production, trade, and comparative advantage

Production, Trade, andComparative AdvantageEarlier we assumed that two individuals, Smith and Jones, were endowed with a fixed amount of oranges and

apples, respectively. Where those oranges and apples came from, we did not ask. We also did not give Smith or

Jones an option as to whether they would get oranges or apples. Instead, we simply asserted they were endowed

with these products.

In this chapter, we introduce production. Now we will imagine that Smith and Jones must produce the

oranges and apples, rather than simply be given them. After describing simple production functions for the two

goods, we shall derive an individual production possibilities frontier and define the economic concept of

opportunity cost. Next we will investigate production decisions under two scenarios: first, when the individual

produces only for himself, and second, when two individuals produce and then trade.

The possibility of trade affects the production decisions when we assume that producers maximize profit and

individuals maximize utility. Individuals are led, we will see, as if by an invisible hand, to produce the goods in which

they have a comparative advantage and trade it with the other. Comparative advantage is defined as the good that

an individual can produce at a lower opportunity cost. Equivalently, comparative advantage is defined as the good

a person is relatively best at producing in comparison to others. We will show that specialization in the comparative

advantage good followed by trade can raise overall welfare.

Finally, we will expand the story of two individuals to consider trade between two countries. This version of the

model was first introduced by David Ricardo in Principles of Political Economy in 1817 and, for this reason the model

is often called the Ricardian model. Readers will learn some of the surprising outcomes of the Ricardian model; for

example, less productive nations can benefit from free trade with their more productive neighbors, and very low-

wage countries cannot use their production cost advantage to completely dominate in trade with high-wage

countries. Readers will also learn why many people, even those who have studied the Ricardian theory, consistently

misinterpret the model results.

1. PRODUCTION POSSIBILITIES

L E A R N I N G O B J E C T I V E S

1. Learn the definitions of terms used to describe the production process, including labor pro-ductivity and unit-labor requirements.

2. Learn how to plot and interpret a simple production possibility curve.

Production is often a complicated process. To produce a fruit product, like apples and oranges, re-quires land that has fruit trees growing on them; it requires workers to tend the fruit trees, harvest thecrop, and manage the process; and it requires capital equipment like baskets to collect the fruit in and

by Steven Suranovic

trucks to transport the product to market. Modern production requires telephones, computers andsoftware for communication, accounting, design, and marketing.

In order to highlight some basic economic principles, it is not necessary to conceive of the produc-tion process in such a complicated way. Instead, we will simplify the process to its barest essentials byassuming that production of products requires nothing more than the time and effort of individualworkers. This is the most basic way to mimic the transformative production process converting an in-put into an output. Also, human effort is a necessary component in every production process, and it isthe workers who earn the income that is subsequently used to make purchases in the market.

Imagine that Smith can spend his day producing either oranges or apples, or both. Suppose the production process in this example consists of spending one hour of time during the day looking for and gathering ripe fruit. The amount of fruit he can collect, or “produce,” in an hour is described in Figure 1.1.

FIGURE 1.1 Smith's Production Possibilities

If he spends the entire hour collecting apples, suppose he can collect 3 apples. But in that case, he de-votes no time to orange collection and therefore gets zero oranges. Thus the point A, zero oranges and3 apples, is a production possibility for Smith and it is marked on the graph.

If Smith instead spends the entire hour collecting oranges, suppose he can collect 10. But in thiscase he devotes no time to apple collection and therefore gets zero apples. This means that point C, 10oranges and zero apples, is another production possibility for Smith and it is also marked on the graph.

Of course, Smith can also split his one hour between apple and orange production and spend 20 or30 or 40 minutes collecting apples and 40, 30, and 20 minutes, respectively, collecting oranges. If hespends 30 minutes collecting apples and oranges at the same rate as before, then he will produce 5 or-anges and 1.5 apples, plotted as point B, which is another production possibility.

258 SURVEY OF INTERNATIONAL ECONOMICS VERSION 1.0.2

production possibilityfrontier (PPF)

The set of all combinations ofoutputs that can beefficiently produced. Notethat efficiency requires fullemployment of all resourcesand production at maximumproductivity.

labor productivity

The amount of output (in kg,lb., gal., #, etc.) that can beproduced per unit of laborinput (in hours, days, weeks,etc.). For example, 10 kg oforanges per day or 1,500 gal.of wine per hour.

unit-labor requirement

The amount of labor (inhours, days, weeks, etc.)needed to produce a unit ofoutput (in kg, lb., gal., #, etc.).[For example, 1/100 hour oflabor per orange; or, 130workers/kiloton of steel]

If he splits his time differently, then it would be possible for him to produce any combination of apples and oranges along the line drawn in Figure 1.1. This line is his production possibility fron-tier (PPF).

The intercept of the PPF on the apple axis is Smith’s labor productivity in apples; it is the quant-ity of apples he can produce in a unit of time, in this case one hour. We can define a variablePRA

S = 3apples/hr as Smith’s apple productivity. Likewise, the intercept of the PPF on the orange axisis Smith’s labor productivity in oranges; it is the quantity of oranges he can produce in a unit of time.

We can define a variable PROS = 10oranges/hr as Smith’s orange productivity.

We can now define the production functions for apples and oranges.

If QAS

is the number of apples produced by Smith, LAS

is the amount of time Smith spends produ-

cing apples and PRAS

is Smith’s apple productivity then QAS = PRA

S × LAS

Sometimes instead of using productivity, economists prefer to use a variable that indicates howmuch labor input is used to produce a unit of output. The unit-labor requirement indicates theamount of time needed to produce one apple and is given as the reciprocal of labor productivity. Forexample, since Smith’s apple productivity is 3 apples per hour, Smith’s unit labor requirement in apples

is 1/3 hour apple. We define the variable aLAS

as Smith’s unit labor requirement in apples and note that

aLAS = 1 / PRA

S. Also, PRA

S = 1 / aLAS

. We can also rewrite the equivalent production function usingthe unit-labor requirement as follows:

QAS =

LAS

aLAS

Smith takes 1/10th hour to produce one orange and if he spends one hour working, then he can pro-

duce: QOS = 1 / (1 / 10) = 10 oranges. The value for the unit-labor requirement is assumed to be exo-

genous, meaning that its value is determined external to the model.Suppose Smith has a similar production function for oranges written as

QOS = PRO

S × LOSorQO

S =LO

S

aLOS

where

<Q

OS

is the number of oranges produced by Smith,

<L

OS

is the amount of time Smith spends producing oranges,

< PROS

is Smith’s orange productivity (PROS

= 10 oranges/hr in the example) and

<a

LOS

is Smith’s unit-labor requirement in oranges (aLOS

hr/orange).

