Power of Trade and

Comparative Advantage

Ka-fu Wong
University of Hong
Kong

1
The Basis of Exchange
• Why do people exchange goods and services in the first
place?
• Why is Kam-po WONG (Chinese: 黃金寶 ) a racing
cyclist, Ka-fu WONG an instructor in a university, and
Thomas FRIEDMAN a prominent writer?

Kam-po WONG Ka-fu WONG Thomas FRIEDMAN

2
Why not do everything on our own?
• Should Ms. Wu Yi do her own household chores?
– Wú Yí ( 吴仪 or 吳儀 ) was one of four vice-
premiers of the State Council of the People's
Republic of China from 2003 - 2008. In 2007,
Forbes magazine considers her the second most
powerful woman in the world.
– She knows how to do household chores.

Brief description and picture taken from

http://en.wikipedia.org/wiki/Wu_Yi

3
Why not do everything on our own?
• Should Ms. Carrie Lam do her own household chores?
– Carrie Lam Cheng Yuet-ngor ( 林鄭月娥 ) is the
current Chief Executive of Hong Kong. Before that
she was the Chief Secretary for Administration, the
most senior rank of principal officials of Hong
Kong, from 2012 to 2017.
– Should we blame her if she does not (or does not
know how to) do household chores?
Brief description and picture taken from
https://en.wikipedia.org/wiki/Carrie_Lam

“Hong Kong chortles over Carrie Lam toilet paper hunt”

http://www.bbc.com/news/blogs-china-blog-38716311
4
Why not do everything on our own?
Grow our own food…

5
Why not do everything on our own?
replace our own roofs…?

…paint our own houses…

6
Why not do everything on our own?

We can all have more of every good and service if we

specialize in the activities at which we are relatively most
efficient.

7
Example: Basis for exchange
• Paul is a house painter whose roof needs replacing. Ron
is a roofer whose house needs painting.
• Although Paul is a painter, he also knows how to install
roofing. Ron, for his part, knows how to paint houses.
• Should Paul roof his own house? Should Ron paint his
own house?

Paul

Ron

8
Example: Basis for exchange
Time required by each to complete each type of job:

Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs

Ron has an absolute advantage over Paul at both

painting and roofing, which means that Ron takes
fewer hours to perform each task than Paul does.

Should Ron do the roofing and painting jobs for both

houses?
9
Example: Basis for exchange
Time required by each to complete each type of job:

Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs

However, Paul has a comparative advantage over

Ron at painting, which means that he is relatively
more efficient at painting than Ron is.

10
Comparative advantage and opportunity
cost

“To have a comparative advantage at a task”


(is the same as)

“To have a lower opportunity cost of performing it”

11
Example: Basis for exchange
Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs

o For Paul, the opportunity cost of painting one house = the

number of roofing jobs he could do in the same time.

o Paul takes 300 hours to paint a house, 400 hours to roof a house.
o So in the time it takes Paul to paint a house, he could complete .
75 roofing jobs.

o So Paul’s opportunity cost of painting a house is .75 roofing jobs.

12
Example: Basis for exchange
Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs

o For Ron, the opportunity cost of painting one house = the number
of roofing jobs he could do in the same time.

o Ron takes 200 hours to paint a house, 100 hours to roof a house.
o So in the time it takes Ron to paint a house, he could complete 2
roofing jobs.

o So Ron’s opportunity cost of painting a house is 2 roofing jobs.

13
Example: Basis for exchange
• Paul’s opportunity cost of painting a house is .75 roofing
jobs.
• Ron’s opportunity cost of painting a house is 2 roofing
jobs.

• Paul thus has a comparative advantage at painting,

because his opportunity cost of painting is lower than
Ron’s.
• Therefore it makes sense for Paul to do both painting
jobs and leave both roofing jobs for Ron.

14
Example: Basis for exchange

Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs

o If each person performed both tasks for himself, the total time
spent would be 700 hours for Paul and 300 hours for Ron.

o By contrast, when each specializes in his comparative

advantage, these totals fall to 600 for Paul and 200 for Ron, a
savings of 100 hours each.

15
Term of Trade (ToT)
o Paul and Ron each has one painting job and one roofing job to
do.

o Specialization with trade will allow them to save 100 hours

each.

o Essentially, they are exchanging one painting job for one

roofing job.
o Paul helps Ron do his painting job in exchange for Ron’s help
of roofing job.

o Term of Trade in this example: one painting job/roofing job.

