Power of Trade and Comparative Advantage Kafu Wong

Power of Trade and Comparative Advantage Ka-fu Wong University of Hong Kong 1

The Basis of Exchange o Why do people exchange goods and services in the first place? o Why is Kam-po WONG (Chinese: 黃金寶) a racing cyclist, Ka-fu WONG an instructor in a university, and Thomas FRIEDMAN a prominent writer? Kam-po WONG Ka-fu WONG Thomas FRIEDMAN 2

Why not do everything on our own? o Should Ms. Wu Yi do her own household chores? o Wú Yí (吴仪 or 吳儀) was one of four vicepremiers of the State Council of the People's Republic of China from 2003 - 2008. In 2007, Forbes magazine considers her the second most powerful woman in the world. o She knows how to do household chores. Brief description and picture taken from http: //en. wikipedia. org/wiki/Wu_Yi 3

Why not do everything on our own? Grow our own food… 4

Why not do everything on our own? replace our own roofs…? …paint our own houses… 5

Why not do everything on our own? We can all have more of every good and service if we specialize in the activities at which we are relatively most efficient. 6

Example: Basis for exchange o Paul is a house painter whose roof needs replacing. Ron is a roofer whose house needs painting. o Although Paul is a painter, he also knows how to install roofing. Ron, for his part, knows how to paint houses. o Should Paul roof his own house? Should Ron paint his own house? Paul Ron 7

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? 8

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. 9

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” 10

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. 11

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. 12

Example: Basis for exchange o Paul’s opportunity cost of painting a house is. 75 roofing jobs. o Ron’s opportunity cost of painting a house is 2 roofing jobs. o Paul thus has a comparative advantage at painting, because his opportunity cost of painting is lower than Ron’s. o Therefore it makes sense for Paul to do both painting jobs and leave both roofing jobs for Ron. 13

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. 14

Term of Trade (To. T) 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. 15

Term of Trade o Paul and Ron each has one painting job and one roofing job to do. When To. T is 1, specialization with trade will allow them to save 100 hours each. o Will they agree to exchange if the To. T is o 2. 0 painting job/roofing job? 16

Term of Trade o Paul and Ron each has one painting job and one roofing job to do. When To. T is 1, specialization with trade will allow them to save 100 hours each. o How many hours would each save if the To. T is o 1. 1 painting job/roofing job? 17

Principle of Comparative Advantage o Everyone does best when each person (or country) concentrates on the activities in which he or she is relatively most efficient. o “Concentrates on the activities in which he or she is relatively most efficient” means specialization. o Specialization by comparative advantage provides the rationale for market exchange. o 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…. o 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. 18

Principle of Comparative Advantage http: //www. nobelprize. org/nobel_prizes/economic-sciences/laureates/ Would any of them have been able to contribute so much to economic sciences if each of them were required to grow their own food, do their own household chores, repair their own car, etc. ? 19

Revealed from data o Kam-po WONG (Chinese: 黃金寶) is a racing cyclist, Kafu WONG is an instructor in a university, and Thomas FRIEDMAN is a prominent writer. Kam-po WONG Ka-fu WONG Thomas FRIEDMAN o It must be the case that Kam-po has the comparative advantage in race cycling, Ka-fu in teaching, Thomas in writing. 20

What if … o Kam-po WONG (Chinese: 黃金寶) is a racing cyclist and Thomas FRIEDMAN is a prominent writer. Kam-po WONG Thomas FRIEDMAN o If we made Thomas a race cyclist and Kam-po a writer, Thomas would produce less wins in cycling races and Kam-po will be writing less exciting books. As a whole, the society will be worse off. 21

Sources of Comparative Advantage o Individual o Inborn talent o Education o Training o Experience o National level o Natural resources o Cultural o Institutions o Non-economic o Adoption of a language o Institutions What can we do to change our comparative advantage? 22

The Production Possibilities Curve (PPC) o A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good. 23

Production possibilities of Chris alone o Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. o If Chris is the only person in the economy, describe the economy's production possibilities curve. 24