Next we can derive an equation for Smith’s PPF by noting that Smith’s time is limited. We formalizethat limitation by writing Smith’s labor constraint:

LAS + LO

S = L

where L represents Smith’s labor endowment, or the number of hours Smith has available to work. Tosimplify, we assume that the labor endowment is exogenous, meaning it has a fixed value determinedexternal to the model (in the example, we have set L = 1 hour.) We assume that Smith is free to allocatehis work time between the two production processes as he sees fit. He may choose to devote all of histime to orange production, or to apple production, or he may split his time between the two.

An alternative way to write the labor constraint is by substituting the production function yieldsLA

S = aLAS QA

S. Rearranging the orange production function yields: LO

S = aLOS QO

S. Plugging these in for

the labor supplies gives

aLAS QA

S + aLOS QO

S = L

PRODUCTION, TRADE, AND COMPARATIVE ADVANTAGE 259

production set (PPS)

The set of all combinations ofoutputs that can feasibly beproduced. Note that outputcombinations that can beachieved with less than fullemployment of resourcesand/or less than maximumproductivity are feasible andthus are contained with thePPS.

Plugging in the values for the unit-labor requirements from above and the one hour of labor endow-ment yields the following equation for Smith’s PPF:

aLAS = 1

3hr/apple aLOS = 1

10hr/orange L = 1hour

Smith’s labor constraint can now be written as

13QA

S + 110QO

S = 1

If the exercise begins with this equation, the simplest way to plot Smith’s PPF is by calculating the in-tercepts. If Smith devotes all his time to orange production, then

QAS = 0, 1

10QOS = 1

and QOS = 10. If instead Smith devotes all his time to apple production, then

QOS = 0,1

3QAS = 1andQA

S = 3

The equation generates the PPF drawn in Figure 1.1In general, the PPF describes all combinations of the goods that can be efficiently produced with

the available endowment of labor. Efficiency requires that labor is fully employed and used at its max-imum productivity. For example, if Smith were lazy one day and only collected 5 oranges in an hour(and 0 apples) even though he could have collected 10 oranges, then we would say Smith is producinginefficiently. Because production is inefficient, the combination (5,0) is also not on his PPF.

The graph also depicts all output combinations within Smith’s production set (PPS). In general,the production possibilities set (PPS) contains all combinations of output that are feasible, or possibleto produce.

The graph also depicts all output combinations within Smith’s production set. In general, the pro-duction possibilities set are all combinations of output that are feasible, or possible to produce. ForSmith, the PPS is given by all output combinations within the triangular area,, including the boundar-ies. Thus all points on the PPF are also contained within the PPS. Points such as (3,1), (1,2), (8,0), and(0,2) are also feasible and are contained within the PPS. However since these points would not requireall of the labor available, or would not use it most effectively, we could call them “inefficient” outputcombinations. In general, the inefficient points are those within the PPS minus those in the PPF, or{PPS} – {PPF}. (Note that the notation {.} means a set of points, therefore {PPF} is the set of all pointscontained within the PPF.)

All points outside the triangular region are the infeasible points. In general, infeasible points arecombinations for which there are insufficient resources, or insufficient technology, to produce. Theseare the points that lie beyond the PPF. For Smith, combinations like (5,5), (1,6) and (10,10) areinfeasible.

K E Y T A K E A W A Y S

< Labor productivity is the quantity of a good that can be produced per unit of labor input.

< The unit-labor requirement is the reciprocal of labor productivity. It is the amount of labor input needed toproduce one unit of output of a good.

< The production possibilities frontier (PPF) describes all combinations of the goods that can be efficientlyproduced with the available endowment.

< Efficient production requires that all available resources are employed and used at full capability.

< The PPF is the plot of the labor constraint in the Ricardian model described in this chapter.


opportunity cost ofproduction

The amount of one good thatmust be given up inproduction in order toproduce one unit of anothergood. Opportunity cost is theslope of the PPF andrepresents the idea thatwhen production efficiency ismaintained, to produce moreof one good requiresdiverting resources from theproduction of another good.

E X E R C I S E S

1. Given the values for Figure 1.1, if Smith wished to produce 8 oranges, how much labor would he need to devote to orange production. With his remaining time, how many apples could he produce? (Assume you can break the apples and oranges into any fraction.)

2. Identify the following points in Figure 1.1 as either Feasible, Efficient, or Inefficient. Also indicate whetherthe point is in the PPF, the PPS, both PPF and PPS, or neither PPF or PPS.

a. (5,1.5)

b. (0,3)

c. (5,5)

d. (0,0)

e. (2,2)

3. Suppose Pablo’s PPF for apples and oranges for one day of work is given by 2QA + 10QO = 1000.

a. Graph this equation.

b. What is Pablo’s productivity in apples? In oranges?

c. What is Pablo’s unit-labor requirement in apples? In oranges?

d. How many apples and oranges would Pablo produce if he spent three-quarters of a dayproducing oranges and the remaining time producing apples?

2. THE OPPORTUNITY COST OF PRODUCTION


1. Learn the opportunity cost of production in a two-goods production model.2. Learn how to identify and compute the opportunity cost on a production possibility frontier.

Opportunity cost measures the value, or cost, of what must be given up in order to do somethingelse. It represents a method of quantifying the limited nature of resources and production. We can’thave an unlimited amount of everything we may like because resources are scarce. When we are usingresources fully and completely, to do more of one thing means we must do less of another. The value ofthe next best opportunity is what economists call the opportunity cost.

In this simple model, Smith has only two things he can produce, oranges and apples. If he uses allof his time, or labor endowment, fully and completely, then he will produce somewhere on his PPF. Toproduce more oranges, Smith must shift his time away from apple production. To produce moreapples, Smith must shift his time away from orange production. Thus, the opportunity cost of orangeproduction is the value of the apples that must be given up to produce another orange. Likewise, theopportunity cost of apples is the value of the oranges that must be given up to produce another apple.

The opportunity cost value for oranges is given by the absolute value of the slope of the PPF. Theslope of Smith’s linear PPF, with oranges plotted on the horizontal axis, can be found by taking the riseover the run between any two points. For example, consider the points on the two axes. When orangeproduction is zero, Smith can produce a maximum of 3 apples; this is the rise. When apple productionis zero, Smith can produce a maximum of 10 oranges; this is the run. Since the PPF is negatively sloped,its value is given as –(3/10) apples per orange. This means that for Smith to produce one more orange,he must give up 3/10 of an apple. Positive 3/10 is Smith’s opportunity cost of orange production. (Note,by calling it a “cost,” we are taking account of the negative relationship between the two. That is, toproduce more of one good, we must give up some of another. This is why we take the absolute value.)

