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Comparative Advantage

The document discusses comparative advantage and how trade allows countries and individuals to specialize in goods and services where they have a comparative advantage. This leads to increased production possibilities and gains from trade. Comparative advantage depends on opportunity costs rather than absolute levels of productivity and everyone can benefit from trade by specializing in their comparative advantage.

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Manjeet Chauhan
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89 views

Comparative Advantage

The document discusses comparative advantage and how trade allows countries and individuals to specialize in goods and services where they have a comparative advantage. This leads to increased production possibilities and gains from trade. Comparative advantage depends on opportunity costs rather than absolute levels of productivity and everyone can benefit from trade by specializing in their comparative advantage.

Uploaded by

Manjeet Chauhan
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Comparative Advantage

Chapter 2-2

Trade and Comparative


Advantage
The

production possibility curve is


bowed because individuals specialize
in the production of goods for which
they have a comparative advantage
and trade with others.

Trade and Comparative


Advantage
To

produce on the production


possibilities curve, individuals must
produce those goods for which they
have a comparative advantage.

Trade and Comparative


Advantage
Adam

Smith argued that humankinds


proclivity to trade leads to individuals
using their comparative advantage.

Markets, Specialization, and


Growth
The

growth in per capita income in


the past two millennia has been
astonishing.
This owes largely to the introduction
of markets and democracy.

Markets, Specialization, and


Growth
Markets

allow specialization, leading


to trade and growth.

Markets, Specialization, and


Growth
As

people are allowed to compete and


specialize, they get better at what
they do, develop new technologies,
and the market grows ever larger.

Per capita income


(in 1990 international dollars)

Growth in the Past Two


Millennia
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
0
McGraw-Hill/Irwin

500

1000

1500

2000

2004 The McGraw-Hill Companies, Inc., All


Rights Reserved.

The Benefits of Trade


When

people trade, both parties


expect to benefit from the trade.
Otherwise, why would they have
traded in the first place?

The Benefits of Trade


The

argument for the benefits of


trade underlies the general policy of
laissez-faire.
Laissez-faire

an economic policy of
leaving coordination of individuals
actions to the market.

Production Possibilities
without Trade
Pakistan

can produce 4,000 yards of


textile per day or 1 ton of chocolate
per day.
Belgium can produce 1,000 yards of
textile a day or 4 tons of chocolate
per day.

Production Possibilities
without Trade
Pakistan

has a comparative
advantage in producing textiles.

Belgium

has a comparative
advantage in chocolate.

Textiles
(in thousands of yards)

Production Possibilities
without Trade
5
4

Pakistan

3
2

Belgium

1
1

McGraw-Hill/Irwin

Chocolate (in tons)

2004 The McGraw-Hill Companies, Inc., All


Rights Reserved.

Production Possibilities
without Trade
Pakistan

has chosen to produce 2,000


yards of textiles and 0.5 tons of
chocolate.
Belgium has chosen to produce 500
yards of textile and 2 tons of
chocolate.

Production Possibilities
without Trade
Point

A: The combination of textile


and chocolate chosen by Pakistan.

Point

B: The combination of textile


and chocolate chosen by Belgium.
Point C: The joint combination
without trade.

Production Possibilities
without Trade

Textiles
(in thousands of yards)

Production Possibilities
without Trade
5
4
Pakistan

3
2

Belgium
B

1
1

McGraw-Hill/Irwin

Chocolate (in tons)

2004 The McGraw-Hill Companies, Inc., All


Rights Reserved.

Production Possibilities
without Trade
The

two extreme combinations are


both countries producing only
textile (point D) and both
producing only chocolate (point E).

The

combined production possibilities


curve with no trade is drawn by
connecting these two points.

Textiles
(in thousands of yards)

Production Possibilities
without Trade
5

4
Pakistan

3
2

Belgium
B

1
1

McGraw-Hill/Irwin

Joint (no trade)

Chocolate (in tons)

E
5

2004 The McGraw-Hill Companies, Inc., All


Rights Reserved.

