Comparative Advantage: The Basis of Exchange

Transcription

1 Comparative Advantage: The Basis of Exchange 1 Exchange and Supply Basis for exchange Principle of comparative advantage Production possibilities curve Economic efficiency International trade 2 Page 1

2 Basis for Exchange Why do people trade? A difference in the comparative advantage (or marginal values to be precise) is a precondition for trade to be mutually beneficial. The exchange benefits the two parties just as much as if there had been a magical, costless increase in goods to the two people. The following analyses presume costs of transaction are negligible (this assumption will be relaxed later) 3 Example 2.1. 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 4 Page 2

3 Example 1 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? 5 Example 1: Basis for exchange Opportunity Cost for 1 Painting Opportunity Cost for 1 Roofing Paul 0.75 Roofing 1.33 Painting Ron 2 Roofing 0.5 Painting For Paul, the opportunity cost of painting one house = the number of roofing jobs he could do during the same time. So Paul s opportunity cost of painting a house is.75 roofing jobs (=300 hrs per painting/400 hrs per roofing). 6 Page 3

4 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 7 Example 1 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. 8 Page 4

5 Example 1 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. 9 Example 1: Basis for exchange Painting Roofing Paul 300 hrs 400 hrs Ron 200 hrs 100 hrs If each person performed both tasks for himself, the total time spent would be 700 hours for Paul and 300 hours for Ron. In contrast, when each specializes in his comparative advantage, these totals fall to 600 for Paul (300 hrs x 2 houses) and 200 for Ron (100hrs x 2 houses), a savings of 100 hours each. This is the gain from exchange. 10 Page 5

6 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. 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. 11 Sources of Comparative Advantage Individual Level Inborn talent Education Training Experience National Level Natural resources Cultural Institutions Non-economic Adoption of a language Institutions What can we do to change our comparative advantage? 12 Page 6

7 The Production Possibilities Curve A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good. 13 Production Possibilities Curve: One-person economy 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) Food (lb/wk) 14 Page 7

8 Production Possibilities Curve: One-person economy Production Possibilities Curve: All combinations of shelter and food that can be produced with Chris s labor. Shelter (sq yd/wk) Food (lb/wk) The absolute value of the slope of the production possibility curve is 6/12 = 1/2. For Chris, this means that the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter. 15 Production Possibilities Curve: One-person economy Shelter (sq yd/wk) A C E A, B, C, D Attainable and efficient E Attainable but inefficient F Unattainable F D Food (lb/wk) B 16 Page 8

9 Production Possibilities Curve: Two-person economy Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Dana is the only person in the economy, describe the economy's production possibilities curve. Shelter (sq yd/wk) 4 Production Possibilities Curve: All combinations of shelter and food that can be produced with Dana s labor. 2 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. 17 Production Possibilities Curve: 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, while Dana has a comparative advantage producing shelter. To maximize an economy output, let Chris specialize in producing food, while Dana in producing shelter. 18 Page 9

10 Production Possibilities Curve: Two-person economy To derive the economy's production possibilities curve, let Chris specialize in producing food until his full capacity is reached (i.e. 12 lb/wk of food). Then, let Dana produce food after that point. Similarly, Let Dana produce shelter first until her full capacity is reached (i.e. 4 sq yd/wk of shelter). Then, let Chris produce shelter after that point. Shelter (sq yd/wk) Food (lb/wk) 19 Production Possibilities Curve: 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) 10 Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food Food (lb/wk) 20 Page 10

11 Production Possibilities Curve: 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 Food (lb/wk) 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. So Chris will have to produce the additional 2 sq yd/wk for them to achieve the desired 6 sq yd/wk. 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. 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. 21 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. 22 Page 11

12 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. 23 Economic Growth: An Outward Shift in the Economy s PPC Coffee (1000s of lb/day) New PPC Factors Shifting the PPC 1. Increases in productive resources (i.e. labor or capital) 2. Improvements in knowledge and technology Original PPC Nuts (1000s of lb/day) 24 Page 12

13 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 25 Factors That Shift The Economy s Production Possibilities Curve Why Have Countries Like Nepal Been So Slow to Specialize? Low population density Isolation Factors that may limit specialization in other countries Laws Customs 26 Page 13

14 Gains from specialization will often be far more spectacular! Division of labor according to talent and temperament Learning by doing Specialized capital equipment 27 Adam Smith on specialization: 28 Page 14

15 Adam Smith on specialization: One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations... I have seen a small manufactory of this kind where only ten men were employed... [who] could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day Too much specialization? Specialization boosts productivity, but it also entails costs. Variety is one of the first casualties. 30 Page 15

16 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. David Ricardo ( ) As with individuals, each trading partner can benefit from exchange, even though one may be more productive than the other in absolute terms. 31 Food for thought If trade between nations is so beneficial, why is free trade so controversial? 32 Page 16