16
Term of Trade (ToT)
o 1.5 painting job / roofing job
o 1.5 painting job per roofing job

o ToT specifies how much painting job can be exchange for one
roofing job.

o If I help you with 1 roofing job, you will help me with 1.5
painting jobs.  Or, more generally, if I help you with x roofing
job, you will help me with 1.5x painting jobs. 

o If I help you with 1 painting job, you will help me with 0.67
(=1/1.5) roofing job.  Or, if I help you with y painting job, you
will help me with 0.67y roofing job. 

17
Term of Trade
o Paul and Ron each has one painting job and one roofing
job to do. When ToT is 1, specialization with trade will
allow them to save 100 hours each.

o Will they agree to exchange if the ToT is

o 2.0 painting job/roofing job?

18
Term of Trade
o Paul and Ron each has one painting job and one roofing
job to do. When ToT is 1, specialization with trade will
allow them to save 100 hours each.

o How many hours would each save if the ToT is

o 1.1 painting job/roofing job?

19
Principle of Comparative Advantage
• Everyone does best when each person (or country) concentrates on
the activities in which he or she is relatively most efficient.
– “Concentrates on the activities in which he or she is relatively
most efficient” means specialization.

• Specialization by comparative advantage provides the rationale for

market exchange.
– It explains why each person does not devote 10 percent of her
time to producing cars, 5 percent to growing food, 25 percent to
building house, 0.0001 percent to brain surgery….

• By performing only those tasks at which we are relatively most

efficient, we can produce vastly more than if we each tried to be
self-sufficient.

20
Principle of Comparative Advantage

http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/

Would any of them have been able to contribute so much

to economic sciences if each of them were required to
grow their own food, do their own household chores,
repair their own car, etc.?
21
Revealed from data
• Kam-po WONG (Chinese: 黃金寶 ) is a racing cyclist, Ka-
fu WONG is an instructor in a university, and Thomas
FRIEDMAN is a prominent writer.

Kam-po WONG Ka-fu WONG Thomas FRIEDMAN

o It must be the case that Kam-po has the comparative
advantage in race cycling, Ka-fu in teaching, Thomas in
writing.
22
What if …
• Kam-po WONG (Chinese: 黃金寶 ) is a racing cyclist and
Thomas FRIEDMAN is a prominent writer.

Kam-po WONG Thomas FRIEDMAN

o If we made Thomas a race cyclist and Kam-po a writer, Thomas

would produce less wins in cycling races and Kam-po will be writing
less exciting books. As a whole, the society will be worse off.
23
Sources of Comparative Advantage

• Individual o National level

– Inborn talent o Natural resources
– Education o Culture
– Training o Institutions
– Experience
o Non-economic
o Adoption of a language
o Institutions

What can we do to change our comparative advantage?

24
The 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.

25
Production possibilities of Chris alone
• Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food.
• If Chris is the only person in the economy, describe the economy's
production possibilities curve.

Shelter (sq yd/wk)

6
4
2
0 4 8 12
Food (lb/wk)
26
Production possibilities of Chris alone
Production Possibilities Curve:
All combinations of shelter and
food that can be produced
with Chris’s labor.

Shelter (sq yd/wk) The absolute value of the

slope of the production
6 possibility curve is
6/12 = 1/2.
4
2 For Chris, this means that
the opportunity cost of an
0 4 8 12 additional pound of food
Food (lb/wk) each week is 1/2 sq yd/wk
of shelter.
27
 Production possibilities of Chris alone
A, B, C, D Attainable and efficient
E Attainable but inefficient
F Unattainable
Shelter (sq yd/wk)
6 A A production mix is inefficient if and
only if we can produce more of one
4 F
C good without the need to reduce the
production of another good.
2 E D
B
0 4 8 12
Food (lb/wk)

28
 Production possibilities of Dana alone
• Dana can produce 4 sq yd/wk of shelter or 4 lb/wk of food. If Dana
is the only one in the economy, describe the economy's production
possibilities curve.

Shelter (sq yd/wk)

Production Possibilities Curve:
All combinations of shelter and
food that can be produced
4
with Dana’s labor.

Food (lb/wk)
2 4
For Dana, the opportunity cost of an additional pound of food each
week is 1 sq yd/wk of shelter. 29
Production Possibilities in a Two-Person
Economy
• For Chris, the opportunity cost of an additional pound of food each
week is 1/2 sq yd/wk of shelter.
• For Dana, the opportunity cost of an additional pound of food each
week is 1 sq yd/wk of shelter.

