SPECIALIZATION AND

COMPARATIVE ADVANTAGE

CHAPTER 5

SPECIALIZATION DEFINED

THE USE OF THE RESOURCES OF AN INDIVIDUAL, A FIRM, A REGION, OR A NATION TO CONCENTRATE PRODUCTION ON ONE OR A SMALL NUMBER OF GOODS AND SERVICES.

(SPECIALIZATION MAKES SENSE WHEN A NATION CAN TRADE THE GOOD IT SPECIALIZES IN FOR OTHER GOODS IT DOES NOT SPECIALIZE IN PRODUCING.)

COMPARATIVE COSTSTHE US AND MEXICO PRODUCE AVOCADOS AND SOYBEANS

ACCORDING TO THE PPT’S BELOW

MEXICO

PRODUCT A B C D E

AVOCADOS 0 20 24 40 60

SOYBEANS 15 10 9 5 0

USA

PRODUCT A B C D E

AVOCADOS 0 30 33 60 90

SOYBEANS 30 20 19 10 0

MEXICOProduct A B C D EAvocados 0 20 24 40 60Soybeans 15 10 9 5 0

USAProduct A B C D EAvocados 0 30 33 60 90Soybeans 30 20 19 10 0

Comparing the costs (use of input resources) shows that the USA can produce more soybeans and more avocados than Mexico.

The USA has an ABSOLUTE ADVANTAGE in producing both goods. In other words, the USA can produce more avocados and soybeans using the same resources. We use our resources more efficiently.

MEXICOProduct A B C D EAvocados 0 20 24 40 60Soybeans 15 10 9 5 0

USAProduct A B C D EAvocados 0 30 33 60 90Soybeans 30 20 19 10 0

Should the USA specialize in the production of soybeans and avocados since we can produce more of them than Mexico?

To answer that question analyze the comparative costs of producing the products in each country.

MEXICOProduct A B C D EAvocados 0 20 24 4060Soybeans 15 10 9 5 0

USAProduct A B C D EAvocados 0 30 33 6090Soybeans 30 20 19 10 0

In Mexico, 5 tons of soybeans must be sacrificed to produce 20 tons of avocados. The 5 to 20 ratio is simplified to: 1S = 4A. In the USA it costs 10 tons of soybeans to obtain 30 tons of avocados. The 10 to 30 ratio is simplified to 1S = 3A.

The USA has a COMPARATIVE ADVANTAGE over Mexico in soybean production. Our opportunity cost is lower than our potential trading partner.

MEXICOProduct A B C D EAvocados 0 20 24 40 60Soybean 15 10 9 5 0

USAProduct A B C D EAvocados 0 30 33 60 90Soybeans 30 20 19 10 0

In Mexico, one ton of avocados cost ¼ ton of soybeans.

In the USA, 1 ton of avocados costs 1/3 ton of soybeans.

Mexico has a COMPARATIVE ADVANTAGE in the production of avocados. They can produce avocados more efficiently than us.

SOYBEANSAVOCADOS

• MEXICO: MUST GIVE UP 4 TONS OF AVOCADOS TO GET 1 TON OF SOYBEANS.

• USA: MUST GIVE UP 3 TONS OF AVOCADOS TO GET 1 TON OF SOYBEANS.

• COMPARATIVE ADVANTAGE: USA

• MEXICO: MUST GIVE UP ¼ TON OF SOYBEANS TO GET 1 TON OF AVOCADOS.

• USA: MUST GIVE UP 1/3 TON OF SOYBEANS TO GET 1 TON OF AVOCADOS.

• COMPARATIVE ADVANTAGE: MEXICO

TERMS OF TRADE• TRADE BETWEEN NATIONS OCCURS WHEN EACH NATION

BENEFITS MORE FROM TRADE THAN FROM DOMESTIC PRODUCTION ALONE.

• THE “TERMS OF TRADE” IS THE AGREED UPON COST OF DOING BUSINESS WITH EACH OTHER. (I AGREE TO GIVE UP ________ SOYBEANS IN ORDER TO GET __________ AVOCADOS.) THE TERMS ARE AGREED UPON THROUGH NEGOTIATIONS.

