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Chapter 2: Comparative Advantage: The Basis for Exchange Slide 2
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Comparative Advantage: The Basis for Exchange
What Do You Think?Do the Nepalese perform their own
services because they are poor or are they poor because they perform their own services?
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 3
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Should Johnnie Cochran write his own will?Cochran earns more than $1,000 per hourThe cost of having a will prepared is less
than $800
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 4
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Absolute AdvantageOne person has an absolute advantage
over another if he or she takes fewer hours to perform a task than the other person
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 5
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Comparative AdvantageOne person has a comparative advantage
over another if his or her opportunity cost of performing a task is lower than the other person’s opportunity cost
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 6
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Principle of Comparative AdvantageShould Paula update her own web page?
Time to updateTime to updateweb pageweb page
Time to complete Time to complete bicycle repairbicycle repair
PaulaPaula 20 minutes20 minutes 10 minutes10 minutes
BethBeth 30 minutes30 minutes 30 minutes30 minutes
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 7
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Principle of Comparative AdvantageShould Paula update her own web page?
Opportunity Cost of Opportunity Cost of updating a web pageupdating a web page
Opportunity Cost of a Opportunity Cost of a bicycle repairbicycle repair
PaulaPaula 2 bicycle repairs2 bicycle repairs 0.5 web page updates0.5 web page updates
BethBeth 1 bicycle repair1 bicycle repair 1 web page update1 web page update
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 8
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Principle of Comparative AdvantageShould Paula update her own web page?
How many web pages and bicycle repairs can Paula and Beth produce a day if they both work eight-hour days?
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 9
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Principle of Comparative Advantage
If Paula splits her time evenly and both produce 16 web pages
PaulaPaula
BethBeth
Web PagesWeb Pages Bicycle RepairsBicycle Repairs
1212
442424
1212
TotalTotal 1616 3636
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 10
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Principle of Comparative Advantage
If they specialized in their comparative advantage
PaulaPaula
BethBeth
Web PagesWeb Pages Bicycle RepairsBicycle Repairs
00
16164848
00
TotalTotal 1616 4848
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 11
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Principle: You can always produce an extra unit of one good at lower opportunity cost through comparative advantage.
That is why the book says (p. 35), that
“The total number of [both] bicycle repairs and web updates accomplished if Paula & Beth both spend part of their time at each activity will always be smaller than … if each specializes [according to] comparative advantage.”
But what about the total number of each?
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 12
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Notice, what if they had to achieve more than 16 web updates per day?
Let’s say we need 20 webs a day, and Paula & Beth still have 8 hours a day.
Even if Beth works her full 8 hours on the web, she can only make 16 pages a day.
That would mean Paula would have to work part-time against her comparative-advantage!
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 13
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
A qualification to Comparative Advantage: a) If there is big enough demand for a good for
which some producer(s) have comparative disadvantage, but an absolute advantage (Paula’s web pages),
b) and that demand can’t be met solely by those producer(s) for whom the good is a comparative advantage, given their limited resources,
Then – The absolute advantage producer(s) of the
good must work against comparative, and with their absolute advantage!
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 14
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Moral – Opportunity Costs (OC) are not constant: they can change and override comparative advantage based solely on labor productivity or some similar measure.
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 15
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The OC of Paula producing another bike repair at some point might not be just “0.5 web page updates.”
If we need those pages badly enough, it could be: “you all die.”
Opportunity Cost of Opportunity Cost of updating a web pageupdating a web page
Opportunity Cost of a Opportunity Cost of a bicycle repairbicycle repair
PaulaPaula 2 bicycle repairs2 bicycle repairs 0.5 web page updates0.5 web page updates
BethBeth 1 bicycle repair1 bicycle repair 1 web page update1 web page update
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 16
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Principle of Comparative AdvantageShould Barb update her own web page?
Productivity in Productivity in programmingprogramming
Productivity inProductivity in
bicycle repairbicycle repair
PatPat 2 webs/hr2 webs/hr 1 bike/hr1 bike/hr
BarbBarb 3 webs/hr3 webs/hr 3 bikes/hr3 bikes/hr
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 17
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Productivity in Productivity in programmingprogramming
Productivity inProductivity in
bicycle repairbicycle repair
PatPat 2 webs/hr2 webs/hr
OC (web) = 0.5 bikesOC (web) = 0.5 bikes
1 bike/hr1 bike/hr
OC (bike) = 2 websOC (bike) = 2 webs
BarbBarb 3 webs/hr3 webs/hr
OC (web) = 1 bikeOC (web) = 1 bike
3 bikes/hr3 bikes/hr
OC (bike) = 1 webOC (bike) = 1 web
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 18
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
The Principle of Comparative AdvantageEveryone does best when each person (or
each country) concentrates on the activities for which his or her opportunity cost is lowest
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 19
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Economic NaturalistWhere have all the .400 hitters gone?Ted Williams (Red Sox), last man to hit
over 400 in a season (.406, in 1941)
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 20
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Sources of Comparative AdvantageIndividual
Inborn talentEducationTrainingExperience
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 21
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Sources of Comparative AdvantageNational Level
Natural resourcesCultural institutions
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 22
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Exchange and Opportunity Cost
Economic NaturalistTelevisions and videocassette recorders
were developed and first produced in the United States.
Why did the United States fail to retain its lead in these markets?
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 23
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Comparative Advantage and Production Possibilities
The Production Possibilities CurveA graph that describes the maximum
amount of one good that can be produced for every possible level of production of another good.
