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comparative advantage:
Individuals and nations gain by producing goods at relatively low costs, and exchanging their outputs for different goods produced by others at relatively low cost. All potential trading partners can gain enormously through appropriate specialization and exchange.
Opportunity cost is the key to comparative advantage:
How do individuals or groups determine which
specific goods or services to produce?
Law of Comparative Advantage
Why doesn’t this picturemake economic sense?
It defies “comparative advantage” and “absolute advantage”
Law of Comparative Advantage
The individual (or country) with the lowest opportunity cost of producing a particular good should specialize in producing that good.
Specialization – The concentration of the productive efforts of individuals and firms on a limited number of activities
Opportunity cost is the key to comparative advantage: Individuals and nations gain by producing goods at relatively low costs and exchanging their outputs for different goods produced by others at relatively low cost. All potential trading partners can gain enormously through appropriate specialization and exchange.
Comparative & Absolute Advantage
Comparative Advantage:
The ability to produce something at a lower opportunity cost than other producers face
Absolute Advantage:
The ability to produce something with fewer resources than other producers use
Opportunity Costs and Efficiency
Before Specialization Hours Worked Production and Consumption
Alaskan 4
4
5 pounds of salmon
1 pound of coffee
Brazilian 4
4
1 pound of salmon
5 pounds of coffee
After Specialization
Hours Worked
Production Consumption
Alaska 8 10 pounds Salmon 5 pounds of salmon
5 pounds of coffee
Brazilian 8 10 pounds Coffee 5 pounds of coffee
5 pounds of salmon
Suppose, for example, that a lawyer whose fees run $250 an hour types twice as fast as her secretary, whose wage is $12
hourly. She still gains by hiring the secretary. Despite her absolute
advantage in typing, the lawyer’s comparative advantage lies in
practicing law.
Comparative Advantage in Early America
“Cash crops did not grow well in the Northern soil and climate. Southerners, on the other hand, had begun to reap huge profits from cotton by the mid-1790s. The South had very little incentive to industrialize. As a result, the North and South continued to develop two distinct economies, including very different agricultural systems.”
---The Americans
Comparative Advantage in Early America
•Northern Comparative Advantageo Industry
•Southern Comparative Advantageo Mass Cotton and Tobacco Production
Other Economic Principles in Early America
•Cost-Benefit Analysis of Slavery• Opportunity Cost: Value of the next best alternative
o North: Chose no slavery • Assume slavery (owning the laborer) is next best
alternative to wage labor (renting the laborer).o South: Chose slavery
• Assume wage labor is next best alternative to slave labor
• Question: Why did the benefits of the choice exceed the opportunity cost?
Other Economic Principles in Early America
•Factors influencing choice of labor typeo Relatively high wages in America
Made renting labor expensive everywhereo Fixed costs of overseeing and possessing slaves
Larger firm size lowers average fixed cost Minimum average cost for slave production occurs at
larger firm size. o Climate and market differences promoted large firm size in
South and small firm size in North.
Other Economic Principles in Early America
•Trade is mutually beneficialo Northern farmers traded with Northern
manufacturerso Facilitated growth of Northern industryo Relative wealth in industry ownership
o Southern farmers traded with European manufacturerso Facilitated growth of Southern plantation systemo Less industrial growth in Southo Relative wealth in plantation ownership
o Beneficial trading was separating North and South
Other Economic Principles in Early America
•“American System”o Tariff in 1816 on imported manufactured goods
from Europe Designed by President Monroe to make North and
South more interdependent Lobbied for by Northern Manufacturers
o Ushered in the “era of good feelings” Circular Flow of Income and Expenditure One person’s spending becomes another’s income
Other Economic Principles in Early America
•Restricting Tradeo Common Incentive:
o Shift the mutually beneficial trade my wayo Limit my competitors
o Tariff of 1816o Shifted South-Europe trade to South-North
tradeo Strengthened Northern Manufacturing
Influenced outcome of Civil War
Illustrating Comparative Advantage
•A Tootsie Roll Game• Ignore absolute advantage to keep things as
simple as possible
•Five “points” to use in production• Country A: Twice as productive at producing
cherry tootsies.• Country B: Twice as productive at producing
cherry tootsies.
Illustrating Comparative Advantage
Country A: Production Possibilities Using Your 5 Points
Your Choice?Allocation of Points Production Possibilities
Points UsedTo ProduceCHERRY
Points UsedTo ProduceORANGE
CHERRY TootsiesProduced
ORANGETootsiesProduced
A 0 5 0 5
B 1 4 2 4
C 2 3 4 3
D 3 2 6 2
E 4 1 8 1
F 5 0 10 0
Illustrating Comparative Advantage
Country B: Production Possibilities Using Your 5 Points
Your Choice?Allocation of Points Production Possibilities
Points UsedTo ProduceCHERRY
Points UsedTo ProduceORANGE
CHERRY TootsiesProduced
ORANGETootsiesProduced
A 0 5 0 10
B 1 4 1 8
C 2 3 2 6
D 3 2 3 4
E 4 1 4 2
F 5 0 5 0
Illustrating Comparative Advantage
• Which production combination did you choose?
• Cherry _________• Orange _________
Illustrating Comparative Advantage
• Trading Opportunityo Would you like to replay the game?
Produce first Then trade
One cherry for one orange, or One orange for one cherry
Illustrating Comparative Advantage
•For Replay of the Game: •Which production combination did you choose?
• Cherry _________• Orange _________
•After trade combination?• Cherry _________• Orange _________
Practice:
Under current conditions, we can produce either 120 autos OR 3 aircraft, therefore: 120A = 3 B.Dividing both sides by 3 yields: 120/3 = 3/3 or 40A = 1B40A = 1B is the number of autos given up to produce one aircraft or the opportunity cost of one aircraft
To Find Which Nation has the Comparative
AdvantageFind opportunity costs for both nationsCompare each product’s opportunity cost from nation to nationNation with the lowest opportunity cost has the comparative advantageIf U.S. has 1A=.025B & G.B. has 1A=.05B, who has the comparative advantage?
Importance of Comparative AdvantageTo benefit from free trade, a nation does not have to be the lowest cost producer in the worldA nation only has to have the lowest opportunity costRemember, opportunity cost is what you give up to do somethingUse all the world’s resources in the relatively most productive ways
Where did this theory Originate?
David Ricardo
See separate bio and examples.