In more general terms, we can specify the slope of the PPF as a function of the underlying para-

meters. For example, starting with the PPF equation aLOS QO

S + aLAS QA

S = L, we can rewrite it in thestandard linear equation form, y = mx + b. In that form y is the variable of the vertical axis (for Smith,

that is QAS

), x is the variable on the horizontal axis (for Smith, that is QOS

), m is the slope of the PPF, andb is the value of the apple intercept. Rearranging the expression algebraically yields,


QAS = − (aLO

S

aLAS )QO

S + LaLAS

This means that the slope of the line is− (aLO

S

aLAS ), which is the ratio of the unit-labor requirements in

production. The opportunity cost of orange production for Smith is the absolute value of the slope, giv-

en as (aLOS

aLAS ). Alternatively, we can write the opportunity cost as

1 / aLAS

1 / aLOS

=PrA

S

PrOS

. This form displays theratio of the productivity of apples to the productivity of oranges. In both versions though, it is theamount of apples that must be given up to produce another orange.

For completeness, the opportunity cost of apples is given by

( aLAS

aLOS )and

1 / aLOS

1 / aLAS

=PrO

S

PrAS both measured in oranges per apple.

Smith’s opportunity cost of apples is either the slope of his PPF, if apples were plotted on the horizontalaxis, or the reciprocal of the current slope. That reciprocal is (10/3) or 3 (1/3) oranges per apple. In oth-er words, to produce one more apple, Smith must give up 3 1/3 orange.


< The opportunity cost of oranges is measured as the quantity of apples that must be given up inproduction in order to produce another unit of oranges.

< The opportunity cost of oranges is represented as the absolute value of the slope of a person’s PFF whenoranges are plotted on the horizontal axis.

E X E R C I S E

1. Suppose Reggie has the following unit-labor requirements producing corn and wheat: aLC = 200 hrs. perton, aLW = 100 hrs. per ton. Nigel has the following unit-labor requirements: aLC = 300 hrs. per ton, aLW =120 hrs. per ton.

a. What is Reggie’s productivity in wheat production? Include units.

b. What is the opportunity cost of corn production for Reggie?

c. What is the opportunity cost of wheat for Nigel?

3. ABSOLUTE AND COMPARATIVE ADVANTAGES

L E A R N I N G O B J E C T I V E

1. Learn the two different methods to compare production capabilities between two people.

Next let’s imagine a second individual called Jones who also has the ability to produce either oranges, apples or both, depending on how he allocates his time. Suppose Jones has the same type of production functions as Smith, but we’ll assume that Jones’s production capabilities are different. Let Jones have the PPF as in Figure 1.2 denoting his production possibilities for one hour of work.


FIGURE 1.2 Jones' Production Possibilities

Recall that the endpoints of the PPF represent his productivities. Thus PRAJ = 10 and PRO

J = 3. Thisalso implies that Jones has different values for the unit-labor requirements. Suppose Jones’s values forhis exogenous variables are as follows:

aLOJ = 1

3 hr/orange aLAJ = 1

10 hr/apple L = 1 hour

With these values, Jones' PPF equation is written as,

13QO

J + 110QA

J = 1

Jones’s PPF is shown as the line connecting the endpoints 10 apples and 3 oranges. Using the formula

we derive Jones’s opportunity cost of orange production as

aLOJ

aLAJ = 1 / 3

1 / 10 = 103

apple per orange. Simil-

arly, Jones’s opportunity cost for apples (in oranges per apple) is

aLAJ

aLOJ = 1 / 10

1 / 3 = 310

This example is explicitly designed so that Jones’s production capabilities are different fromSmith’s. Recall that Smith can produce 10 oranges but only 3 apples in an hour, whereas Jones can


absolute advantage

An advantage that oneperson (or one country) hasover another when a productcan be produced cheaper(i.e., lower labor cost) and hasgreater efficiency inproduction (higherproductivity).

comparative advantage

An advantage that oneperson (or one country) hasover another when a productcan be produced at a loweropportunity cost.

produce 3 oranges or 10 apples. Clearly Smith is better at producing oranges, while Jones is better atapple production.

We express that technically by saying that Smith has an absolute advantage in orange produc-tion because both of the following are true: his unit-labor requirement in oranges is lower and his labor

productivity is higher. More formally, aLOS < aLO

J[(1/10) < (1/3)], which also implies that

1aLOS > 1

aLOJ

[10 > 3].

Similarly, Jones has an absolute advantage in apples because aLAJ < aLA

S[(1/10) < (1/3)] and

1aLAJ > 1

aLAS

[10 > 3].To have an absolute advantage means that it is cheaper to produce something (lower labor cost)

and that one is more efficient in production (higher productivity).There is a second, even better way to compare production capabilities between Smith and Jones by

defining comparative advantage. A person has comparative advantage in the production of a good ifhe can produce it at a lower opportunity cost. In the previous example with Smith and Jones, Smith has

comparative advantage in oranges because

aLOS

aLAS <

aLOJ

aLAJ

[numerically, (3/10) apples/orange < (10/3)apples/orange].

Interestingly, if one person has a comparative advantage in one good, then the other person must

have the comparative advantage in the other. This is true in this specific case because

aLAJ

aLOJ <

aLAS

aLOS

[(3/10) oranges/apple < (10/3) oranges/apple].

Comparative advantage is another way to describe a technological advantage, and it turns out to bethe most appropriate way. One of the fundamental economic lessons we can now explain is that indi-viduals can improve their well-being (i.e., they can become happier) if they specialize in producing thegood in which they have a comparative advantage and trade it with another.


< Absolute Advantage is one method used to compare production technologies between two people orcountries, based on superior productivity in an industry or lower labor cost per unit of output.

< Comparative Advantage is a second method used to compare production technologies between twopeople or countries, based on lower opportunity cost in production of a product.

E X E R C I S E S

1. Suppose Reggie has the following unit-labor requirements producing corn and wheat: aLC = 200 hrs. perton, aLW = 100 hours per ton. Nigel has the following unit-labor requirements: aLC = 300 hrs. per ton, aLW =120 hours per ton.

a. Demonstrate that Reggie has the absolute advantage in wheat production using productivitycomparisons.

b. Demonstrate that Reggie has the absolute advantage in corn production using unit laborrequirement comparisons.

c. Use the opportunity cost method to determine who has the comparative advantage in corn.

2. Suppose Carl’s factory can produce either 100 tables or 200 chairs per day. Suppose his brother Sam’sfactory can produce either 75 tables or 150 chairs per day.

a. Whose factory has the absolute advantage in chair production?

b. Whose factory has the absolute advantage in table production?

c. Whose factory has the comparative advantage in tables?