• Thus, Chris has a comparative advantage in producing food,

because the opportunity cost of producing food is only half as large
as it is for Dana.

• By the same token, Dana has a comparative advantage producing

shelter.

30
 Production Possibilities in a Two-Person
Economy
• Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana
can produce 4 sq yd/wk of shelter or 4 lb/wk of food. If Chris and
Dana are the only two people in the economy, describe the
economy's production possibilities curve.

Shelter (sq yd/wk)

Wrong!

Food (lb/wk)
31
 Production Possibilities in a Two-Person
Economy
• Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana
can produce 4 sq yd/wk of shelter or 4 lb/wk of food. If Chris and
Dana are the only two people in the economy, describe the
economy's production possibilities curve.

Shelter (sq yd/wk)

Wrong!

Food (lb/wk)
32
 Production Possibilities in a Two-Person
Economy
• Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana
can produce 4 sq yd/wk of shelter or 4 lb/wk of food. If Chris and
Dana are the only two people in the economy, describe the
economy's production possibilities curve.

Shelter (sq yd/wk)

Food (lb/wk)
33
 Production Possibilities in a Two-Person
Economy
Dana and Chris, a married couple, have decided to consume, jointly,
6 sq yd/wk of shelter and 8 lb/wk of food. How should they divide
the task of producing these quantities?

Shelter (sq yd/wk) Dana works full time making

10 shelter; Chris works 1/3 week
on shelter, 2/3 week on food.

6
4

Food (lb/wk)
8 12 16
34
Production Possibilities in a Two-Person
Economy
Shelter (sq yd/wk)
10 Dana works full time making shelter; Chris works
1/3 week on shelter, 2/3 week on food.
6
4

Food (lb/wk)
8 12 16
o Dana has a comparative advantage in producing shelter, but even
if she spends all his time producing shelter, she can make only 4
sq yd/wk.
o So Chris will have to produce the additional 2 sq yd/wk for them to
achieve the desired 6 sq yd/wk.
o Since Chris is capable of producing 6 sq yd/wk of shelter on his
own, it will take him only 1/3 of a week to produce 2 sq yd.
o This leaves 2/3 of a week for him to produce food, which is exactly
how much time he needs to produce the desired 8 lb/wk.
35
The Principle of Increasing Opportunity Cost (Also
called “The Low-Hanging-Fruit Principle”)
• 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.

For Chris, the opportunity cost of an additional pound of food each week is
1/2 sq yard of shelter per week.

For Dana, the opportunity cost of an additional pound of food each week is 1
sq yard of shelter per week.

Start with everyone producing shelter.

If we want to increase the amount of food, we will be better off allocating
Chris to the task first. Then, start to use Dana only after Chris’s time is all
used up.
36
The Principle of Increasing Opportunity Cost (Also
called “The Low-Hanging-Fruit Principle”)
• 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.
For Chris, the opportunity cost of an additional sq yard of shelter is 2 pounds
of food per week.
For Dana, the opportunity cost of an additional sq yard of shelter is 1 pound
of food per week.

Start with everyone producing food.

If we want to increase the amount of shelter, we will be better off allocating
Dana to the task first. Then, start to use Chris only after Dana’s time is all used
up.

37
Production Possibilities in a Three-Person
Economy
• Chris and Dana are now joined by George, whose
production-possibilities curve is shown below. What is
the production-possibilities curve for the new economy
consisting of Chris, Dana, and George?

Shelter (sq yds/wk)

2 George's production
possibility curve

Food
1 (lbs/wk) 38
The Principle of Increasing Opportunity Cost (Also
called “The Low-Hanging-Fruit Principle”)
• 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.
For Chris, the opportunity cost of an additional sq yard of shelter is 2 pounds
of food per week.
For Dana, the opportunity cost of an additional sq yard of shelter is 1 pound
of food per week.
For George, the opportunity cost of an additional sq yard of shelter is 1/2
pound of food per week.

Start with everyone producing food.

