Comparative
Advantage
Why trade makes everyone better off
REVIEW
1. Explain how you would use the concept of
opportunity cost in everyday life.
2. Differentiate between increasing and constant
opportunity cost PPCs
3. Explain why the Law of Increasing Opportunity
Cost occurs.
4. Explain how you calculate PER UNIT opportunity
cost.
5. Explain difference between productive and
allocative efficiency on the PPC
6. Identify the 2 Shifters of the PPC
7. Give 2 SPECIFIC scenarios that would shift a
PPC outward (Use Pizza and Robots)
8. List 10 types of Soda
Objectives
•
Define absolute advantage and comparative advantage.
•
Explain why comparative advantage, rather than absolute
advantage, is the key to trade.
•
Define specialization and exchange.
•
Explain how both parties in a trade gain from voluntary exchange.
•
Understand two different approaches to determining comparative
advantage: the input method and the output method.
•
Analyze data to determine which party has the absolute and
comparative advantages in different products.
4
Absolute Advantage
The ability to produce
a good using fewer
resources than another
producer (or the ability
to produce more goods
with the same
resources)
5
What if…
Danny can type 120 wpm
with 0 errors, while Ben can
type 60 wpm with 0 errors
Who has the absolute
advantage in typing?
How do you know?
6
Comparative Advantage
the ability to produce a good
at a lower opportunity cost
much more important than
absolute advantage
Trade based on comparative
advantage increases
consumption possibilities
David Ricardo
7
Absolute and Comparative Advantage
Absolute Advantage
•The producer that can produce the most output OR
requires the least amount of inputs (resources)
•Ex: Papa John has an absolute advantage in pizzas
because he can produce 100 and Ronald can only make 20.
Comparative Advantage
•The producer with the lowest opportunity cost.
•Ex: Ronald has a comparative advantage in burgers
because he has a lowest PER UNIT opportunity cost.
Countries should trade if they have a
relatively lower opportunity cost
They should specialize in the good that is “cheaper” for
them to produce
Copyright
ACDC Leadership 2015
8
I forgot to tell you…
Danny is a lawyer who earns $120/hour (types 120 wpm)
Ben is a security guard who earns $12/hour (types 60 wpm)
A 600-word document must be typed
How long will it take each to type the document?
Who should type the document?
Why?
9
Let’s assume
Given the Same Resources & Technology
Bananas
Nails
New Zealand
1000
4000
Ghana
600
800
Which country has the absolute advantage in
the production of bananas? Explain.
Which country has the absolute advantage in
the production of nails? Explain.
10
Can New Zealand possibly benefit from
trade with Ghana?
Yes!
All gains from trade are based on comparative
advantage
Unless trade partners have exactly the same opportunity
costs, each will have a comparative advantage in the
production of some good or service
11
New Zealand’s PPC
4000
Nails
3000
2000
1000
0
0
250
500
Bananas
750
1000
Ghana’s PPC
PPC
600
Nails
450
300
150
0
0
200
400
Bananas
13
600
800
So, the more important
questions are…
Given the Same Resources & Technology
Bananas
Nails
New Zealand
1000
4000
Ghana
600
800
Which country has the comparative advantage
in bananas? Explain.
Which country has the comparative advantage
in nails? Explain.
14
Basic Rules
A nation should export goods for which it has a
comparative advantage
A nation should import goods for which it does not have
a comparative advantage (goods for which it is at a
comparative disadvantage)
15
Sticking with our example..
Which country should export bananas? Which
country should import bananas? Why?
Which country should export nails? Which
country should import nails? Why?
16
Terms of Trade
Partners will trade as long
as the “price’ of the good
each partner is obtaining
from trade is less than the
opportunity cost of
producing the good itself
“good terms of trade”
benefit both parties
17
Sticking with our Example
Would Ghana buy 1 nail from New Zealand at a
cost of 1 banana per nail? Explain.
So, what should Ghana charge New Zealand for
bananas so that both benefit?
18
Let’s also assume…
Ghana specializes in bananas and New Zealand
specializes in nails.
Ghana keeps 300 bananas for itself and trades the other
300 to New Zealand at a rate of 2 nails per banana.
What does each nation end up with?
How can we tell that each nation benefited?
19
Before & After Trade
Without Trade
With Trade
Production Consumption
Gains
Production
Consumption
Bananas
300
300
600
300
+/-0
Nails
400
400
0
600
+200
Bananas
200
200
0
300
+100
Nails
3200
3200
4000
3400
+200
G
NZ
20
Ghana’s PPC
PPC
800
Nails
600
400
200
0
0
150
300
450
Bananas
21
600
New Zealand’s PPC
PPC
4000
Nails
3000
2000
1000
0
0
250
500
750
Bananas
22
1000
Handout 1 Cheat Sheet
Jean-Baptiste Say
Partner
Overview of Solution to
Comparative Advantage Problem
1. Determine absolute advantage
2. Determine comparative advantage
A. Is it an input or an output problem?
B. Set up the table properly
C. Perform the math (remember input vs. output)
D. Determine who has comparative advantage
E. Determine acceptable terms of trade (if asked)
F. Know who should import/export which goods/services.
It’s like magic!
This is true for individuals,
firms, and whole economies!
This is why economists
generally oppose trade
restrictions!
International trade makes
countries better off, but
doesn’t necessarily make all
individuals better off.
26
Complete the Statement
Specialization and trade can improve/increase….
Gains from trade are based entirely on….
Nations should import goods for which they have….
Good terms of trade must….
27
More handouts practice in class
Practice
Given the Same Resources & Technology
Capes
Masks
Gotham City
1500
500
Metropolis
400
1600
Which city should specialize in capes? Why?
Which city should import masks? Why?
Would 1 cape for 5 masks be good terms of trade? Explain.
29
Pineapples
Radios
Kenya
30
10
India
40
40
1. Who has an absolute advantage in Radios?
2. What is the cost of one radio for India?
3. What is the per unit opportunity cost for 1
pineapple for Kenya?
4. Who has a comparative advantage in pineapples?
5. Who has a comparative advantage in radios?
6. Who should import pineapples?
7. Trading 1 radio for how many pineapples would
benefit both countries?
Copyright
ACDC Leadership 2015
Pineapples
Kenya
India
Radios
30(1P costs 1/3R) 10 (1R costs 3 P)
40 (1P costs 1R)
40 (1R costs 1P)
Kenya wants Radios
If the terms of trade for 1 radio is greater than 3
pineapples then Kenya is worse off and should make
radios on their own.
India wants Pineapples
If the terms of trade for 1 radio is less than 1
pineapple then India is worse off and should make
pineapples on their own.
What terms of trade benefit both countries?
Copyright
ACDC Leadership 2015