Power of Trade and

Comparative Advantage

Chen Zhao
University of Hong
Kong
The Basis of Exchange
• Why do people exchange goods and services in the first place?
• Why is Drake a rapper and J.K. Rowling a writer?

Drake J.K. Rowling

Why not do everything on our own?

• Should Donald Trump wash the dishes for his family?

– He certainly knows how to do it.

DISHES CLEAN
Why not do everything on our own?
grow our own food…
Why not do everything on our own?
milk our own cow…
Why not do everything on our own?
replace our own roofs…?

paint our own houses…

Why not do everything on our own?
o We can all have more of every good and service if we specialize in the
activities at which we are relatively most efficient.
Example: Basis for exchange
• Paul is a house painter and Ron is a roofer.
• Each of them wants his house painted and roof replaced.
• 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
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?
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.
Comparative advantage and opportunity cost

“To have a comparative advantage at a task”

“To have a lower opportunity cost of performing it”

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.

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.

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.
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.
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: one painting job/roofing job.

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?

o What is the range of ToT (painting job/roofing job) on which agreement is possible?

Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs
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?
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 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 housing, 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.
Principle of Comparative Advantage

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

Would any of them have been able to contribute to economics if each of

them were required to grow their own food, do their own household
chores, repair their own car, etc.?
Inferred from data
• Drake is a rapper and J.K. Rowling is a writer.

Drake J.K. Rowling

• It is very likely that Drake has the comparative advantage in producing Hip-Hop
music, J.K. Rowling in writing.
• Specialization makes “Hotline Bling” and Harry Potter possible.
Sources of Comparative Advantage

• Individual o National level

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

What can we do to change our comparative advantage?

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.
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)
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.
Production possibilities of Chris alone

A, B, C, D Attainable and efficient

E Attainable but inefficient
Shelter (sq yd/wk) F Unattainable
6 A

4 F
C
2 E D
B
0 4 8 12
Food (lb/wk)
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.
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.

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 and 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)
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 and 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)
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 and 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)
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
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.
The Low-Hanging-Fruit Principle
• In expanding the production of any good, employ resources with lower opportunity cost
first.

For Chris, the opportunity cost of an additional unit of food is 1/2 unit of shelter.

For Dana, the opportunity cost of an additional unit of food is 1 unit of shelter.

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 after Chris’s time is all used up.
The Low-Hanging-Fruit Principle
• In expanding the production of any good, employ resources with lower opportunity cost
first.

For Chris, the opportunity cost of an additional unit of shelter is 2 units of food.

For Dana, the opportunity cost of an additional unit of shelter is 1 unit of food.

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 after Dana’s time is all used up.
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)
The Low-Hanging-Fruit Principle
• In expanding the production of any good, employ resources with lower opportunity cost
first.

For Chris, the opportunity cost of an additional unit of shelter is 2 units of food.

For Dana, the opportunity cost of an additional unit of shelter is 1 unit of food.

For George, the opportunity cost of an additional unit of shelter is 1/2 unit of
food.
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 after George’s time is all used up.
Then, use Chris after Dana’s time is all used up.
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
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)
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.
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)
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
– Learning by doing
How much does specialization matter?
How much does specialization matter? (I)
• George and Tom are mechanics.
• Tom can replace 15 clutches per day or 10 sets of brakes:
the opportunity cost of replacing a set of brakes is 1.5 clutches.
• George can replace 10 clutches per day or 15 sets of brakes:
the opportunity cost of replacing a set of brakes is 2/3 clutches.

• Their garage provides full services, which includes replacing 1 clutch and 1 set of brakes.

• How much more full services can they accomplish if they specialize?
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
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
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
How much does specialization matter? (I)
• So if neither George nor Tom specializes, the two can produce a total of only
12 full services per day, .
• If they specialize, they can produce a total of 15 full services per day.

• A 25% increase in output isn’t bad,

– but cannot explain why industrialized countries produce so much more
than developing countries.
How much does specialization matter? (II)
• Gary and Eric are mechanics.
• Eric can replace 30 clutches per day or 6 sets of brakes:
the opportunity cost of replacing a set of brakes is 5 clutches.
• Gary can replace 6 clutches per day or 30 sets of brakes:
the opportunity cost of replacing a set of brakes is 0.2 clutches.

• How much more full services can they accomplish if they specialize?

• Note that the difference in opportunity cost (5 vs. 0.2) is larger than that the earlier case
(3/2 vs. 2/3).
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
How much does specialization matter? (II)
Clutch
replace-
If they don’t specialize, ments
each can replace only 5 per day
clutches per day and 5 Clutch 30
replace-
sets of brakes, for a total ments per
of 10 daily replacements day
of each type. Tom
George Eric
6 Gary
5
5
0 5 30 0 56
Brake
Brake
replace-
replace-
ments
ments
per day
per day
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 full services.
• If they don’t specialize, each can replace 5 clutches per day and 5 sets of
brakes, for a total of 10 full services.
• The gain in output is 200%.

The gains from specialization are larger when differences

in opportunity cost are larger.
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.
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.
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)
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?
How does international trade expand domestic consumption
possibilities?
o If Islandians specialize (produce at E) and sell all their produce in the world
market, each day they would earn
o $200 +$100 = $300.

Bananas
(lb/day)
120
E
100

Tea
100 120 (lb/day)
How does international trade expand domestic consumption
possibilities?
Bananas
Then, they could buy at most
(lb/day)
300 pounds of bananas (point
300 F 1x300 + 2x0 = 300
F) or at most 150 pounds of
tea (point G).

In fact, any combination of

tea and bananas on the line
1x150 + 2x75 = 300
FG is available.
120 E
In a open economy, 100 1x100 + 2x100 = 300
consumption possibilities >
production possibilities 1x0 + 2x150 = 300
G
Tea
100 150
120 (lb/day
Consumption Possibilities Curve (CPC)
o A graph that describes the maximum amount of one good that can be
consumed for every possible level of consumption of the other good.

o How to maximize consumption possibilities:

Step 1: Choose the production mix that generates the largest amount of
income.
Step 2: Spend all the income you earned.
Can we do better by producing differently?
Bananas
(lb/day)
The slope of CPC is 300 F 1x300 + 2x0 = 300
determined by the price
ratio.

It is the highest line

with the slope that 1x150 + 2x75 = 300
passes through PPC. 120 E
100 1x100 + 2x100 = 300

1x0 + 2x150 = 300

G
Tea
100 150
120 (lb/day
Production mix and CPC
o Suppose tea can be purchases and sold at $6 per pound and bananas at $1
per pound.
o Where is the CPC?
Bananas
(lb/day)
120
E
100

Tea
100 120 (lb/day)
Factors that May Limit Specialization
• Low population density
• Geographic Isolation
• Laws
• Customs
Factors that May Enhance Specialization
• Urbanization
• Difference in preferences
• Learning by doing
A Quote

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

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

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