If we want to increase the amount of shelter, we will be better off allocating
George to the task first. Then, start to use Dana only after George’s time is all
used up. Then, start to use Chris only after Dana’s time is all used up.
39
Production Possibilities in a Three-Person
Economy
Shelter
(sq yd/wk) Production Possibilities Curve:
12 All combinations of shelter
and food that can be produced
with the labor of Chris, Dana
and George.
6

12 16 17
Food (lb/wk)

Opportunity cost of producing 1 pound per week of food

George's = 2 sq yds/wk of shelter.
Chris's = 1/2 sq yd/wk of shelter
Dana's = 1 sq yd/wk of shelter 40
Production Possibilities in a Two-Person
Economy
• If the economy consisting of Chris, Dana, and George is
to produce 14 lbs/wk of food and 4 sq yds/wk of shelter,
how should each person's work time be allocated?

Shelter Chris: 0 sq yds/wk of shelter, 12 lbs/wk of food.

(sq yd/wk) Dana: 2 sq yds/wk of shelter, 2 lbs/wk of food.
12
George: 2 sq yds/wk of shelter, 0 lbs/wk of food.

6 production point

4
2

12 14 16 17
Food (lb/wk) 41
The Production Possibilities Curve for an
Economy with Many Workers
Food (lbs/wk)

Clothing (garments/wk)

Produce the initial units of clothing using the resources that

are relatively most efficient at clothing production, and only
then turn to those that are relatively less efficient at clothing
production.
42
 Economic Growth:
An Outward Shift in the Economy’s PPC

Factors Shifting the PPC

Coffee 1. Increases in productive resources
(1000s of lb/day) (i.e. labor or capital)
2. Improvements in knowledge and
New PPC
technology

Original PPC

Nuts
(1000s of lb/day)

43
Factors That Shift The Economy’s Production
Possibilities Curve
• Increasing Productive Resources
– Investment in new factories and equipment
– Population growth
• Improvements in knowledge and technology
– Increasing education
– Gains from specialization

44
How much does specialization matter?

45
How much does specialization matter? (I)
• George and Tom are mechanics.
• Tom can replace 15 clutches per day or 10 sets of brakes, i.e., the
opportunity cost of replacing a pair of brakes is 1.5 clutches;
• George can replace 10 clutches per day or 15 sets of brakes, i.e.,
the opportunity cost of replacing a pair of brakes is 2/3 clutches.

• At their garage, the number of brake replacements performed each

day is the same as the number of clutch replacements.

• How much more can they accomplish if they specialize than

if each performed an equal number of brake and clutch
replacements?

46
How much does specialization matter? (I)
o If he doesn’t specialize, George can replace only 6
clutches per day and 6 sets of brakes.

Clutch replace- George’s production

ments per day possibilities curve:
C = 10 - (2/3) B
10 George
Want equal number of both
6 types of jobs: C = B

Brake So write C = 10 – (2/3)C

0 6 15 replace- and solve for C = 6.
ments per
day

47
How much does specialization matter? (I)
o If Tom doesn’t specialize, he too can produce 6 jobs of
each type per day.
Clutch replace-
ments per day
Tom’s production
possibilities curve: 15
C = 15 - (3/2) B Tom
Want equal number of both 6
types of jobs: C = B

So write C = 15 – (3/2)C 0 Brake

and solve for C = 6.
6 10 replace-
ments per
day
48
How much does specialization matter? (I)
o By specializing, they can replace 15 clutches per day
(Tom) and 15 sets of brakes (George).

Clutch replacements/day
25

15

15 25
Brake replacements/day
49
How much does specialization matter? (I)
• So if neither George nor Tom specializes, the two can
produce a total of only 12 jobs of each type per day, .
• If they specialize, they can produce a total of 15 jobs
per day.

• A 25% increase in output isn’t bad,

– but cannot explain why industrialized countries
produce so much more than developing countries.

50
How much does specialization matter? (II)
• Gary and Eric are mechanics. Eric can replace 30 clutches per day
or 6 sets of brakes, i.e., the opportunity cost of replacing a pair of
brakes is 5 clutches.
• Gary can replace 6 clutches per day or 30 sets of brakes, i.e., the
opportunity cost of replacing a pair of brakes is 0.2 clutches.
• At their garage, the number of brake replacements performed each
day is the same as the number of clutch replacements.

• Note that the difference in opportunity cost (5 vs. 0.2) is larger than
that in what we had earlier (3/2 vs. 2/3).

• How much more can they accomplish if they specialize than

if each performed an equal number of brake and clutch
replacements?