Production possibilities of Chris alone Production Possibilities Curve: All combinations of shelter and food that can be produced with Chris’s labor. 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. 25

Production possibilities of Chris alone A, B, C, D E Attainable and efficient Attainable but inefficient Unattainable F A F C E D B 26

Production possibilities of Dana alone o 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 with Dana’s labor. 4 2 2 4 Food (lb/wk) For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter. 27

Production Possibilities in a Two-Person Economy o For Chris, the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter. o For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter. o 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. o By the same token, Dana has a comparative advantage producing shelter. 28

Production Possibilities in a Two-Person Economy o 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) 29

Production Possibilities in a Two-Person Economy o 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) 30

Production Possibilities in a Two-Person Economy o 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) 31

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 shelter; Chris works 1/3 week on shelter, 2/3 week on food. 10 6 4 8 12 16 Food (lb/wk) 32

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 8 12 16 Food (lb/wk) 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. 33

The Principle of Increasing Opportunity Cost (Also called “The Low-Hanging-Fruit Principle”) o 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. For Chris, the opportunity cost of an additional pound of food each week is 1/2 sq yard of shelter per week. For Dana, the opportunity cost of an additional pound of food each week is 1 sq yard of shelter per week. 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 only after Chris’s time is all used up. 34

The Principle of Increasing Opportunity Cost (Also called “The Low-Hanging-Fruit Principle”) o 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. For Chris, the opportunity cost of an additional sq yard of shelter is 2 pounds of food per week. For Dana, the opportunity cost of an additional sq yard of shelter is 1 pound of food per week. 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 only after Dana’s time is all used up. 35

Production Possibilities in a Three-Person Economy o 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? 36

The Principle of Increasing Opportunity Cost (Also called “The Low-Hanging-Fruit Principle”) o 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. For Chris, the opportunity cost of an additional sq yard of shelter is 2 pounds of food per week. For Dana, the opportunity cost of an additional sq yard of shelter is 1 pound of food per week. For George, the opportunity cost of an additional sq yard of shelter is 1/2 pound of food per week. 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 only after George’s time is all used up. Then, start to use Chris only after Dana’s time is all used up. 37

Production Possibilities in a Three-Person Economy 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 38

Production Possibilities in a Two-Person Economy o 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? Chris: 0 sq yds/wk of shelter, 12 lbs/wk of food. Dana: 2 sq yds/wk of shelter, 2 lbs/wk of food. George: 2 sq yds/wk of shelter, 0 lbs/wk of food. 39

The Production Possibilities Curve for an Economy with Many Workers 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. 40

Economic Growth: An Outward Shift in the Economy’s PPC Factors Shifting the PPC Coffee (1000 s of lb/day) 1. Increases in productive resources (i. e. labor or capital) New PPC 2. Improvements in knowledge and technology Original PPC Nuts (1000 s of lb/day) 41

Factors That Shift The Economy’s Production Possibilities Curve o Increasing Productive Resources o Investment in new factories and equipment o Population growth o Improvements in knowledge and technology o Increasing education o Gains from specialization 42

How much does specialization matter? 43

How much does specialization matter? (I) o George and Tom are mechanics. o Tom can replace 15 clutches per day or 10 sets of brakes, i. e. , the opportunity cost of replacing a pair of brakes is 1. 5 clutches; o George can replace 10 clutches per day or 15 sets of brakes, i. e. , the opportunity cost of replacing a pair of brakes is 2/3 clutches. o At their garage, the number of brake replacements performed each day is the same as the number of clutch replacements. o How much more can they accomplish if they specialize than if each performed an equal number of brake and clutch replacements? 44

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. George’s production possibilities curve: C = 10 - (2/3) B Want equal number of both types of jobs: C = B So write C = 10 – (2/3)C and solve for C = 6. 45

How much does specialization matter? (I) o If Tom doesn’t specialize, he too can produce 6 jobs of each type per day. Tom’s production possibilities curve: C = 15 - (3/2) B Want equal number of both types of jobs: C = B So write C = 15 – (3/2)C and solve for C = 6. 46

