Transcript Principles of Microeconomics

Comparative Advantage:
The Basis of Exchange
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Exchange and Supply
 Basis for exchange
 Principle of comparative advantage
 Production possibilities curve
 Economic efficiency
 International trade
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Basis for Exchange
 Why do people trade?
 A difference in the comparative advantage (or marginal
values to be precise) is a precondition for trade to be
mutually beneficial.
 The exchange benefits the two parties just as much as
if there had been a magical, costless increase in goods
to the two people.
 The following analyses presume costs of transaction are
negligible (this assumption will be relaxed later)
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Example 2.1. Basis for exchange
 Paul is a house painter whose roof needs replacing. Ron
is a roofer whose house needs painting.
 Although Paul is a painter, he also knows how to install
roofing. Ron, for his part, knows how to paint houses.
 Should Paul roof his own house? Should Ron paint his
own house?
Paul
Ron
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Example 1 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?
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Example 1: Basis for exchange
Opportunity Cost for
1 Painting
Opportunity Cost for
1 Roofing
Paul
0.75 Roofing
1.33 Painting
Ron
2 Roofing
0.5 Painting
 For Paul, the opportunity cost of painting one house = the
number of roofing jobs he could do during the same time.
 So Paul’s opportunity cost of painting a house is .75
roofing jobs (=300 hrs per painting/400 hrs per roofing).
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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”
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Example 1 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.
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Example 1 Basis for exchange
 Paul’s opportunity cost of painting a house is .75
roofing jobs.
 Ron’s opportunity cost of painting a house is 2 roofing
jobs.
 Paul thus has a comparative advantage at painting,
because his opportunity cost of painting is lower than
Ron’s.
 Therefore it makes sense for Paul to do both painting
jobs and leave both roofing jobs for Ron.
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Example 1: Basis for exchange
Painting
Roofing
Paul
300 hrs
400 hrs
Ron
200 hrs
100 hrs
 If each person performed both tasks for himself, the
total time spent would be 700 hours for Paul and 300
hours for Ron.
 In contrast, when each specializes in his comparative
advantage, these totals fall to 600 for Paul (300 hrs x
2 houses) and 200 for Ron (100hrs x 2 houses), a
savings of 100 hours each. This is the gain from
exchange.
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Principle of Comparative Advantage
 Everyone does best when each person (or country)
concentrates on the activities in which he or she is
relatively most efficient.
 “Concentrates on the activities in which he or she is
relatively most efficient” means specialization.
 Specialization by comparative advantage provides the
rationale for market exchange.
 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.
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Sources of Comparative Advantage
 Individual Level
 Inborn talent
 Education
 Training
 Experience
 National Level
 Natural resources
 Cultural
 Institutions
 Non-economic
 Adoption of a language
 Institutions
What can we do to change our comparative advantage?
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The Production Possibilities Curve
 A graph that describes the maximum amount of one
good that can be produced for every possible level of
production of the other good.
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Production Possibilities Curve:
One-person economy
 Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of
food.
 If Chris is the only person in the economy, describe the
economy's production possibilities curve.
Shelter (sq yd/wk)
6
4
2
0
12
4
8
Food (lb/wk)
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Production Possibilities Curve:
One-person economy
Production Possibilities Curve:
All combinations of shelter and
food that can be produced
with Chris’s labor.
Shelter (sq yd/wk)
6
4
2
0
12
4
8
Food (lb/wk)
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.
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Production Possibilities Curve:
One-person economy
A, B, C, D
E
6
4
2
0
Unattainable
F
Shelter (sq yd/wk)
Attainable and efficient
Attainable but inefficient
A
F
C
E
D
B
12
4
8
Food (lb/wk)
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Production Possibilities Curve:
Two-person economy
 Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If
Dana is the only person 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.
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Production Possibilities Curve:
Two-person economy
 For Chris, the opportunity cost of an additional pound of
food each week is 1/2 sq yd/wk of shelter.
 For Dana, the opportunity cost of an additional pound
of food each week is 1 sq yd/wk of shelter.
 Thus, Chris has a comparative advantage in producing
food, while Dana has a comparative advantage
producing shelter.
 To maximize an economy output, let Chris specialize in
producing food, while Dana in producing shelter.
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Production Possibilities Curve:
Two-person economy
 To derive the economy's production possibilities curve, let Chris
specialize in producing food until his full capacity is reached (i.e. 12
lb/wk of food). Then, let Dana produce food after that point.
Similarly, Let Dana produce shelter first until her full capacity is
reached (i.e. 4 sq yd/wk of shelter). Then, let Chris produce
shelter after that point.
Shelter (sq yd/wk)
Food (lb/wk)
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Production Possibilities Curve:
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.
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6
4
8
12
16
Food (lb/wk)
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Production Possibilities Curve:
Two-person economy
Shelter (sq yd/wk)
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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)
 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.
 So Chris will have to produce the additional 2 sq yd/wk for them to
achieve the desired 6 sq yd/wk.
 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.
 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.
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The Principle of Increasing Opportunity Cost
(Also called “The Low-Hanging-Fruit Principle”)
 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.
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The Production Possibilities Curve for an
Economy with Many Workers
Food (lbs/wk)
Clothing (garments/wk)
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.
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Economic Growth:
An Outward Shift in the Economy’s PPC
Factors Shifting the PPC
Coffee
(1000s of lb/day)
1. Increases in productive resources
(i.e. labor or capital)
New PPC
2. Improvements in knowledge and
technology
Original PPC
Nuts
(1000s of lb/day)
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Factors That Shift The Economy’s Production
Possibilities Curve
 Increasing Productive Resources
 Investment in new factories and equipment
 Population growth
 Improvements in knowledge and technology
 Increasing education
 Gains from specialization
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Factors That Shift The Economy’s Production
Possibilities Curve
 Why Have Countries Like Nepal Been So Slow to
Specialize?
 Low population density
 Isolation
 Factors that may limit specialization in other countries
 Laws
 Customs
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Gains from specialization will often be far more
spectacular!
 Division of labor according to talent and
temperament
 Learning by doing
 Specialized capital equipment
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Adam Smith on specialization:
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Adam Smith on specialization:
“One man draws out the wire, another straightens it, a third cuts it, a
fourth points it, a fifth grinds it at the top for receiving the head; to
make the head requires two or three distinct operations... I have
seen a small manufactory of this kind where only ten men were
employed... [who] could, when they exerted themselves, make
among them about twelve pounds of pins in a day. There are in a
pound upwards of four thousand pins of middling size. Those ten
persons, therefore, could make among them upwards of forty-eight
thousand pins in a day. Each person, therefore, making a tenth part
of forty-eight thousand pins, might be considered as making four
thousand eight hundred pins in a day. But if they had all wrought
separately and independently, and without any of them having been
educated to this peculiar business, they certainly could not each of
them have made twenty, perhaps not one pin in a day...”
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Too much specialization?
 Specialization boosts
productivity, but it
also entails costs.
 Variety is one of the
first casualties.
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Comparative Advantage and International Trade
 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.
David Ricardo
(1772-1823)
 As with individuals, each trading
partner can benefit from
exchange, even though one may
be more productive than the
other in absolute terms.
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