4. GAINS FROM SPECIALIZATION AND TRADE


1. Learn to identify the gains from trade and specialization in an Edgeworth box diagram.2. Learn how the profit motive inspires specialization and trade.

Before we consider the motivation and effects of trade, let’s first consider what Smith and Jones wouldchoose to do if they are not intending to meet in a market and to trade with each other. In other words,what if they are independent and produce only for themselves? This situation is referred to as autarky(i.e., no trade). The outcome in this situation is relevant because the gains from trade are based on acomparison to this base case when individuals do not trade.

Smith’s consumption choice will depend on Smith’s preferences, or demands, for the two goods. If Smith loved oranges and hated apples, then he might produce 10 oranges and 0 apples (point C in Fig-ure 1.1). If he hates oranges but loves apples then he might choose to produce 3 apples and 0 oranges (point A in Figure 1.1). If he prefers more of both goods, to less, AND if his preferences exhibit di-minishing marginal utility, then he will likely prefer to consume a variety of apples and oranges.

Suppose Smith has preferences that can be described with a set of indifference curves. Suppose he also chooses a feasible production/consumption bundle that maximizes his utility. That would occur at a point where an indifference curve is tangent to the production possibility frontier. To prove this, note that at any other point on Smith’s PPF, which are the other efficient production possibilities, the associ-ated indifference curve through that point must lie below the one depicted. Therefore, the tangency point must be the maximum utility Smith can attain on his own. In Figure 1.3, that point is shown as 5 oranges and 1.5 apples. (To simplify the exposition, the indifference curve tangency is drawn at the midpoint of the PPF. This is not a necessary outcome.)


FIGURE 1.3 Smith's Autarky Equilibrium

As in the previous chapter, we will imagine that Jones exhibits some unusual behavior, always prefer-ring to look at things upside down. So we’ll draw his PPF with the origin in the upper right corner. As before, oranges increase to the left in Figure 1.4, while apples increase in the downward direction.

Assuming Jones has preferences resulting in an indifference curve as drawn, and if Jones maxim-izes utility, then he will choose to produce at a point where an indifference curve is just tangent to the PPF. In Figure 1.4, this would be at the point with 1.5 oranges and 5 apples. (Also at the midpoint of his PPF for simplicity.)


FIGURE 1.4 Jones' Autarky Equilibrium

Next let’s consider what might happen if Smith and Jones produce for themselves independently but,perhaps by chance, happen to meet each other during the day. That meeting place is called a market.Smith is carrying his production bundle with him, as is Jones, and neither has consumed anything yet.

The individual production points on each person’s PPF represent their initial endowment. Smith comes to the market endowed with 1.5 apples and 5 oranges, Jones arrives with 5 apples and 1.5 or-anges. We can now construct an Edgeworth box diagram (Figure 1.5) by superimposing Jones’s up-side down PPF diagram on top of Smith’s and overlapping their individual production points. Note that the length of the Edgeworth box is 6.5 oranges, which corresponds to the total combined produc-tion of oranges (5 + 1.5 = 6.5). The height of the box is also 6.5 and corresponds to the total combined production of apples.


FIGURE 1.5 Production and Trade Before Specialization

There is something immediately obvious by looking at the Edgeworth box: the endowment point is notan optimum for either Smith or Jones. Because their two indifference curves are not tangent to eachother, they form a lens to the upper left of the endowment point. This means there are trading possibil-ities in which they can trade to mutual advantage.

For example, suppose Smith were to offer one orange to Jones for one apple. In this case, Smithwould end up with 4 oranges and 2.5 apples (he started with 5 oranges and 1.5 apples). Jones wouldend up with 4 apples and 2.5 oranges. This new consumption point is clearly inside the lens formed bytheir indifference curves, which implies that both Smith and Jones would reach a higher indifferencecurve and thereby increase their utility. Happiness bursts could be created for both via trade!

However, Smith and Jones could do even better for themselves by shifting their production if theyplan to meet in the market again in the future. Indeed they will each have an incentive to do so oncethey recognize the following potential gains from trade.

Consider the previous trade pattern of one orange for one apple. This implies a terms of trade, orthe price of oranges, that is (PO/PA) = 1 apple per orange. If Smith is smart and a profit seeker, then heshould realize the following: if tomorrow he were to produce one additional orange and shift his timeaway from apple production, he would have to give up 3/10 apple. This is his opportunity cost of pro-ducing another orange ( = aLO/aLA = 3/10). Suppose he assumes he can come to the market and tradewith Jones one apple for every orange, or perhaps the market is bigger and every day one could come tothe market and trade as many oranges for as many apples as one wants at the one-to-one price.

Put another way, the price Smith gets for his oranges at the market is one apple, but the cost for

Smith of producing another orange is 3/10 apple (i.e.,

POPA

>aLOS

aLAS

).


Because price exceeds the cost, it is profitable for Smith to produce more oranges. Continuing withthis logic, because Smith is already producing 1.5 apples for himself, why not give up this apple pro-duction to produce more oranges and then trade the oranges with Jones at the better price. By shiftinghis time from apple production to orange production, Smith can produce 5 additional oranges givingup only 1.5 apples.

In a similar vein, Jones will discover that the price of apples in the market (PA/PO = 1 orange perapple) is greater than his opportunity cost of producing apples (= aLA/aLO = 3/10 orange per apple),

that is,

PAPO

>aLAJ

aLOJ

. This means it is profitable for Jones to produce more apples.But what happens after they specialize?The shift in production changes the size of the Edgeworth box as shown in Figure 1.6. The pro-

duction point is now in the lower right corner, with Smith producing 10 oranges and 0 apples and Jones producing 10 apples and 0 oranges. The first thing to note is that the Edgeworth box itself has grown in overall size. Before specialization, Smith and Jones together produced 6.5 oranges and 6.5 apples. With specialization, Smith and Jones combined produce 10 oranges and 10 apples. Specializa-tion in the comparative advantage goods generates more oranges and more apples! Indeed this is one of the most important features of comparative advantage: the improvement in world productive effi-ciency, meaning the increase in output for the same overall level of inputs. Without labor being added to the economy, and simply by rearranging production, Smith and Jones are able to expand overall out-put of the two goods.