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 24
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Comparative Advantage and Production Possibilities
The Production Possibilities CurveAssume
A small economy thato Produces only two goods - coffee and nutso Has only one worker who works 6 hrs/day
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 25
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Susan’s Production Possibilities
0
Coffee(lb/day)
Nuts(lb/day)
Opportunity Cost (OC)1. OC nuts = Loss in
coffee/gain in nuts = 2
2. OC coffee = Loss in nuts/gain in coffee = 1/2
16
8
4 8
24
Production Possibilities Curve: Allcombinations of coffee and nuts thatcan be produced with Susan’s labor
A
B
C
D
12
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 26
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Susan’s Production Possibilities
The scarcity principle: Having more of one good generally means having less of another good.
Coffee(lb/day)
Nuts(lb/day)
A
B
C
D
24
0
16
8
4 8 12
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 27
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Attainable and Efficient Points on Susan’s Production Possibilities
Nuts(lb/day)
A
B
Combination F: Unattainable
C
Combination E: Inefficient
D
Combinations A, B, C, and D: Efficient
Coffee(lb/day)
24
0
16
8
4 8 12
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 28
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Comparative Advantage and Production Possibilities
The Production Possibilities CurveAttainable Point
Any combination of goods that can be produced using currently available resources
Unattainable PointAny combination that cannot be produced using
currently available resources
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 29
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Comparative Advantage and Production Possibilities
The Production Possibilities CurveEfficient Point
Any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 30
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Comparative Advantage and Production Possibilities
The Production Possibilities CurveInefficient Point
Any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 31
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Tom’s Production Possibilities
0
Nuts(lb/day)
How Individual Productivity Affects the Slope and Position of the Production Possibilities Curve
Tom’s Production Possibilities Curve for a 6 hour day
Coffee(lb/day)
4
8
8 16
A
B
C
D
12Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor
24
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 32
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Individual Production Possibilities Curves Compared
Nuts(lb/day)0
12
24
Tom’s Production Possibilities Curve
Tom has an absolute and comparative advantage in
picking nuts
24
12
Susan’s Production Possibilities Curve
Susan has an absolute and comparative advantage in picking coffee
Coffee(lb/day)
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 33
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Production Without Specialization
Nuts(lb/day)0
12
24
12 24
Susan’s Production Possibilities Curve
Assume: Susan and Tom allocate their time so each person’s output is half nuts and half coffee
Tom’s Output = 2 hrs picking nuts = 8 lbs 4 hrs picking coffee = 8 lbs
Susan’s Output = 2 hrs picking coffee = 8 lbs4 hrs picking nuts = 8 lbs
Total Output = 16 lbs each
8
8
BTom’s Production Possibilities Curve
Coffee(lb/day)
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 34
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Production With Specialization
Nuts(lb/day)0
12
24
12 24
Susan’s Production Possibilities Curve
Tom’s comparative advantage is in nuts so he specializes in nuts and produces 24 lbs
Susan’s comparative advantage is in coffee so she specializes in coffee and produces 24 lbs
Susan gives Tom 12 lbs of coffee for 12 lbs of nuts
E
Tom’s Production Possibilities Curve
Coffee(lb/day)
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 35
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The gains from specialization grow larger as the difference in opportunity cost increasesFor Example
Susan: 5 lb coffee/hr 1lb nuts/hr
Tom: 1 lb nuts/hr 5 lb coffee/hr
Comparative Advantageand Production Possibilities
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 36
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The gains from specialization grow larger as the difference in opportunity cost increasesWithout Specialization
Tom: 5 hrs coffee = 5 lb 1 hr nuts = 5 lb
Susan: 1 hr coffee = 5 lb 5 hrs nuts = 5 lb
Total: 10 lb 10 lb
Comparative Advantage and Production Possibilities
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 37
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
The gains from specialization grow larger as the difference in opportunity cost increasesWith Specialization
Tom: 30 lb coffee 0 lb nuts
Susan: 0 lb coffee 30 lb nuts
Total: 30 lb 30 lb
Comparative Advantageand Production Possibilities
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 38
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Production PossibilitiesCurve For a Large Economy
Nuts(1000s of lb/day)
Assume: An economy that produces only two goods, coffee and nuts
100
80
Why would the Production Possibilities Curve have
an outward bow?
Coffee(1000s of lb/day)
E
AB
C
D
1520
9095
20 30 75
77
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 39
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Principle of Increasing Opportunity Cost (“The Low-Hanging-Fruit Principle”)
In expanding the production of any good, first employ those resources with the lowest opportunity costs, and only later turn to resources with higher opportunity costs.
Comparative Advantage and Production Possibilities
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 40
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Economic Growth: An Outward Shift in the Economy’s PPC
Coffee(1000s of lb/day)
Nuts(1000s of lb/day)
Original PPC
New PPC
Factors Shifting the PPC1. Increases in productive resources
(i.e., labor or capital)
2. Improvements in knowledge and technology
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 41
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Factors That Shift The Economy’s Production Possibilities Curve
Increasing Productive ResourcesInvestment in new factories and equipment Population growth
Improvements in Knowledge and TechnologyIncreasing educationGains from specialization
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 42
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Factors That Shift The Economy’s Production Possibilities Curve
Why have countries Like Nepal been So slow to specialize?Low population densityIsolation
Some factors that may limit specialization in other countries:LawsCustoms
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 43
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Factors That Shift The Economy’s Production Possibilities Curve
Can we have too much specialization?
What do you think?What are the costs of specialization?
Chapter 2: Comparative Advantage: The Basis for Exchange Slide 44
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Copyright c 2004 by The McGraw-HillCompanies, Inc. All rights reserved.
Comparative Advantage and International Trade
Economic NaturalistIf trade between nations is so beneficial,
why are free-trade agreements so controversial?