TERMS OF TRADE

• THROUGH NEGOTIATIONS MEXICO AND THE USA AGREE TO TRADE AVOCADOS AND SOYBEANS AT THE RATE OF 1 TON OF SOYBEANS FOR 3 ½ TONS OF AVOCADOS.

• THOSE TERMS WOULD BE AGREED TO BECAUSE THEY ARE BETTER THAN THE COMPARATIVE COSTS OF DOMESTIC PRODUCTION.

TERMS OF TRADETHE US GETS 3 ½ TONS OF AVOCADOS FROM MEXICO AND GIVES MEXICO 1 TON OF SOYBEANS. THAT RATE IS BETTER THAN ITS OWN DOMESTIC COST OF 3 TONS OF AVOCADOS FOR 1 TON OF SOYBEANS.

USAProduct A B C D EAvocados 0 30 33 60 90Soybeans 30 20 19 10 0

TERMS OF TRADE

• MEXICO CAN GET 1 TON OF SOYBEANS FOR 3 ½ TONS OF AVOCADOS. THAT RATE IS BETTER THAN THE 4 TONS IT WOULD GIVE UP IF IT PRODUCED SOYBEANS ITSELF.

MEXICOProduct A B C D EAvocados 0 20 24 40 60Soybeans 15 10 9 5 0

GAINS FROM SPECIALIZATION AND TRADE

IF EACH NATION FELT THAT POSITION C WAS BEST FOR THEIR COUNTRY’S NEEDS AND WANTS, THEY WOULD TRY TO IMPROVE UPON THOSE NUMBERS THROUGH TRADE.

USAProduct A B C D EAvocados 0 30 33 60 90Soybeans 30 20 19 10 0

MEXICOProduct A B C D EAvocados 0 20 24 40 60Soybeans 15 10 9 5 0

GAINS FROM SPECIALIZATION AND TRADE• IF MEXICO SPECIALIZES IN AVOCADO PRODUCTION THEY

CAN PRODUCE 60 TONS OF AVOCADOS. IF THEY TRADE WITH THE USA AT A RATIO OF 3 ½ TONS OF AVOCADOS IN EXCHANGE FOR 1 TON OF SOYBEANS THEY CAN TRADE 35 TONS OF AVOCADOS FOR 10 TONS OF SOYBEANS.

• MEXICO WOULD BE LEFT WITH 25 TONS OF AVOCADOS AFTER SPECIALIZATION AND TRADE. ONE TON OF AVOCADOS BETTER THAN THEIR SOCIETY’S IDEAL LEVEL AT POSITION C.

GAINS FROM SPECIALIZATION AND TRADE• IF THE USA SPECIALIZED IN SOYBEAN PRODUCTION IT

COULD PRODUCE 30 TONS OF SOYBEANS. IF WE TRADE WITH MEXICO SO THAT WE RECEIVE 3 ½ TONS OF AVOCADOS FOR 1 TON OF SOYBEANS. WE CAN GIVE MEXICO 10 TONS OF SOYBEANS AND GET 35 TONS OF AVOCADOS.

• WE WOULD BE LEFT WITH 20 TONS OF SOYBEANS, 1 TON BETTER THAN OUR IDEAL LEVEL AT POSITION C.

COUNTRY OUTPUTS BEFORE

SPECIALIZATION

OUTPUTS AFTER

SPECIALIZAITON

AMOUNTS TRADED

OUTPUTS AVAILABLE AFTER TRADE

GAINS FROM

SPECIALIZATION AND

TRADEMEXICO 24

avocados60

avocados-35

avocados25

avocados1

avocados9

soybeans0

soybeans+10

soybeans10

soybeans1

soybeans

USA 33 avocados

0 avocados

+35 avocados

35 avocados

2 avocados

19 soybeans

30 soybeans

-10 soybeans

20 soybeans

1 soybeans

Through specialization and international trade a nation can overcome the production constraints imposed by its domestic PPT and PPC!

AVOCADOS

90

35

33

30 19 20

X *

SOY BEANS

UNITED STATES OF AMERICA

Through trade we can achieve beyond our capabilities to produce

AVOCADOS

SOY BEANS

24

25

60

15 9 10

X*

MEXICO

Through trade we can achieve beyond our capabilities to produce