51
How much does specialization matter? (II)
By specializing, they can
Clutch
replace- replace 30 clutches per
ments per day (Eric) and 30 sets of
day brakes (Gary)
36
30

Brake
0 30 36 replace-
ments
per day
52
How much does specialization matter? (II)
Clutch
replace-
If they don’t specialize, ments
per day
each can replace only
Clutch 30
5 clutches per day and replace-
5 sets of brakes, for a ments per
total of 10 daily day
replacements of each Tom
Eric
type. 6 George
Gary
5
5
0 5 30 0 56
Brake
Brake
replace-
replace-
ments
ments
per day
per day

53
How much does specialization matter? (II)
• By specializing, they can replace 30 clutches per day
(Eric) and 30 sets of brakes (Gary), i.e., 30 daily
replacement of each type.
• If they don’t specialize, each can replace only 5 clutches
per day and 5 sets of brakes, for a total of 10 daily
replacements of each type.
• The gain in output is 200%.

The gains from specialization are larger when differences

in opportunity cost are larger, and when individuals enjoy
absolute advantage in their respective specialties.
54
If we were to choose a team member …
o When we form a team, it is better we choose a team
member who has different strengths from ours so that
their presence might cover our weakness.

o In essence, we are choosing team members that will

allow us to gain the most from specialization.
o The gains from specialization are larger when
differences in opportunity cost are larger.

55
Comparative Advantage and International
Trade
• The same logic that leads the individuals in an economy
to specialize and exchange goods with one another also
leads nations to specialize and trade among themselves.

• As with individuals, each trading partner can benefit

from exchange, even though one may be more
productive than the other in absolute terms.

56
How does international trade expand
domestic consumption possibilities?
o Elizabeth and Dennis are the only two workers in
Islandia, a small island nation, and their production
possibilities curve is as shown.

Bananas
(lb/day)
In a closed economy,
120 consumption possibilities =
E
100 production possibilities

Tea
100 120 (lb/day)
57
How does international trade expand
domestic consumption possibilities?
• In the world market, tea can be purchased or sold at a
price of $2 per pound and bananas can be bought or
sold at a price of $1 per pound.

• How does the opportunity to trade in the world markets

for bananas and tea affect consumption opportunities in
Islandia?

58
How does international trade expand
domestic consumption possibilities?
o If Islandians specialized at the point E and sold all their
produce in the world market, they would earn
o 100x$2 +100x$1 = $300 per day.

Bananas
Producing at A, they can earn: 120x$1 = $120
(lb/day) Producing at B, they can earn: 120x$2 = $240
120 A
E
100

B Tea
100 120 (lb/day)
59
How does international trade expand
domestic consumption possibilities?
Bananas
They could buy as (lb/day)
many as 300 pounds of 300 F 1x300 + 2x0 = 300
bananas per day (point
F) or as many as 150
pounds per day of tea
(point G). Islandia
could also consume any 1x150 + 2x75 = 300
combination of tea and 120 E
bananas on the line FG. 100 1x100 + 2x100 = 300

In a open economy, 1x0 + 2x150 = 300

consumption possibilities > G
production possibilities Tea
100 150
120 (lb/day 60
Production mix and CPC
o Suppose tea can be purchases and sold at $6 per pound
and bananas at $1 per pound.

o What would be the best choice of production mix and

the CPC?

61
Factors That Shift The Economy’s Production
Possibilities Curve
• Why have countries like Nepal been so slow to
specialize?
– Low population density
– Isolation from the rest of the world

• Factors that may limit specialization in other countries

– Lack of a good legal system and law enforcement

62
Urbanization
o Suppose we move more people to live in cities, we will
expect …

63
Adam Smith
o “It is the maxim of every prudent master of a family never
to attempt to make at home what it will cost him more to
make than to buy. The tailor does not attempt to make his
own shoes, but buys them of the shoemaker. ….If a foreign
country can supply us with a commodity cheaper than we
ourselves can make it, better buy it of them with some part
of the produce of our own industry employed in a way in
which we have some advantage.”

64
Alan Blinder

"... one true test of whether a person is an economist is

how devoutly he or she lives by the principle of
comparative advantage."
--- Central Banking in Theory and Practice (1998, p.1)

http://en.wikipedia.org/wiki/Alan_Blinder
65
Additional reasons and benefits from trade
o Different preferences.
o Each prisoner of war received the same amount of
soaps and cigarette from the Red Cross.
o Yet, trade happened.

o Specialization → ↑ knowledge → ↑productivity

o Learning by doing

Additional readings:
Radford, R. A. (1945): “The Economic Organisation of a P.O.W. Camp,” Economica,
New Series, Vol. 12, No. 48 (Nov., 1945) (pp. 189-201)

66