How much does specialization matter? (I) o By specializing, they can replace 15 clutches per day (Tom) and 15 sets of brakes (George). 47

How much does specialization matter? (I) o So if neither George nor Tom specializes, the two can produce a total of only 12 jobs of each type per day, . o If they specialize, they can produce a total of 15 jobs per day. o A 25% increase in output isn’t bad, o but cannot explain why industrialized countries produce so much more than developing countries. 48

How much does specialization matter? (II) o Gary and Eric are mechanics. Eric can replace 30 clutches per day or 6 sets of brakes, i. e. , the opportunity cost of replacing a pair of brakes is 5 clutches. o Gary can replace 6 clutches per day or 30 sets of brakes, i. e. , the opportunity cost of replacing a pair of brakes is 0. 2 clutches. o At their garage, the number of brake replacements performed each day is the same as the number of clutch replacements. o Note that the difference in opportunity cost (5 vs. 0. 2) is larger than that in what we had earlier (3/2 vs. 2/3). o How much more can they accomplish if they specialize than if each performed an equal number of brake and clutch replacements? 49

How much does specialization matter? (II) By specializing, they can replace 30 clutches per day (Eric) and 30 sets of brakes (Gary) 50

How much does specialization matter? (II) If they don’t specialize, each can replace only 5 clutches per day and 5 sets of brakes, for a total of 10 daily replacements of each type. Gary Eric 51

How much does specialization matter? (II) o By specializing, they can replace 30 clutches per day (Eric) and 30 sets of brakes (Gary), i. e. , 30 daily replacement of each type. o If they don’t specialize, each can replace only 5 clutches per day and 5 sets of brakes, for a total of 10 daily replacements of each type. o The gain in output is 200%. The gains from specialization are larger when differences in opportunity cost are larger, and when individuals enjoy absolute advantage in their respective specialties. 52

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. 53

Comparative Advantage and International Trade o 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. o As with individuals, each trading partner can benefit from exchange, even though one may be more productive than the other in absolute terms. 54

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. In a closed economy, consumption possibilities = production possibilities 55

How does international trade expand domestic consumption possibilities? o 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. o How does the opportunity to trade in the world markets for bananas and tea affect consumption opportunities in Islandia? 56

How does international trade expand domestic consumption possibilities? o If Islandians specialized at the point E and sold all their produce in the world market, they would earn o $200 +$100 = $300 per day. 57

How does international trade expand domestic consumption possibilities? They could buy as many as 300 pounds of bananas per day (point F) or as many as 150 pounds per day of tea (point G). Islandia could also consume any combination of tea and bananas on the line FG. In a open economy, consumption possibilities > production possibilities 58 1 x 300 + 2 x 0 = 300 1 x 150 + 2 x 75 = 300 1 x 100 + 2 x 100 = 300 1 x 0 + 2 x 150 = 300

Production mix and CPC o Suppose tea can be purchases and sold at $6 per pound and bananas at $1 per pound. o What would be the best choice of production mix and the CPC? 59

Factors That Shift The Economy’s Production Possibilities Curve o Why Have Countries Like Nepal Been So Slow to Specialize? o Low population density o Isolation from the rest of the world o Factors that may limit specialization in other countries o Laws o Customs 60

Urbanization o Suppose we move more people to live in cities, we will expect … 61

Adam Smith o “It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. …. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. ” 62

Alan Blinder ". . . one true test of whether a person is an economist is how devoutly he or she lives by the principle of comparative advantage. " --- Central Banking in Theory and Practice (1998, p. 1) http: //en. wikipedia. org/wiki/Alan_Blinder 63

Additional reasons and benefits from trade o Different preferences. o Each prisoner of war received the same amount of soaps and cigarette from the Red Cross. o Specialization → ↑ knowledge → ↑productivity o Learning by doing Additional readings: Radford, R. A. (1945): “The Economic Organisation of a P. O. W. Camp, ” Economica, New Series, Vol. 12, No. 48 (Nov. , 1945) (pp. 189 -201) 64