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Focus: How Do The Concepts of Comparative and Absolute Advantage Help Explain Why Nations Trade?
Focus: How Do The Concepts of Comparative and Absolute Advantage Help Explain Why Nations Trade?
AP Macroeconomics
August 2014
Why do nations trade?
• “You could say…that globalization, driven not
by human goodness but by the profit motive,
has done far more good for far more people
than all the foreign aid and soft loans ever
provided by well-intentioned governments
and international agencies.”
Paul Krugman, “The Magic Mountain,” New York Times,
January 23, 2001
Adam Smith, The Wealth of Nations
(often called the Father of Modern Economics)
Classical
Economist who
promoted the
idea of
comparative
advantage as
the basis for
trade.
Comparative Advantage
A person or a nation has a comparative
advantage in the production of a product
when it can produce the product at a lower
opportunity cost than another person or
nation.
Comparative advantage as
the basis for trade
is one of the most important ideas in
economics.
It is also one of the least intuitive.
Comparative Advantage
• A person or nation should specialize in the
production of a good for which it has a lower
opportunity cost and trade to obtain those
goodsts for which its opportunity cost is
higher.
Specialization and Trade
• Gains from trade are based on comparative
advantage, not absolute advantage
• Specialization and trade increase productivity,
national output, & standard of living.
• Everyone can benefit:
– a greater quantity of goods and services
– a greater variety of goods.
What should a nation produce?
• The goods for which it has the lowest
OPPORTUNITY COSTS!
Bake Make
Cakes Pizza
Bake Make
Cakes Pizza
Mr. Pinson has a lower opportunity cost in producing cakes; therefore, he should
specialize in the production of cakes. Ms. Gray has a lower opportunity cost in
producing pizza; therefore, she should specialize in the production of pizza.
Terms of trade
Bake Make
Cakes Pizza
Pinson will specialize in cakes. Gray will specialize in pizzas.
Q of Coconuts Q of Coconuts
30
20
9 8
28 40 6 10
Q of Fish
Q of Fish
Will the Castaways Gain From Trade?
Coconuts Fish
Tom has the lower opportunity cost in fishing and Hank has the lower
opportunity cost gathering coconuts. Therefore, Tom should
specialize in fishing and Hank should specialize in gathering
coconuts.
Tom’s PPF Hank’s PPF
Q of Coconuts Q of Coconuts
30
20
11 9
9 8
28 31 40 6 9 10
Q of Fish
Q of Fish
After specialization and trade, Tom and Hank can consume outside their PPCs.
Benefits from
Specialization and Trade
Input/Output Problems
Distinguishing input from output problems.
• An OUTPUT problem presents the data as
products produced given a set of resources. (ex.
Number of pens produced)
• An INPUT problem presents the data as amount of
resources needed to produce a fixed amount of
output. (ex. Number of labor hours to produce 1
bushel)
• When identifying absolute advantage, input
problems change the scenario from who can
produce the most to who can produce a given
product with the least amount of resources.
Which type of problem?
• Acres to produce one unit of each.
Apples Pears
Tom 10 5
Sam 6 2
• Input problem
Absolute Advantage?
• Acres to produce one unit of each.
Apples Pears
Tom 10 5
Sam 6 2
Apples Pears
Tom 10 5
Sam 6 2
Output problem
Absolute Advantage?
• Number caught per day.
Trout Bass
Tom 4 6
Sam 24 12
Trout Bass
Tom 4 6
Sam 24 12
Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
• Input problem
Explanation:
• Days to produce one unit of each.
Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
• This is an input problem as it refers to how many days
(work days for labor) will be needed to produce 1 unit.
The problem is phrased in terms of resources used rather
than products produced.
Absolute Advantage?
• Days to produce one unit of each.
Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
Namibia 60 10
Colombia 24 8
Output problem
Explanation?
• To produce the following from one ton of olives.
Canned Olives Olive Oil
Namibia 60 10
Colombia 24 8
• This is an output problem because it is the number
produced (output in canned olives and olive oil)
from a given unit of resources (1 ton of olives)
Absolute Advantage?
• To produce the following from one ton of olives.
Canned Olives Olive Oil
Namibia 60 10
Colombia 24 8
• Which nation has the absolute advantage in both
products?
Namibia
Explanation:
• To produce the following from one ton of olives.
Canned Olives Olive Oil
Namibia 60 10
Colombia 24 8
• Namibia has an absolute advantage in producing
both products because it can produce more given
the unit of resources available (1 ton of olives).
How to Handle a
Comparative Advantage Problem
on the AP Exam
1. The question will have information about two
nations producing two of the same products.
This information will be given to you in a
Production Possibilities table or on a Production
Possibilities curve or maybe a word problem
form.
2. Ask what type of problem: Output or input?
2. Determine which nation or person has the
absolute advantage in producing each of the
two goods or services.
3. Determine which nation or person has the
comparative advantage in producing each of
the two goods or services.
– For each nation, determine the opportunity cost
of producing one unit of each good.
– Identify the nation that has the lowest
opportunity cost of producing one unit of each
good. That nation has the comparative
advantage.
4. Determine the terms of trade. Each country
will specialize in the production of the good in
which it has the comparative advantage and will
export that good. It will import the other good.
The terms of trade will be whatever is mutually
beneficial to the two countries. (They will want to
be better off after trade than before trade.)
• If the country exports Good A, it will want more of
Good B than it would get before specialization.
• If the country imports Good A, it will want to pay
less in terms of Good B than it would have to pay
before specialization and trade.
Corn Sunscreen
Mexico 300 150