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Principles of Microeconomics, 1st Canadian Edition

Robert H. Frank, Cornell University
Ben S. Bernanke, Princeton University
Lars Osberg, Dalhousie University
Melvin Cross, Dalhousie University
Brian MacLean, Laurentian University

Comparative Advantage: The Basis for Exchange

Cyberlecture

This chapter introduces you to the basis for exchange – comparative advantage. You will learn how to identify comparative advantage, and to calculate the gains from specialization and trade between people and between countries.

What are absolute advantage and comparative advantage?
A person, or society, has an absolute advantage in the production of a product if they can produce the product using fewer inputs than anyone else.
A person, or society, has a comparative advantage in the production of a product if they can produce the product at a lower opportunity cost than anyone else. If two people, or two societies, specialize in producing the product in which they have a comparative advantage, they will increase the total value of available goods and services.

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 lowest.
To calculate opportunity cost, use the formula:

Opportunity Cost = What you give up
What you get

Compare the opportunity cost of production of a good with other producers – person with person, province with province, country with country – to determine who has the comparative advantage in the production of that product.

Practice Activity 1
Try answering some questions about calculating opportunity cost.

What is the source of comparative advantage?
People develop a comparative advantage in the production of a good because of:

natural ability
specialized education or training
experience at producing the product

Countries develop a comparative advantage in the production of a good because of:

natural resource endowments
characteristics of the culture of the country
government regulation of business
technological change

What is a production possibilities curve?
A production possibilities curve (PPC) shows all the combinations of two goods that a person or society can produce in a given period of time with given resources and technology.
The following graph shows a PPC for one person who has chosen to produce two goods.

The PPC slopes down because of the scarcity principle: trade-offs must be made as production of one good increases.

slope of the PPC measures the opportunity cost of producing additional units of one good
- slope = rise (or fall) ÷ run
- opportunity cost = give up (fall) ÷ get (run)
with two-good economy, the price of one good is how much of the other good that must be forgone
points along the PPC represent an efficient use of resources
points inside the PPC (closer to the origin) represent inefficient use of resources
points outside the PPC are unattainable with the available resources and technology

What events will make the PPC look different?
If a person's productivity changes, the PPC changes too.

the PPC may shift outwards if the person is more productive
the PPC may shift inwards if the person is less productive
the slope of the PPC may change if the person is better or worse at producing one or both of the goods

Note from the above graph that Susan has an absolute advantage over Tom in production of both goods.

Susan produces more of both goods in the same time period

Tom has a comparative advantage in producing sugar cane.

Tom's opportunity cost of producing sugar cane is: 6 nuts ÷ 6 sugar cane = 1 nut per sugar cane
Susan's opportunity cost of producing sugar cane is: 24 nuts ÷ 12 sugar cane = 2 nuts per sugar cane

Economic Naturalist
So who does the typing when the boss is faster than the secretary?

How is a two-person PPC different from a one-person PPC?
A two-person PPC reflects the two different opportunity costs of production. It is kinked with the slope to the left of the kink representing the opportunity cost of one of the producers, and the slope to the right representing the opportunity cost of the other producer.

Note that the opportunity cost of producing more nuts to the right of the kink is greater than the opportunity cost to the left.

in general, the opportunity cost of producing a good increases as more of it is produced

The Principle of Increasing Opportunity Cost:
In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs.
If people specialize in producing the product in which they have a comparative advantage – a lower opportunity cost – a greater amount of output will be produced in the same time with the same number of resources.

workers learn to produce more efficiently
workers exploit their own best-developed skills
workers do not have to switch tasks with their attendant time-consuming set-up costs

How is an economy-wide PPC different than one-person and two-person PPCs?
An economy-wide PPC has a downward slope, is bowed out and is smooth.

downward slope reflects principle of scarcity
the bowed out shape reflects increasing opportunity cost of producing increasing amounts of one good
an economy has a lot of workers with a lot of different opportunity costs
- there are so many kinks, that the curve becomes smooth

Practice Activity 2
Try answering some questions about an economy-wide PPC.

What is the Circular Flow of Income and Expenditure?
The Circular Flow of Income and Expenditure shows that the movement of money and goods in our economy is dependent upon exchange.

the flow of income derives from an exchange of labour for wages
the flow of expenditures derives from an exchange of goods and services for money

Exchange is required in a complex economy because workers specialize in the production of goods and services, and must trade, or exchange, for the other things they need.

How is comparative advantage important for international trade?
If countries specialize in producing the goods in which they have a comparative advantage, they can trade their excess production for different goods that have been more cheaply produced by other countries. This increases the amount of goods and services available to each country.

The differences in the opportunity costs of production between countries create different relative prices for the same product. In the above graph, a country that doesn't trade is constrained in consumption by its own relative prices. If the country trades, it can purchase goods at a lower relative price.

The World Trade Organization (WTO), with 142 member countries, is the only global international organization administering rules of trade between nations. The WTO has calculated some of the savings consumers have reaped as a consequence of free trade. See what the WTO thinks your savings have probably been at http://www.wto.org/english/thewto_e/whatis_e/10ben_e/10b04_e.htm.

Does everyone gain from trade?
The logic of comparative advantage shows that everyone can gain from trade. However, everyone does not gain from trade.

expansion of an industry in one country may lead to contraction of a competing industry in another country
- workers could lose jobs
large powerful countries can use trade sanctions to hurt smaller countries
countries that are open to trade may find foreigners purchasing large shares of their industrial sector
- profits would flow out to foreigners

Not everyone agrees that freer international trade would decrease global poverty. In fact, this opinion piece asserts that the West became rich behind high tariff barriers that suppressed international trade: http://www.policyalternatives.ca/publications/comment19.html. Check it out and see if you agree.

Understanding Questions
Do I understand this chapter? As a check to your understanding of the material in this chapter, you should be able to answer our questions.

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