Comparative Advantage

Why trade makes everyone better off

REVIEW1. Explain how you would use the concept of

opportunity cost in everyday life. 2. Differentiate between increasing and constant

opportunity cost PPCs3. Explain why the Law of Increasing Opportunity

Cost occurs. 4. Explain how you calculate PER UNIT opportunity

cost.5. Explain difference between productive and

allocative efficiency on the PPC6. Identify the 2 Shifters of the PPC7. Give 2 SPECIFIC scenarios that would shift a

PPC outward (Use Pizza and Robots)8. List 10 types of Soda

Objectives• Define absolute advantage and comparative advantage.

• Explain why comparative advantage, rather than absolute advantage, is the key to trade.

• Define specialization and exchange.

• Explain how both parties in a trade gain from voluntary exchange.

• Understand two different approaches to determining comparative advantage: the input method and the output method.

• Analyze data to determine which party has the absolute and comparative advantages in different products.

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Absolute Advantage

The ability to produce a good using fewer resources than another producer (or the ability to produce more goods with the same resources)

5

What if…

Danny can type 120 wpm with 0 errors, while Ben can type 60 wpm with 0 errors

Who has the absolute advantage in typing?

How do you know?

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Comparative Advantage

the ability to produce a good at a lower opportunity cost

much more important than absolute advantage

Trade based on comparative advantage increases consumption possibilities

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David Ricardo

Absolute and Comparative AdvantageAbsolute Advantage

•The producer that can produce the most output OR requires the least amount of inputs (resources)•Ex: Papa John has an absolute advantage in pizzas because he can produce 100 and Ronald can only make 20.

Comparative Advantage•The producer with the lowest opportunity cost.•Ex: Ronald has a comparative advantage in burgers because he has a lowest PER UNIT opportunity cost.

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Countries should trade if they have a relatively lower opportunity cost

They should specialize in the good that is “cheaper” for them to produceCopyright

ACDC Leadership 2015

I forgot to tell you…

Danny is a lawyer who earns $120/hour (types 120 wpm)

Ben is a security guard who earns $12/hour (types 60 wpm)

A 600-word document must be typed

How long will it take each to type the document?

Who should type the document?

Why?

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Let’s assume

Which country has the absolute advantage in the production of bananas? Explain.

Which country has the absolute advantage in the production of nails? Explain.

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Given the Same Resources & Technology

Bananas Nails

New Zealand 1000 4000

Ghana 600 800

Can New Zealand possibly benefit from trade with Ghana?

Yes!

All gains from trade are based on comparative advantage

Unless trade partners have exactly the same opportunity costs, each will have a comparative advantage in the production of some good or service

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New Zealand’s PPC

0

1000

2000

3000

4000

0 250 500 750 1000

Bananas

Nai

ls

Ghana’s PPC

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PPC

0

150

300

450

600

0 200 400 600 800

Bananas

Nai

ls

So, the more important questions are…

Which country has the comparative advantage in bananas? Explain.

Which country has the comparative advantage in nails? Explain.

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Given the Same Resources & Technology

Bananas Nails

New Zealand 1000 4000

Ghana 600 800

Basic Rules

A nation should export goods for which it has a comparative advantage

A nation should import goods for which it does not have a comparative advantage (goods for which it is at a comparative disadvantage)

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Sticking with our example..

Which country should export bananas? Which country should import bananas? Why?

Which country should export nails? Which country should import nails? Why?

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Terms of Trade

Partners will trade as long as the “price’ of the good each partner is obtaining from trade is less than the opportunity cost of producing the good itself

“good terms of trade” benefit both parties

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Sticking with our Example

Would Ghana buy 1 nail from New Zealand at a cost of 1 banana per nail? Explain.

So, what should Ghana charge New Zealand for bananas so that both benefit?

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Let’s also assume…

Ghana specializes in bananas and New Zealand specializes in nails.

Ghana keeps 300 bananas for itself and trades the other 300 to New Zealand at a rate of 2 nails per banana.

What does each nation end up with?

How can we tell that each nation benefited?

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Before & After Trade

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Without Trade With Trade Gains

Production Consumption Production Consumption

GBananas 300 300 600 300 +/-0

Nails 400 400 0 600 +200

NZBananas 200 200 0 300 +100

Nails 3200 3200 4000 3400 +200

Ghana’s PPC

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PPC

0

200

400

600

800

0 150 300 450 600Bananas

Nai

ls

New Zealand’s PPC

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PPC

0

1000

2000

3000

4000

0 250 500 750 1000Bananas

Nai

ls

Handout 1 - Cheat Sheet

Jean-Baptiste Say Partner

Overview of Solution to Comparative Advantage Problem1. Determine absolute advantage

2. Determine comparative advantage

A. Is it an input or an output problem?

B. Set up the table properly

C. Perform the math (remember input vs. output)

D. Determine who has comparative advantage

E. Determine acceptable terms of trade (if asked)

F. Know who should import/export which goods/services.

It’s like magic!

This is true for individuals, firms, and whole economies!

This is why economists generally oppose trade restrictions!

International trade makes countries better off, but doesn’t necessarily make all individuals better off.

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Complete the Statement

Specialization and trade can improve/increase….

Gains from trade are based entirely on….

Nations should import goods for which they have….

Good terms of trade must….

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More handouts - practice in class

Practice

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Given the Same Resources & Technology

Capes Masks

Gotham City 1500 500

Metropolis 400 1600

Which city should specialize in capes? Why?

Which city should import masks? Why?

Would 1 cape for 5 masks be good terms of trade? Explain.

KenyaIndia

Pineapples Radios

30 1040 40

1. Who has an absolute advantage in Radios?2. What is the cost of one radio for India?3. What is the per unit opportunity cost for 1

pineapple for Kenya?4. Who has a comparative advantage in pineapples?5. Who has a comparative advantage in radios?6. Who should import pineapples?7. Trading 1 radio for how many pineapples would

benefit both countries?Copyright ACDC Leadership 2015

KenyaIndia

Pineapples Radios

30 1040 40

(1P costs 1/3R) (1R costs 3 P)

(1P costs 1R) (1R costs 1P)

Kenya wants RadiosIf the terms of trade for 1 radio is greater than 3 pineapples then Kenya is worse off and should make radios on their own.India wants PineapplesIf the terms of trade for 1 radio is less than 1 pineapple then India is worse off and should make pineapples on their own.

What terms of trade benefit both countries? Copyright ACDC Leadership 2015