FIGURE 1.6 Production and Trade After Specialization


After specialization, a second action must occur to distribute the surplus—namely trade. For example, suppose Smith and Jones trade to point E in Figure 1.6. The resulting trade pattern would be 4 or-anges from Smith for 4 apples from Jones, generating a terms of trade of PO/PA = 1 apple per orange. By looking at the diagram, it is easy to see that both Smith and Jones would reach a higher indifference curve, thereby increasing their overall utility. More specifically though, point E gives Smith 6 oranges and 4 apples, as opposed to 5 oranges and 1.5 apples before specialization and trade. Since Smith has more of both goods he must be happier. Likewise Jones now has 4 oranges and 6 apples, which is more than the 1.5 oranges and 5 apples he had before specialization and trade. Thus Jones must also be happier.

If point E is the optimum, then Smith's and Jones’s indifference curves will be tangent to each oth-er and both will achieve the condition that the terms of trade equals their marginal rate of substitution.

This example demonstrates the advantages that arise from the division of labor. Smith and Joneshave two options really: either produce both goods for themselves or specialize in producing one of thetwo goods and trade for the other. By doing the latter, by dividing labor and concentrating on what oneis best at producing, the two can expand their overall consumption of both goods. Specialization inone’s comparative advantage good creates surplus value; trade distributes the surplus between the twoparties. Specialization and trade, the division of labor and trade, generates happiness bursts all around!There are gains from trade for everyone.

It is especially worth noting that by pursuing profit, Smith and Jones are led to specialize in thegood in which they have a comparative advantage. Following on Adam Smith, we might say they areled, as if by an “invisible hand,” to specialize in the good in which they have a comparative advantage.Economists today might say they are led by the profit motive in a free market. In either case, it is thedesire to do better for themselves that enables both to become better off.


< If two individuals producing for themselves with different production capabilities come together in themarket, there is an incentive to trade to their mutual advantage.

< When the terms of trade of a good exceeds the opportunity cost of the same good, the resulting profit willinduce an individual to specialize in the production of that good.

< Because of the pursuit of profit, individuals are led, as if by an “invisible hand,” to specialize in theircomparative advantage good and trade it in the market to mutual advantage.

E X E R C I S E S

1. Suppose that in one day, Ling can produce either 500 ice cream cones or 1,000 cups of coffee. Simi canproduce either 400 ice cream cones or 500 cups of coffee.

a. Who has the absolute advantage in the production of coffee?

b. What is Simi’s opportunity cost of coffee production?

c. Who has the comparative advantage in coffee production?

d. Construct an Edgeworth box diagram with right-side-up Ling and upside-down Simi when bothspecialize in their comparative advantage goods.

2. Suppose Smith and Jones have PPF's as described above in this section. Suppose after the two trade thefirst time before specialization, that Smith recognizes the potential profit by specializing in oranges butJones does not recognize the same possibility. Thus, suppose the second time the two meet Smith isspecializing in oranges but Jones continues to produce his autarky (no specialization) consumptionbundle.

a. Draw the Edgeworth box for this scenario.

b. Would a one orange for one apple trade make both traders better off?

c. Would a one orange for one apple trade make Smith better than he was in autarky before hespecialized?

d. What are the implications if only one trader pursues his self interest and specializes?


5. DAVID RICARDO AND COMPARATIVE ADVANTAGE


1. Learn that it is possible to have a comparative advantage even if one does not have an abso-lute advantage in anything.

2. Learn that comparative advantage is more relevant than absolute advantage in determiningspecialization and gains from trade.

In the example in Section 4 the numbers were chosen so that Smith had an absolute advantage in or-ange production and Jones had an absolute advantage in apple production. This means that Smith istechnologically better than Jones in orange production while Jones is technologically better than Smithin apples. Later we derived opportunity costs to show that Smith also had a comparative advantage inorange production, and Jones a comparative advantage in apple production. All of this might suggestthat for someone to have a comparative advantage, he must be technologically superior in the produc-tion of something. However, this conclusion not only is wrong but also leads to common misunder-standings of comparative advantage.

David Ricardo first presented the theory of comparative advantage in his 1817 book On the Prin-ciples of Political Economy and Taxation. In a famous example about international trade, he showedthat a national absolute advantage in production was not necessary for specialization and trade to beadvantageous for both countries. In that example, he began with an alternative assumption—namelythat one country had an absolute advantage in the production of both products and, therefore, that theother country had no technological advantage at all. What would happen in this instance? Casual ob-servation might lead one to conclude that trade would not occur. However, Ricardo showed that tradewas still likely in almost all circumstances.

To demonstrate why, suppose Smith and Jones have the following values for their exogenousvariables:

TABLE 1.1

aLOS = 1

10 hr/orange aLAS = 1


aLOJ = 1

5 hr/orange aLAJ = 1


Because, aLOS < aLO

J[(1/10) < (1/5)] and aLA

S < aLAJ

[(1/6) < (1/5)], Smith has an absolute advantage inthe production of both oranges and apples. However, calculating opportunity costs reveals that Smith’sopportunity cost of oranges is

aLOS

aLAS = (1 / 10)

(1 / 6) = 610 = 3

5 apple/orange,

while Jones’s opportunity cost is:

aLOJ

aLAJ = (1 / 5)

(1 / 5) = 1 apple/orange.

Because Smith has a lower opportunity cost for oranges, Smith has a comparative advantage in orangesrelative to Jones. Also because,

aLAJ

aLOJ = (1 / 5)

(1 / 5) = 1 <aLAS

aLOS = (1 / 6)

(1 / 10) = 53 ,

Jones has a comparative advantage in apple production.Notice that although Smith is absolutely better producing both oranges and apples relative to

Jones, Jones still has a comparative advantage in apples. Ricardo showed that even in this circumstance,specialization in one’s comparative advantage good followed by trade could result in benefits for both


individuals. We demonstrate that outcome in Figure 1.7, which depicts the Edgeworth box formed by Smith’s and Jones’s PPFs. The PPFs overlap at the point representing specialization in each one’s com-parative advantage good. Thus Smith produces at the point 10 oranges and 0 apples, while Jones pro-duces 5 apples and 0 oranges.

FIGURE 1.7 Advantageous Trade without an Absolute Advantage

Suppose the black points on each PPF represent the optimal consumption choice for Smith and Joneswithout trade. Suppose the tangency between the two indifference curves is the optimal consumptionpoint with specialization and trade. Clearly the consumption point with specialization and trade allowsboth Smith and Jones to reach a higher indifference curve compared to no trade. Thus specializationand trade can raise both Smith’s and Jones’s utility even though Jones is worse at producing bothgoods. The key, as Ricardo showed, is that you produce the good in which you have a comparativeadvantage.



< David Ricardo made the first formal presentation of the principle of comparative advantage, hence themodel is often called the Ricardian model.

< Opportunity cost differences can occur even when one person (or country) is absolutely better (or worse)than the other in all goods.

< Maximum gains from trade can occur after specialization in one’s comparative advantage good.