Production Possibilities with


Trade
Point

F: This is where each nation is


focusing on that activity for which it
has a comparative advantage.
Pakistan

produces 4,000 yards of textile.


Belgium produces 4 tons of chocolate.

Production Possibilities with


Trade
Combined Production Possibilities
No Trade
Fabric
Chocolate

Specializing
and Trade

Gains to
Trade

2,500 yards 4,000 yards 1,500 yards


2.5 Tons

4 tons

1.5 Tons

Textiles
(in thousands of yards)

Production Possibilities with


Trade
5

Gains from trade


Joint (with trade)
F

4
3

Joint (no trade)

2
1
1

McGraw-Hill/Irwin

Chocolate (in tons)

E
5

2004 The McGraw-Hill Companies, Inc., All


Rights Reserved.

Production Possibilities with


Trade
The

combined PPC is bowed out


because of Point F comparative
advantage and specialization.

U.S. Textile Production and


Trade
Two

hundred yeas ago, the U.S had a


comparative advantage in textile
production.
Now, countries with cheaper labor,
such as Bangladesh have the
comparative advantage in textile
production.

U.S. Textile Production and


Trade
The

gains from trade show up as


higher pay for workers in Bangladesh
and lower-priced cloth for U.S.
consumers.

Comparative Advantage and Gains from


Trade

Comparative Advantage and


Gains from Trade

Tom and Hanks Opportunity


Costs of Fish and Coconuts
Toms
Hanks
Opportun Opportuni
ity Cost
ty Cost
One
fish

3/4
coconut

One
cocon 4/3 fish
ut

2 coconuts

1/2 fish

Specialize and Trade


Both

castaways are better off when they


each specialize in what they are good at and
trade.

Its

a good idea for Tom to catch the fish for


both of them, because his opportunity cost of
a fish in terms of coconuts not gathered is
only 34 of a coconut, versus 2 coconuts for
Hank.

Correspondingly,

its a good idea for Hank to


gather coconuts for the both of them.

Comparative Advantage and


Gains from Trade

Comparative Advantage and


Gains from Trade

How the Castaways Gain


from Trade

Both Tom and Hank experience gains from trade:


Toms consumption of fish increases by two,
and his consumption of coconuts increases by
one.
Hanks consumption of fish increases by
four, and his consumption of coconuts
increases by two.

Comparative vs. Absolute


Advantage
An

individual has a comparative


advantage in producing a good or service if
the opportunity cost of producing the good is
lower for that individual than
for other people.
An

individual has an absolute advantage


in an activity if he or she can do it better
than other people. Having an absolute
advantage is not the same thing as having a
comparative advantage.

Tom vs. HankAbsolute vs.


Comparative
Tom

has an absolute advantage in both activities:


he can produce more output with a given amount of
input (in this case, his time) than Hank.
But weve just seen that Tom can indeed benefit
from a deal with Hank because comparative, not
absolute, advantage is the basis for mutual gain.
So Hank, despite his absolute disadvantage, even in
coconuts, has a comparative advantage in coconut
gathering.
Meanwhile Tom, who can use his time better by
catching fish, has a comparative disadvantage in
coconut-gathering.

Comparative Advantage and


International Trade (Ex.: The
U.S. Economy)

Comparative Advantage and


International Trade (Ex.: The
Canadian Economy)

PITFALLS: Misunderstanding
Comparative Advantage

A common mistake is to confuse comparative


advantage with absolute advantage.
Ex.: U.S. vs. Japan in 1980s
Commentators: U.S. might soon
have no comparative advantage in
anything
Wrong! They meant absolute
advantage

Summing up
Specialization

leads to higher

production
Everyone has different Opportunity
costs, everyone has comparative
advantage/disadvantage in
something.
It is comparative and not absolute
advantage the basis for mutual gain.

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