ECO202: Principles of Macroeconomics

Chapter 2: Comparative Advantage

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 Learning Objectives: Understand

1. The Principle of Comparative Advantage

2. The role of comparative advantage in

international trade

3. Factors that shift the menu of production

possibilities

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 Introduction

 There are two basic ways that people can satisfy their
wants. The first is to be economically self-sufficient.
The second is to specialize in the production of one
thing and then trade with others.
 With rare exceptions, individuals and nations tend to
rely on specialization and trade. This chapter
considers the reasons for economic interdependence.
What exactly do people gain when they trade with one
another? Why do people choose to become
interdependent?
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 An Example

 Two tasks – cooking and laundry and two people – Monica

(a cook) and Rachel (a waitress), who both like to eat and to
wear clean and ironed clothes.
– The gains from trade are obvious if Monica can only cook
and Rachel can only do laundry.
– The gains from trade are also fairly obvious if Rachel and
Monica are capable of doing the other task, but only at great
effort. Then specialization and trade can benefit both.
– Gains from trade are less obvious if one person is better than
the other person at doing both tasks.

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 Production Advantages

 Definitions
 Absolute advantage
 Lowest production cost
 one person has an absolute advantage over another if he or
she takes fewer hours (resources) to perform a task than the
other person

 Comparative advantage
 Lower opportunity cost than someone else
 one person has a comparative advantage over another if his or
her opportunity cost of performing a task is lower than the
other person’s opportunity cost

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 The Principle of Comparative Advantage

The Principle of Comparative Advantage

Everyone does best when each concentrates
on the activity with the lowest opportunity cost

Opens doors for specialization  have you ever met an

engineer who is also a medical doctor? Or a mechanic who
is also a professor?  defines the basis for trade among
people and countries

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 The Principle of Comparative Advantage

 Two parties have different opportunity costs

for two activities
 Concentrate on the activities of your lowest
opportunity cost
 Identify the task with which the person or country
has a comparative advantage in
 Total value of output increases with specialization
• By specializing on producing tasks with which a person or a
country has a comparative advantage, the opportunity for trade
exists

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 Sources of Comparative Advantage

 Where does comparative advantage come from?

 At the individual level
 Talent
• Education, training and experience
 At the national level
 Natural resources
 Cultures or societal norms
• Languages
• Institutions
- Value placed on craftsmanship
- Support for entrepreneurship

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 An Example

 Two goods - lamb and rice; and two people - a

sheep farmer and a rice farmer (each of whom likes
to consume both rice and lamb).
 Production Possibilities
 The rice farmer and the sheep farmer both work
eight hours per day and can use this time to grow
rice, raise sheep, or both.
 Table below shows the amount of time each takes
to produce one kilogram of either good:

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 Example

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 PPCs

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 PPC and Opportunity Cost

 Note that these production possibilities frontiers represent the

farmer’s and the rancher’s consumption possibilities because
we are assuming that there is no trade.
 Suppose the sheep farmer suggests that the rice farmer
specialize in the production of rice and then trade with the
sheep farmer for lamb.
 The sheep farmer will spend six hours a day producing lamb
(18 kg) and two hours a day growing rice (12 kg).
 The rice farmer will spend eight hours a day growing rice (32
kg).
 The sheep farmer will trade 5 kg of lamb for 15 kg of rice.
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 Gains From Trade

In both cases, they are able to consume quantities

of rice and lamb after the trade that they could not
reach before the trade.

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 Gains from Specialization and Trade

 Without trade, each person can consume

along his production possibilities curve
 What you produce determines what you
consume
 With trade, each person's consumption can
be greater than production
 Produce according to comparative advantage
 Trade to get what you want

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 Should Roger Federer Wash His Own Car?

 Imagine that Federer can wash his car faster than anyone else can.
 This implies that he has an absolute advantage.
 Suppose that it takes him two hours to wash his car. In that same two
hours, he could film a commercial for which he would earn $20,000.
This means that the opportunity cost of washing his car is $20,000.
 It is likely that someone else would have a lower opportunity cost of
washing Federer’s car; this individual would have a comparative
advantage.
 Both he and the person hired will be better off as long as he pays the
individual more than the individual’s opportunity cost and less than
$20,000.

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 The Dynamic Economy

 What shifts the PPC?

A PPC represents current choices
 Changes in choices occur over time due to
• More resources
- Investment in capital
- Population growth
• Improvements in technology
- More specialization: start-up and switching costs
• Increases in knowledge

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 Some Countries Resist Specialization

 Specialization is easier when

 Population density passes a threshold
 Markets are connected
 Transportation for goods
 Communications for services
 Legal framework supports business
 Financial markets enable start-ups

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 Too Much Specialization?

 Imagine this:
 Your hair stylist only cuts blonde hair
 A professor for each chapter!
 Seven bookstores, each open a different day of
the week
 A grocery store for every type of food

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 Comparative Advantage and International
Trade

 Principle of Comparative Advantage and

gains from trade apply worldwide
 Potentially large gains from trading with
different and distant countries
 “Controversial” trade
 Benefits the society broadly
 Costs are concentrated
 Some industries
 People who lose their jobs
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 Comparative Advantage and International
Trade

 Despite some concentrated losses, in general, free trade

is a welfare expanding activity. Why? Because by
taking advantage of specialization and trade, a country
stops wasting national resources in relatively
unproductive sectors and industries.
 This means that even if a small group of producers and
their employees are hurt by free trade and competition,
this loss, in general, is more than offset by the gains
consumers experience due to lower prices, better
quality and less wasting of national resources overall.
That is, free trade makes total economic “pie” bigger.
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 Comparative Advantage and International
Trade

 However, often those producers are very successful in

lobbying for national laws to limit free trade and
competition from abroad. Why?
 Because the benefits of protectionism are highly
concentrated and visible, but the benefits of free trade are
wide-spread, and thus less visible.
 In other words, unfortunately, in many countries where a
small number of special interest groups is able to exercise
its huge influence, “complete free trade is not politically
feasible. Why? Because it's only in the general interest
and in no one's special interest.” (Milton Friedman)
  
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