< A person (or country) can gain from trade even if one does not have an absolute advantage in any good.

< A person (or country) can gain from trade even if one has the absolute advantage in every good.

6. A SECOND METHOD OF DEFINING COMPARATIVEADVANTAGE


1. Learn how to determine comparative advantage on the basis of relative productivities.

As was defined earlier, a person has a comparative advantage in the good that he can produce at alower opportunity cost. But opportunity cost is a complicated way to measure cost because it involvescomparison of two production processes. It also does not lend itself well to intuition. Thus, an alternat-ive way to define comparative advantage is in terms of relative productivities. For instance, in this ex-ample Smith is absolutely better at producing both oranges and apples.

But his productivity advantage in oranges is1

(1 / 10)1

(1 / 5)= (1 / 5)

(1 / 10) = 15 × 10

1 = 2 times

while his productivity advantage in apples is1

(1 / 6)1

(1 / 5)= (1 / 5)

(1 / 6) = 15 × 6

1 = 65 = 1.2 times

.That both numbers exceed one means Smith has an absolute advantage in both goods. However,

his advantage is twice as large in oranges and only 1.2 times larger in apples. His comparative advant-age product, then, is the one that he is most better at producing, which is oranges.

In contrast, Jones’s relative productivities are the reciprocals of those above. We would say thatJones is half as good as Smith in orange production and 5/6 as good in apple production. Since bothnumbers are less than one, Jones has an absolute disadvantage in both goods. However, we alreadyknow that Jones’s comparative advantage is in apples. This corresponds to the good in which Jones isleast worse at producing, which is also the good he is relatively best at producing.

Thus if an individual, or country, is absolutely better at producing all goods and services, then itscomparative advantage goods will be those in which its productivity advantage is largest. If an indi-vidual, or country, is absolutely worse at producing all goods and services, then its comparative advant-age goods will be those in which its productivity disadvantage is smallest. The lesson is intuitive really:everyone should work to achieve his or her own highest potential. If people do that it will maximizeproduction given the limited resources available and can raise the welfare of all participants relative tothe alternatives.


< If an individual, or country, is absolutely better at producing all goods and services, then the comparativeadvantage good(s) will be those in which the productivity advantage in an item is largest.

< If an individual, or country, is absolutely worse at producing all goods and services then the comparativeadvantage good(s) will be those in which the productivity disadvantage is smallest.


7. MISUNDERSTANDINGS ABOUT COMPARATIVEADVANTAGE


1. Learn why economically weaker, or less productive, countries may not be at a disadvantage intrade with other more productive countries.

Sometimes when people think about trade between nations, they imagine that there are economicallystrong countries, like the United States, Germany, and other developed countries, and economicallyweak countries, such as the developing countries in Africa and elsewhere. If the strong and the weakcountries are allowed to compete and trade with each other in a free market, it is also sometimes pre-sumed that the strong nations will take advantage of the weak or that the strong will benefit from tradeat the expense of the weak countries. An analogy is sometimes made with competition in the naturalworld, which often results in the survival of the fittest at the expense of the weak and vulnerable.

Although this way of thinking may be valid in the context of military power, the theory of compar-ative advantage demonstrates why it is misguided with respect to economic power. In the model con-structed in Section 6, we assumed that one country was technologically superior in the production ofboth goods available to produce. Consequently, the other country was assumed to be technologicallyinferior. In this circumstance, we can reasonably claim that one country is economically more powerfulthan the other weaker country. However, it is a fallacy to presume that greater “power” implies advant-age for some and disadvantage for others. The Ricardian model shows that if a country pursues profitby seeking the best price to sell its products, it will be led by an invisible hand to specialize in its com-parative advantage good and will trade that good with the other country to its own advantage. Despitehaving inferior economic “power,” a country can still benefit from trade.

This result is quite remarkable and does not conform to most people’s intuition. Perhaps this ex-plains a tendency for people to believe that a country needs an absolute advantage in something in or-der for trade to be beneficial. Benefits from trade that derive from your country’s “power” in producingsomething makes perfect sense and is highly intuitive. This notion isn’t wrong, of course. This intuitiveargument for advantageous trade based on absolute advantage is fully consistent with comparativeadvantage.

Economists would say that each country having an absolute advantage in a product is a sufficientcondition for both countries to gain from trade, but it is not a necessary condition. It is not necessarybecause a country can gain from trade even when it is inferior in producing everything.

We can also reflect upon this result in the context of individuals instead of countries. Imagine aperson that is inferior to all others in his or her productive capacity, perhaps an individual with physic-al or mental challenges. The theory of comparative advantage would suggest that such individuals canstill participate, contribute, and benefit by engaging in a free market system. The key is to discover thatoccupation in which one is relatively best at.

As an example, in Ithaca, New York, there is a business called Challenge Industries. This companyhires individuals who face barriers to employment, including people with physical and mental disabilit-ies. It then identifies jobs in the community in which each individual is capable of achieving success.This is an example of comparative advantage in action.

A community, a country, and the world can maximize its productive potential by allocating itspeople and resources on the basis of what those resources are relatively best at producing—that is, onthe basis of comparative advantage.

One last point worth mentioning is that comparative advantage, for individuals or countries, neednot be unchangeable. In economic models, we assume that the unit-labor requirements defining thetechnology are fixed. However, those variables are likely to change over time and indeed can be in-duced to change in a particular way. For example, students in college will specialize in a particular ma-jor field, or field of study. The knowledge they acquire in their major will make them relatively moreknowledgeable than others about that subject and thus will shift their comparative advantage in thatdirection. A little education may not be enough to overturn their original advantage, but extendedtraining in a discipline surely will.



< An absolute advantage in production is not necessary for a country to gain from trade with another.

< When free market exchange between countries occurs, the more advanced, or more productive countrydoes not take advantage of the less advanced country.

8. PRODUCTION POSSIBILITIES WITH MORE THANTWO INDIVIDUALS


1. Learn to construct a multiperson production possibility frontier with two goods.

A number of important production relationships can be demonstrated by constructing an economy-wide PPF out of the PPFs of two or more individuals. In the following example, we consider an eco-nomy comprising of three sisters; Olga, Maria, and Irina. As before, we assume that these individualscan choose to devote their work effort to the production of either oranges, apples, or some combina-tion. We will assume, though, that the productive capabilities differ between the sisters.

In Figure 1.8, the individual PPF for each sister is displayed as the triangle surrounding each sis-ter’s name. Thus, Olga’s PPF indicates that if she devotes all of her daily work effort to apple produc-tion, she can produce 10 apples (50 - 40 = 10). If instead she specializes in orange production, she can produce 25 oranges. She can also produce any combination in between the two endpoints. Similarly, Maria can produce 15 oranges, 15 apples, or some combination in between. Irina can produce 10 or-anges, 25 apples, or some combination in between.

