Say what now COMPARATIVE ADVANTAGE Comparative Advantage and

Say what now? COMPARATIVE ADVANTAGE

Comparative Advantage and Trade • In a market economy, individuals engage in trade; they provide goods and services to others and receive goods and services in return. • There are gains from trade: people can get more of what they want through trade than they could if they tried to be self-sufficient. This increase in output is due to specialization: each person specializes in the task that he or she is good at performing.

Adam Smith, Wealth of Nations, 1776 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 taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. Absolute Advantage 3

Adam Smith: Wealth of Nations • The economy, as a whole, can produce more when each person specializes in a task and trades with others.

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

David Ricardo, On the Principle of Political Economy and Taxation, 1817 Two men can both make shoes and hats, and one is superior to the other in both employments; but in making hats, he can only exceed his competitor by one-fifth or 20 percent, and in making shoes he can excel him by one-third or 33 percent; --will it not be for the interest of both that the superior man should employ himself exclusively in making shoes, and the inferior man in making hats? Comparative Advantage 6

• This model has provided a clear illustration of the gains from trade. • As long as people have different opportunity costs, everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something. • An individual has an absolute advantage in producing a good or service if he or she can make more of it with a given amount of time and resources. Having an absolute advantage is not the same as having a comparative advantage.

Outputs per input: Opportunity Cost Over (OOO) Computers Oppor. Cost of 1 Comptr Tomatoes Oppor. Cost of 1 tomato USA 50 5000/50=100 T 5000 50/5000=. 01 C Mexico 10 4000/10=400 T 4000 10/4000=. 0025 C Which country has the lowest opportunity cost for computers? USA (only 100 bushels of tomatoes) Which country has the lowest opportunity cost for tomatoes? Mexico (only. 0025 of one computer) What should be the terms of trade? 1 computer for > 100 tomatoes and < 400 tomatoes

Inputs per output: Opportunity cost Under (IOU) Worker hours per computer Opportunity Cost of 1 computer Worker hours per DVD player Opportunity Cost of 1 DVD player USA 3 hours 3/2=1. 5 DVD players 2 hours 2/3=. 67 computers Japan 3 hours 3/1=3 DVD players 1 hour 1/3=. 33 computers Which country has the lowest opportunity cost for computers? USA (only 1. 5 DVD players) Which country has the lowest opportunity cost for DVD players? Japan (only. 33 of a computer) What should be the terms of trade? 1 computer for > 1. 5 DVD players and < 3 DVD players

Check your Understanding 1. In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the US, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. 1. Which country has an absolute advantage in the production of automobiles? In washing machines? 2. Which country has a comparative advantage in the production of washing machines? In autos? 3. What type of specialization results in the greatest gains from trade between the two countries?

Which country has an absolute advantage in the production of automobiles? In washing machines? • The US has an absolute advantage in both.

Which country has a comparative advantage in the production of washing machines? In autos? Italy United States 1 Automobile 2 2/3 washers (8/3) 3 washers (3/1) 1 Washing Machine 3/8 auto 1/3 auto Since 1/3 < 3/8, the US has a comparative advantage in washing machines. This means Italy has a comparative advantage in cars.

What type of specialization results in the greatest gains from trade between the two countries? • The greatest gains are realized when each country specializes in producing the good for which it has a comparative advantage. Therefore, based on this example, the United States should specialize in washing machines and Italy should specialize in automobiles.

Review • Individual choice is the basis of economics • Market and command economy • Incentives (property rights) • Marginal analysis • Resources (land, labor, capital, entrepreneurship) • Scarcity • Opportunity cost • Positive & normative economics • Economic aggregates • Business cycle (aggregate output, unemployment, inflation) • Economic growth (technology) • Other things equal assumption (models) • PPC • Trade-offs/trade/gains from trade • Efficiency (specialization) • Absolute & comparative advantage