comparative advantage and gains from trade
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Comparative Advantage and Gains from Trade. Overview. Principle Five: Trade can make everyone better off Voluntary exchange between people must be mutually beneficial…otherwise one side would cancel the deal. - PowerPoint PPT PresentationTRANSCRIPT
Comparative Advantage and
Gains from Trade
Overview
Principle Five:
• Trade can make everyone better off
• Voluntary exchange between people must be mutually beneficial…otherwise one side would cancel the deal.
• Logic of specialization and exchange is clear for individuals: self-sufficiency would be hard.
• Do you grow your own food or make your own clothes?
The Production Possibilities Frontier
The Production Possibilities Frontier: illustrates the different quantities of two goods an economy can produce given the available factors of production and current state of technology.
The Production Possibilities Frontier can be used to illustrate:
a) the concept of opportunity cost
b) the concept of economic efficiency
c) the concept of gains from trade
The Production Possibilities Frontier
High Tech Goods
Agricultural Goods
1,000
3,000
B
200
2,000
800500
1,000
2,800
C
AD
Points along the frontier are efficient.
Point B is inefficient
Point D is unattainable given current technology
Movement from Point A to Point C demonstrates opportunity cost. Opportunity cost of 300 more units high tech goods is 800 units of agricultural goods
Shifts in The Production Possibilities Frontier
High Tech Goods
Agricultural Goods
1,000
3,000
2,000
800
2,200A
A technological advance in high tech goods shifts the production possibilities outward. As a result, more of both goods can be produced.
900
B
1,500
Production Possibilities Frontier and Gains from Trade
• The production possibilities frontier can also be used to analyze gains from trade.
• Consider two men on a deserted island: Gilligan and Skipper.
• Each has 6 hours a day to secure food.
– Gilligan is better at collecting coconuts.
– Skipper is better at fishing.
Coconuts Fish
Gilligan
Per hour: 2 1
In 6 hours: 12 6
Skipper
Per hour: 1 2
In 6 hours: 6 12
Productivity Table
Gilligan’s PPF
.
.
12
6Fish
Coconuts
.4
4
Gilligan likes to consume an equal number of fish and coconuts.
Without trade, his PPF allows him to consume four of each
Skipper’s PPF
Coconuts
Fish
.6
.12
Without trade, his PPF allows him to consume four of each.
4
4
Skipper also likes to consume an equal number of fish and coconuts.
Opportunity Costs
• Gilligan:– One more fish = 2 fewer coconuts – One more coconut = .5 fewer fish
• Skipper:– One more fish = .5 fewer coconuts – One more coconut = 2 fewer fish
Coconuts Fish
Gilligan
Per hour: 2 1
In 6 hours: 12 6
Skipper
Per hour: 1 2
In 6 hours: 6 12
The Benefits of Exchange
If the men specialize in what they do best, trade will make them better off:
Coconuts Fish
Gilligan
Produce:
Trade:
Consume:
Skipper
Produce:
Trade:
Consume:
12 0
0 12
- 6 + 6
+ 6 - 6
6 6
6 6
Gilligan’s Exchange w/ Skipper
.
.
12
6 Fish
Coconuts
.4
4
Without trade, his PPF allows him to consume four of each
With trade, Gilligan specializes in collecting coconuts….
…and trades away six coconuts for six fish…
…after which he has more of both goods.
6
Skipper’s Exchange w/ Gilligan
Coconuts
Fish
.
6
.12
Without trade, his PPF allows him to consume four of each
.
4
4
With trade, Skipper specializes in catching fish….
…and trades away six fish for six coconuts.
…after which he has more of both goods.
6
The Principle of Comparative Advantage: An Overview
• Differences in the costs of production determine the following:– Who should produce what– How much should be traded for each product
• In the previous example, Gilligan could produce coconuts at a lower cost and the Skipper could produce fish at a lower cost.
• Two ways to measure differences in costs of production:– The number of hours required to produce a unit of output
(for example, one fish or one coconut).– The opportunity cost of sacrificing one good for another.
Comparative Advantage
• Comparative Advantage: The comparison among producers of a good according to their opportunity cost.
• In the previous example:
– Gilligan’s opportunity cost of producing one more fish was two coconuts. Skipper’s opportunity cost of one more fish was .5 coconuts. Thus, Skipper has a comparative advantage in producing fish.
– Skipper’s opportunity cost of producing one more coconut was 2 fish. Gilligan’s opportunity cost of one more coconut was .5 fish. Thus, Gilligan has a comparative advantage in producing coconuts.
Absolute Advantage
• Absolute Advantage: The comparison among producers of a good according to their productivity.
• In the previous example:
– Gilligan required only 30 minutes to produce one coconut whereas the Skipper required one hour: Gilligan had an absolute advantage in collecting coconuts
– Skipper required only 30 minutes to produce one fish whereas Gilligan required an hour: Skipper had an absolute advantage in fishing
• When trading partners have absolute advantage in opposite goods, benefits of exchange are pretty clear…
– Gilligan (coconuts) and Skipper (fish)
– Colombia (coffee) and Chile (fish)
– Saudi Arabia (oil) and New Zealand (sheep)
…but what if one trading partner has an absolute advantage in everything? Is trade still worthwhile?
Enter: Maryanne
Opportunity Cost and Comparative Advantage
Coconuts FishGilliganPer hour: 2 1
In 6 hours: 12 6
MaryannePer hour: 3 3
In 6 hours: 18 18
Productivity Table
Can Maryanne profit from trading with a bozo like Gilligan? Can Gilligan benefit from trade, too?
• Maryanne has an absolute advantage over Gilligan in the production of both goods
• She is better off than he is in the absence of trade
YES
Absolute Advantage and Gains from Trade
Maryanne’s PPF
Coconuts
Fish
.18
.18
Maryanne also likes to consume an equal number of fish and coconuts.
Without trade, her PPF allows her to also consume nine of each
.
9
9
Coconuts Fish
Gilligan
Produce:
Trade:
Consume:
Maryanne
Produce:
Trade:
Consume:
12 0
3 15
- 7 + 5
+ 7 - 5
= 5 = 5
= 10 = 10
The Benefits of Exchange
Gilligan’s Exchange w/ Maryanne
.
.
12
6 Fish
Coconuts
.4
4
Without trade, his PPF allows him to consume four of each
With trade, Gilligan specializes in collecting coconuts….
…and trades away seven coconuts for five fish…
…after which he has more of both goods.
5
5
Maryanne’s Exchange w/ Gilligan
Coconuts
Fish
.18
.18
.
9
9
With trade, Maryanne moves toward a specialization in fishing….
.
…and trades away five fish for seven coconuts…
…after which she has more of both goods.
15
3
10
10
Comparative Advantage and Gains from Trade
• The benefits of trade ultimately come from comparative (not absolute) advantage
• Everyone has a comparative advantage in something, so opportunities for exchange are everywhere
• Even when a person or a country has an absolute advantage in everything, they can still benefit from trade due to comparative advantage.
International Trade
• Trade at international prices allows a nation to consume beyond its PPF
Agricultural goods
Manufacturing goods
Production and consumption in the absence of trade
.International trade line
Production with trade
.
.Consumption with trade