Each sister’s opportunity cost of orange production is given by the slope of her indifference curve.Thus, Olga’s opportunity cost for oranges is 10/25 = 2/5 = 0.4 apples/orange. Maria’s opportunity costfor oranges is 15/15 = 1 apple/orange, and Irina’s opportunity cost for oranges is 25/10 = 2.5 apples/or-ange. This implies that Olga has the comparative advantage in oranges, Irina the comparative advant-age in apples, and Maria is intermediate between the two.

FIGURE 1.8 A Three-Sisters PPF

In Figure 1.8, the sisters' PPFs are positioned in a way that plots the household production frontier, made up of the summation of the three individual PPFs. Notice that if all three specialized in apples, the total household apple production would be 10 + 15 + 25 = 50. If all three specialized in orange


production, total household production would be 25 + 15 + 10 = 50. That defines the endpoints of thehousehold PPF. To determine the interior segments, we order the PPFs according to increasing oppor-tunity cost of oranges moving from left to right along the frontier. This will enable us to extend the PPFas far outward as possible.

To see how the most efficient production may be chosen from the set of production possibilities, we can superimpose on the PPF diagram a set of household indifference curves. In Figure 1.9, we de-pict two examples using indifference curves representing two different preference orderings. If prefer-ences are like those depicted with indifference curve I1, then the utility maximizing household produc-tion and consumption occurs at point A. Note that to produce at A, Olga must specialize in producing her comparative advantage good (oranges), Irina must specialize in her comparative advantage good (apples), and Maria produces a little of both.

If instead the household had a stronger desire for apples, the indifference curves might be repres-ented by I2. In this case, utility maximizing consumption and production would occur at point B. Toproduce at B, Olga still specializes in orange production, but Irina and Maria both specialize in appleproduction.

FIGURE 1.9 Household Utility Maximization

Next let’s consider how inefficiencies can arise when the principle of comparative advantage is not fol-lowed. For example, suppose this household did not function like a free market in which each sister produced that which would maximize her own utility. Suppose the household is instead headed by a dictatorial father who is not interested in freedom or comparative advantage. For some unknown reas-on, he demands that Irina produce only oranges and Olga produce only apples. Given these con-straints, the PPF is plotted in Figure 1.10 along with the original, and more efficient, PPF.


FIGURE 1.10 Inefficient Production

Notice that when Irina and Olga are forced to produce the good in which they do not have a comparat-ive advantage, the constrained PPF shifts inward. If the household maximizes utility under preferenceslike those depicted with I1, then consumption and production would occur at point C. Notice that at C,all three sisters produce on their individual production frontiers. That means they are each using theirlabor input fully. Despite being fully employed, point C represents a significant reduction in apple andorange production and consumption for the household, relative to the unconstrained case. It also dis-plays quite vividly the kind of losses that will occur when production on the basis of comparative ad-vantage is not realized.

This is what economists mean when they talk about inefficiencies in production. It means that theeconomy is not achieving its fullest productive potential and therefore cannot obtain the greatest pos-sible utility for its citizens. Happiness is not at a maximum given the available resources and the givenproduction technology.

There are really two ways for an economy to produce inside its unconstrained PPF and thus exhib-it inefficiencies: first, when some producers do not produce according to comparative advantage, as at point C, and second, when some resources are unemployed. For an example of the second condition, consider point D in Figure 1.10. The household could achieve production at D if Olga produces 25 or-anges according to her comparative advantage, Irina produces 25 apples according to her comparative advantage, and Maria sleeps all day! Curiously, point D generates more oranges and apples than point C. This means that in this example, shifting Olga and Irina to their comparative advantage activities creates enough extra production to compensate for all of Maria’s work effort. This can also explain why an economy can grow while its unemployment rate increases. If efficiency improvements occur among those who are working, it can offset the losses caused by rising unemployment.

Lastly, the efficient PPF displays a relationship that is likely to hold for much more complex PPFs.As we move to the right along the efficient frontier, thereby producing more oranges and fewer apples,


the opportunity cost of orange production increases. This pattern is sometimes referred to as the prin-ciple of increasing costs. What this implies is that it costs less to produce the first few oranges than itdoes to produce the last few oranges. Here’s why.

To maintain efficiency, it is best to move those resources that are most useful in producing or-anges, and thus least useful in producing apples, into orange production first. In the example above,that means first moving Olga into orange production because her opportunity cost of oranges is thelowest, which also implies that she is the most productive individual in orange production. Next, it isbest to move Maria into orange production because her opportunity cost is intermediate between theother two. Once Maria is producing only oranges, the only resource left to move over is Irina, who isthe least productive in oranges and therefore must give up the greatest number of apples to produceeach additional orange.

If we had 100 individuals, or a thousand, or a million, each with the ability to produce apples, or-anges or some combination, then the efficient production frontier would be derived by ordering the in-dividual PPFs from the lowest to the highest opportunity cost of oranges, just like we ordered the three sisters' PPFs. Under these assumptions, the PPF would look like that in Figure 1.11. The slope of a tangent line at each point on the PPF represents the opportunity cost at that point. Since the slope of a tangent line increases (in absolute value terms) moving to the right along the curve, the opportunity cost is increasing. Thus, in general, an economy’s efficient frontier in two goods is negatively sloped and bowed out, or convex to the origin, reflecting an increasing opportunity cost of oranges (or the OC of the good plotted on the horizontal axis).

FIGURE 1.11 A PPF with Many Individual Producers



< The outer frontier of a multiperson PPF consists of the individual PPFs ordered from lower to higheropportunity cost of the good on the horizontal axis.

< Moving from left to right, the PPF exhibits increasing opportunity cost of production of the good plottedon the horizontal axis.

< A household indifference curve tangent to the multiperson PPF determines the utility maximizingproduction and consumption point for the household.

E X E R C I S E S

1. Use Figure 1.8 to answer the following questions:

a. What is Olga’s unit-labor requirement in apple production?

b. What is Maria’s labor productivity in orange production?

c. How much more productive is Olga in orange production than Irina?

d. What is Maria’s apple productivity relative to Irina’s?

e. What is Irina’s opportunity cost of apple production?

2. Use the three sisters' PPFs as illustrated in Figure 1.8 to answer the following questions:

a. Plot the household PPF if only Olga and Maria are producing.

b. How many oranges and apples would the household produce if Olga and Maria each specializedin their comparative advantage goods?

c. Plot the household PPF if only Irina and Maria are producing.

d. How many oranges and apples would the household produce if Irina and Maria each specializedin their comparative advantage goods?

