washing

28. Loads Rooms 0.8 0.4 Bill Hours per task 0.75 0.25 Hillary What does Bill give up to vacuum a room? Bill gives up 1/2 load of wash to vacuum a room 1 room costs ½ load of wash Vacuuming takes ½ as long as washing

29. 1 Load 1 Room Bill Hillary Opportunity Cost of: 2 rooms ½ load 3 rooms

30. Wash Rooms Bill Hours per task Hillary What does Hillary give up to vacuum a room? 0.8 0.4 0.75 0.25 Hillary gives up 1/3 load of wash to vacuum a room 1 room costs 1/3 load of wash Vacuuming takes 1/3 as long as washing

31. 1 Load 1 Room Bill Hillary Opportunity Cost of: 2 rooms ½ load 1/3 load 3 rooms

32. Bill has a comparative advantage in washing Hillary has a comparative advantage in vacuuming

33. How to determine who has the comparative advantage in what Input per unit of output data 1. Determine the input per per unit of output for each agent 2. Make an opportunity cost table (agents by goods) 3. For each good (column) choose a unit of exchange 4. Determine the opportunity cost of each good in terms of the unit of exchange by dividing the input use of each good by the input use of the unit of exchange 5. The country with the lower opportunity cost has a comparative advantage in the production of each good

34. Example Computation Corn Peanuts Corn Peanuts 2.50 0.25 U.S. U.S. 4.00 0.50 Mexico Mexico 10 p 1/10 c 8 p 1/8 c • Peanuts is unit of exchange for corn • Corn is unit of exchange for fish 4. Fill in comparative advantage table (unit of good per unit of exchange) 5. Mexico has the comparative advantage in corn production 5a. U.S. has the comparative advantage in peanut production

35. Time for a break and review

36. Specialization and Gains from Trade If individuals/countries specialize according to their comparative advantage, a more efficient use of given resources occurs. As a result, the output of at least one good rises, without decreasing that of any other good.

37. Loads Rooms 2 rooms Bill ½ load Opportunity cost Hillary 3 rooms 1/3 load The rate of substitution between outputs If Bill cleans 1 less room, he washes 1/2 more load of laundry. (1 less room) x (½ load per room) = ½ more loads of laundry If Bill cleans 2 less rooms, he washes 1 more load of laundry. (2 less rooms) x (½ load per room) = 1 more loads of laundry

38. Loads Rooms 2 rooms Bill ½ load Opportunity cost Hillary 3 rooms 1/3 load The rate of substitution between outputs If Bill does 1 more load of laundry, he cleans 2 less rooms. (1 more load) x (2 rooms per load) = 2 less rooms If Bill does 2 more loads of laundry, he cleans 4 less rooms. (2 more loads) x (2 rooms per load) = 4 less rooms

39. Loads Rooms 2 rooms Bill ½ load Opportunity cost Hillary 3 rooms 1/3 load The rate of substitution between outputs If Hillary does 1 more load of laundry, she cleans 3 less rooms (1 more load) x (3 rooms per load) = 3 less rooms If Hillary cleans 2 more rooms, she washes 2/3 less loads of laundry (2 more rooms) x (1/3 load per room) = 2/3 more loads of laundry

40. Loads Rooms 2 rooms Bill ½ load Opportunity cost Hillary 3 rooms 1/3 load Now adjust tasks and see what happens Bill does 2 more loads of laundry and Hillary does 2 less loads (2 more loads) x (2 rooms per load) = 4 less rooms (Bill) (2 less loads) x (3 rooms per load) = 6 more rooms (Hillary) Net impact is 2 more rooms vacuumed

41. Corn Peanuts U.S. Mexico Now adjust tasks and see what happens 10 p 1/10 c Opportunity cost 8 p 1/8 c US grows 1,000 less bu corn and Mexico grows 1,000 more bu corn (1,000 less bu corn) x (10 lbs per bu) = 10,000 more lbs of peanuts (1,000 more bu) x (8 lbs per bushel) = 8,000 less lbs of peanuts Net impact is 2,000 more lbs of peanuts

42. Corn Peanuts U.S. Mexico Another example 10 p 1/10 c Opportunity cost 8 p 1/8 c US grows 10,000 less corn and Mexico grows 100,000 less peanuts (10,000 less bu corn) x (10 lbs per bu) = 100,000 more lbs of peanuts (100,000 less lbs) x (1/8 bushels per pound) = 12,500 more corn Net impact is 2,500 more bushels of corn

43. Corn Peanuts U.S. Mexico A third example 10 p 1/10 c Opportunity cost 8 p 1/8 c US grows 4,000 more corn and Mexico grows 40,000 more peanuts (4,000 more bu corn) x (10 lbs per bu) = 40,000 less lbs of peanuts (40,000 more lbs) x (1/8 bushel per pound) = 5,000 less corn Net impact is 1,000 less bushels of corn Oops!!

44. Helpful note on finding tradeoffs The tradeoff in the US is 1 bushel corn for 10 pounds of peanuts Suppose we produce 3,000 less bushels of corn in the US How much will peanuts rise?

45. Helpful note on finding tradeoffs The tradeoff in the Mexico is 1 bushel corn for 8 pounds of peanuts Suppose we want 30,000 less lbs of peanuts How much will corn rise?

46. If countries specialize according to their comparative advantage, a more efficient use of given resources occurs. The world output of at least one good rises, without decreasing that of any other good.

47. Gains from trade With the opening of trade, there will be a net increase in world output. Therefore, international trade flows can be arranged so that no country would have less of anything, while each country would some of the gain in total output.

48. Corn Peanuts Corn Peanuts U.S. U.S. Mexico Mexico World Corn U.S. Peanuts Corn Mexico Peanuts Opportunity cost + 1000 - 100 + 100 - 800 10 p 1/10 c + 0 + 200 8 p 1/8 c Gain from imports (+) Loss from exports (-) Gain Production +0 - 100 + 100 +100 -900 + 1000 +0 -100 + 100 - 800 +900 +100 US imports 100 corn and exports 900 peanuts 900/100 = 9 so the US is trading 9 for 1

49. Corn Peanuts Corn Peanuts U.S. U.S. Mexico Mexico World Corn U.S. Peanuts Corn Mexico Peanuts Opportunity cost + 100 - 10 + 12 - 96 10 p 1/10 c + 2 + 4 8 p 1/8 c Gain from imports (+) Loss from exports (-) Gain Production +1 - 10 + 11 +2 -98 + 100 +1 -11 + 12 - 96 +98 +2 US imports 11 corn and exports 98 peanuts 98/11 = 8.909 the US is trading 8.909 for 1

50. Corn Peanuts Corn Peanuts U.S. U.S. Mexico Mexico World Corn U.S. Peanuts Corn Mexico Peanuts Opportunity cost + 400 - 40 + 45 - 360 10 p 1/10 c + 5 + 40 8 p 1/8 c Gain from imports (+) Loss from exports (-) Gain Production +5 - 40 + 45 +40 -360 + 400 +0 -45 + 45 - 360 +360 +0 US imports 45 corn and exports 360 peanuts 360/45 = 8 so the US is trading 8 for 1