Chapter 2

Comparative advantage: the basis for trade

Core principles
- The principle of comparative advantage
- The principle of increasing opportunity cost

2.1 Opportunity cost and specialization

- Economic systems based on specialization and the exchange of goods and services are
generally far more productive than those with less specialization.
- Absolute advantage – when one person is able to produce a good or service, or perform
a given task, with less resources than another person.
- Comparative advantage – when one person’s opportunity cost of producing a good or
service, or of performing a given task, is lower than another person’s opportunity cost.
Measured in terms of opportunity cost.

2.2 The principle of comparative advantage

- The principle of comparative advantage – everyone can do better when each person (or
each country) concentrates on the activities for which their opportunity cost is lowest.
- EXAMPLE of opportunity cost.
Ø Work out the opportunity cost for both person.
Ø Compare the opportunity cost for one activity for both person.
Ø I.e. go horizontally, then vertically.
- If you want to produce a certain amount of one item, let the person with absolute
advantage do it.

The gains to specialization

- Specialisation will lead to a higher output for the group than self sufficiency will, if a
comparative advantage exists.
- Specialisation has costs and benefits.
- Without specialization “jack-of-all-trades”. Not efficient.
- Complete specialization. Devote all resources to task that has the lowest opportunity
cost.

Sources of comparative advantage

- Individual:
Ø Inborn talent
Ø Education and training
Ø Experience
- National level:
Ø Natural resources – topography and climate
 Ø Infrastructure
Ø Cultural institution – e.g. English language.
- Comparative advantage can change over time – it is dynamic.

2.3 Illustrating comparative advantage graphically

The production possibilities curve
- Production possibilities curve (PPC) – a graph that describes the maximum amount of
one good that can be produced for every possible level of production of the other good.
I.e. all combinations of the two tasks that can be produced with one’s labour. Also known
as production frontier.
- Straight line means a constant slope.
- Downward slope illustrates the scarcity principle.
- Labour fully – full employment given current technology. Resource level is fixed.

- Attainable point – any combination of goods that can be produced using currently
available resources. All points either on or below and to the left of the PPC are attainable.
- Unattainable point – any combination of goods that cannot be produced using currently
available resources. All points lying above and to the right of the PPC are unattainable.

- Inefficient point – any combination of goods for which currently available resources
enable an increase in the production of one good without a reduction in the production
of the other. Any point that lies below and to the left of the PPC is inefficient.
- Efficient point – any combination of goods for which currently available resources do not
 allow an increase in the production of one good without a reduction in the production of
the other. Any point on the PPC is an efficient point.

- Opportunity cost can be determined from the slope:

(rise over run)

Ø I.e. opportunity cost of 1kg of nuts is 2kg of coffee, and opportunity cost of 1kg of
coffee is 1/2kg of nuts.

Individual productivity and the slope and position of the PPC

- Combining production possibilities.

Using the PPC to show the gains from specialization

- With specialization they are able to produce to point C.
- If they traded with each other they can get a new slope, the consumption possibility line.
- It is differences in opportunity costs that give rise to gains from specialization, and the
gains from specialization grow larger as these differences increase.

2.4 A production possibilities curve for a many-person economy

- Production possibilities curve for a large economy with millions of workers has a gentle
outward bow shape.

- A bow-shaped PPC means that the opportunity cost of producing nuts increases as the
economy produces more of them.
- The greater the difference among individuals’ opportunity costs, the more bow-shaped
the PPC will be, and the greater will be the potential gains from specialization.
- The shape of the PPC illustrates the general principle that when resources have different
opportunity costs, we should always exploit the resource with the lower opportunity
cost first.
- Increasing opportunity cost principle – in expanding the production of any good, first
employ those resources with the lowest opportunity cost, and only afterwards turn to
resources with higher opportunity costs. Also known as low-hanging-fruit principle.

Factors that shift the economy’s production possibilities curve

- Economic growth is demonstrated by an outward shift in the economy’s production
possibilities curve.
- Factors that cause economic growth include:
Ø Increasing productive resources
o Investment in new factories and equipment
o Population growth
Ø Improvements in knowledge and technology
o Investment in education, R&D and ICT
o Gains from specialization.
- Productivity gains from specialization are often very spectacular.
- It eliminates many of the switching and start-up costs people incur when they move back
and forth among numerous tasks. Also apply to tools and equipment.
- Low population density, laws and customs and a lack of well-developed markets can
impede a country’s ability to take advantage of the gains from specialization and
exchange. Population growth may also decrease standard of living.

2.5 Can we have too much specialization?

- Speculation also entails costs.
- People enjoy variety in the work they do.
- Psychological costs of repetitive factor work.

Production and the consumption possibilities and the benefit of trade (chapter 8)
- Closed economy – an economy that does not trade with the rest of the world.
- Open economy – an economy that trades with the rest of the world.

Consumption possibilities with and without international trade

- Consumption possibilities – the combinations of goods and services that a country’s
citizens might feasibly consume.
- A country’s economic welfare depends most directly not on what a country can produce,
but what its citizens can consume.
- In a closed economy, society’s consumption possibilities are identical to its production
possibilities.
- In a open economy, a society’s consumption possibilities are typically greater than its
production possibilities.
- Consumption possibilities in an open economy are described by a downward sloping line
that just touches the PPC.
- A country maximizes its consumption possibilities by producing at the point where the
consumption possibilities line just touches the PPC.
- It will then trade so as to reach its most preferred point on the consumption possibilities
line.
-
- Tangent is the Domestic price line.
- China was a closed economy
Tangent: Domestic price line - computer: coke
Two countries will trade if their domestic price line is different
Stop trading when their domestic price line is the same