3. In the late 1950s, as a part of the Great Leap Forward campaign in China, Mao Zedong wanted to expandsteel production in the country by mobilizing the rural masses to produce steel using backyard furnacessupplied with collected scrap metal. Use the economic argument in this chapter to explain why the effortwas an abysmal failure.

9. SOURCES OF ECONOMIC GROWTH


1. Learn how the multiperson PPF can be used to demonstrate the four important sources ofgrowth.

If we imagine that having more goods and services available for citizens to consume is better than hav-ing fewer, then we may wish to know what can induce the expansion of production. In other words,what are the sources of economic growth.

The PPF diagrams can be used to identify all of the fundamental reasons why economic growthoccurs. There are four basic causes of growth:

1. An increase in resources (inputs in production)2. A re-employment of unemployed resources3. An increase in productivity4. A reallocation of resource usage on the basis of comparative advantage

Let’s consider first an increase in new resources. Resources refer to the inputs that are used to producethe final goods and services that are consumed. In the more complex real world, those resources in-clude human labor, animal labor, land or space, and capital equipment such as machinery. If an eco-nomy adds more workers, equipment, or any other resources to the production process, then surely theeconomy would be able to produce more.

Consider the household economy from before. However, let’s assume that initially Maria is tooyoung to work and is not considered part of the workforce. In that case, household production willonly involve the production of Olga and Irina.


In Figure 1.12, the household PPF using only Olga and Irina’s production capability is formed by the outside edges of Olga and Irina’s PPFs meeting at point A. Notice that without Maria, household production possibilities are everywhere interior to the PPF formed with Maria included, shown as the outer boundary with the three PPFs combined. The change between the two represents the economic growth that is achievable when Maria enters the workforce as a new productive resource. In other words, when resources are added to the production process, the household PPF shifts outward. This is a visual depiction of economic growth. With added labor, the economy can produce more of both goods if it desires.

The same story is told if Maria were originally unemployed rather than being too young to be partof the labor force. If Maria were unemployed for some reason, then production would occur along theinternal PPF, such as at point A. If Maria is re-employed, the production possibilities shift outward,thereby inducing economic growth.

FIGURE 1.12 The Effect of More Resources

The third cause of economic growth is productivity improvements. This involves a change in one exo-genous variable in the model—namely the unit-labor requirement in production. Any reduction in aunit-labor requirement implies an increase in productivity and an improvement in technology. We alsosometimes call this technological change. Technological change is a complex process that would re-quire an entire course to examine in detail. However, it occurs largely because of new inventions orstreamlined production techniques.

Figure 1.13 illustrates the effects of technological change. Suppose, for simplicity, the economy consists of just Olga and Irina. Given their original productivities, the household PPF is plotted as be-fore as the external surfaces of their PPFs intersecting at point A. Suppose though that Olga and Irina improve their productivities of orange and apple production, respectively. Suppose Olga’s orange pro-ductivity rises from 25 oranges to 35 oranges per day. Let Irina’s apple productivity rise from 25 to 35


apples per day. Suppose their productivities with respect to their non-comparative advantage goods re-main the same.

The larger individual PPFs are plotted in Figure 1.13 to form the household PPF given by the ex-terior segments intersecting at point B. Notice that the increase in productivities for the two sisters has shifted the entire household PPF outwards, enabling the household to produce and consume more or-anges and more apples, as it would if it were to move from point A to B. Alternatively, one can say that if economic growth occurs, one possible cause is an improvement in technology causing a rise in productivity.

FIGURE 1.13 The Effects of Technological Change

A final source of economic growth was already shown earlier. Recall in Figure 1.10 that if Olga and Irina were forced to specialize in the good in which they did not have a comparative ad-vantage, then production might take place at a point such as C. It is worth emphasizing that at point C, all three sisters are fully employed; there is no unemployment of resources. Still production takes place inside the efficient frontier. If starting from point C, the economy could reallocate resources efficiently, meaning Olga and Irina are allowed to produce according to their comparative advantage, then pro-duction could expand to points like A or B in which production of both goods increase.

This then offers another source of economic growth. Even if an economy has no unemployed re-sources to draw on, cannot expand resources further, and cannot improve technology, there is still one outlet for economic growth—namely, efficiency improvements on the basis of comparative advantage. If we ask how to promote this increase in efficiency, the free market answer is to allow self-interested individuals to seek as much profit as possible. By allowing individuals to use prices as a guide, their de-sire to make more money will lead them, as if by an invisible hand, to specialize in their comparative advantage good and trade it with others. Finally, it is worth noting that even if production occurs ineffi-ciently, like at point C in Figure 1.10, production can be expanded by the other methods: the


reemployment of unemployed resources, the expansion of resources, and the improvement in techno-logy. These are the only ways for an economy to grow.

K E Y T A K E A W A Y

< There are four fundamental reasons for economic growth displayed using the multiperson PPF:

< An increase in new resources, such as labor or capital, to production

< A reemployment of previously unemployed resources

< An increase in productivity

< A reallocation of resources on the basis of comparative advantage

10. ADDITIONAL EXERCISES

E X E R C I S E S

1. Consider the Edgeworth box diagram below for Saher and Jing, each working for one week, but splittingtheir time to produce both cheese and wine. Use the diagram to answer the following questions.

A. What would be the total output of cheese and wine if Saher and Jing produce at point A?

B. Who has the absolute advantage in wine production? Why?

C. What is Saher’s opportunity cost of cheese?

D. Who has the comparative advantage in cheese? Explain why.

E. What would be the total output of cheese and wine if Saher specialized in wine and Jingspecialized in cheese?

F. What would be the total output of cheese and wine if Saher and Jing specialized in theircomparative advantage goods?

2. Suppose there are two sisters, Irina and Maria, whose individual and joint PPFs for one hour of work eachare presented in the following diagram.

A. Which sister has the absolute advantage in the production of apples? Irina, Maria, or neither.Briefly indicate why.

B. Which sister has the comparative advantage in apples? Irina, Maria, or neither?C. If the sisters maximize household utility by producing at point B how many oranges and apples

does Maria produce?

D. If the sisters maximize household utility by producing at point A how many oranges and applesdoes Maria produce?

E. If Irina’s productivity of one good increased sufficiently, the comparative advantages wouldswitch. What value must Irina’s productivity rise above to make this happen?

F. Point C could be achieved without switching comparative advantage if Maria’s productivity inthis good increased sufficiently, ceteris paribus.


FIGURE 1.14 Figure for Exercise 1

FIGURE 1.15 Figure for Exercise 2


production, trade, and comparative advantage

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