In Day 2, we take the concept of opportunity cost a step further and define both absolute and compara;ve advantage.

Transcription

1 In Day 2, we take the concept of opportunity cost a step further and define both absolute and compara;ve advantage. 1

2 If you think it through, it makes sense. Imagine I can earn $30 by, say wri;ng and selling my lesson plans. Should I spend 5 hours of my life cleaning my house? If I do, I ve lost 5 hours of ;me in which I could have earned $150. I d be beger off hiring a cleaner they could get it done in just four hours at a cost of $20 an hour (or $80 total). I could spend $80 and free myself up to earn $150. Or.. I could do it myself and save $80 but at the cost of $150 in lost income. Clearly, I m beger off hiring the cleaner. However, if my ;me goes down to $15 an hour, I d be beger off doing it myself (5 hours at $15 an hour is $75 in lost wages versus the cost of $80 I d get for hiring the cleaner). 2

3 In my example, the cleaner has an absolute advantage over me in that they can clean the house faster than I can (4 hours versus five for me). But note, my decision to hire the cleaner occurred because the opportunity cost of cleaning the house myself ($150 in lost earnings) was beger than the $80 cost of hiring the cleaner. It had nothing to do with wheter or not the cleaner was faster than me it had everything to do with opportunity cost. 3

4 The person with the lower opportunity cost is said to have the compara;ve advantage and in making economic decisions, we should use compara;ve advantage and opportunity cost to guide us, not absolute advantage. 4

5 We can change the scenario to give a new person (my wife in this example) the absolute advantage regarding housework (she is faster than the cleaner). But given my wife s opportunity cost of her ;me, it s;ll makes more sense to go with the cleaner and their compara;ve advantage. 5

6 The table demonstrates the overall cost of each op;on. Note that the cleaner results in the lowest cost. For the cleaner, we assume their opportunity cost must be less than $20 an hour or they wouldn t be willing, as ra;onal people, to work for $20 an hour if they had beger-paying opportuni;es available. 6

7 Another example of compara;ve advantage. Even if Pam the lawyer was beger at secretarial work than Ann, it would s;ll make more sense for Pam to s;ck to lawyer work, as she gives up $150 an hour in earnings if she does anything else. Ann could be five ;mes slower on secretarial work than Pam and it would s;ll make sense for Pam to be the lawyer and Ann to be the secretary. 7

8 Here, we are going to introduce a very simple mode. Two men, Tom and Hank, share a desert island. The only two ac;vi;es possible are fishing or gathering coconuts. For Tom, if he does nothing but fish, he can gather 40 fish a day. If he only gathers coconuts, he can get 30. Or, he can get any possible combina;on of fish and coconuts along the line that connects 30 coconuts to 40 fish. The line is called the produc;on possibility fron;er. Any point along that line represents Tom using all his ;me (it is efficient ). Any point inside the line means that Tom isn t working as hard as he could be working (it is inefficient). Any point outside the line, is simply not possible. 8

9 Here is Hank s produc;on possibility graph. Note that Tom has an absolute advantage over Hank in both coconuts (30 over Hank s 20) and fish (40 over Hank s ten). 9

10 Since there are only two resources on the island, we can express the price of each resource in terms of the other. For Tom, every ;me he gets an extra fish, he is giving up the chance to get three-fourths of a coconut. Every ;me Tom gets an extra coconut, he is giving up four-thirds of a fish. Note that Tom gives up fewer poten;al coconuts to get an extra fish compared to Hank. We could say that Tom has a lower opportunity cost for fish or that Tom has the compara;ve advantage over Hank in fishing. Hank, on the other hand, has a lower opportunity cost and thus the compara;ve advantage in gathering coconuts. 10

11 We should follow the principle of compara;ve advantage and let the person with the compara;ve advantage gather the resource for which they have the lowest opportunity cost. This means fishing for Tom and gathering coconuts for Hank. 11

12 Following their compara;ve advantage and specializing in one resource, Tom and Hank can trade their surplus. This results in Tom (pictured here) being able to achieve consump;on that is outside (greater than) his produc;on possibility fron;er. 12

13 Wit Hank, the advantages are even bigger than were Tom s. Both Tom and Hank are demonstrably beger off through specializing through the principle of compara;ve advantage and then trading with each other. They achieve more through specializa;on and trading than they ever could alone. 13

14 Through specializa;on and trade, Tom and Hank gain access to 6 extra fish and 3 extra coconuts. We call this the gains from trade. 14