The Basis for Trade: Comparative Advantage
Here are some hypothetical numbers used to illustrate the ideas of trade-offs, specialization, and comparative advantage. Assume Sri Lanka, using all her resources efficiently, can produce either 1,000 bags of rice OR 3,000 bags of tea. Let’s also assume that, using all her resources efficiently, Kenya can produce either 1,000 bags of rice OR 1,000 bags of tea. Further, assume that the countries have similar resource endowments and that, initially, they are not trading with each other. Therefore, each of the countries has to produce both rice and tea for its citizens. Suppose that, in the no-trade situation, Sri Lanka was consuming 400 bags of rice and 1,800 bags of tea, and in the no-trade situation, Kenya was consuming 500 bags of rice and 500 bags of tea.
The trading price is set at one bag of rice for two bags of tea, and Kenya wishes to keep at least 550 bags of rice after trade.
Notes on Specialization and Comparative Advantage
8.1 The Production Possibilities Curve
- Economists advocate trade because it maximizes total production in a world of scarce resources.
- The production possibilities curve (PPC; also known as the production possibilities frontier, or PPF) shows the different combinations of two goods or services that can be produced with a fixed set of resources. The PPC graph features three zones, based on whether a particular combination of outputs is unattainable (outside of the PPC), efficient (on the PPC), or inefficient (inside of the PPC).
- Use the compass directions of northeast and southwest to describe whether a particular basket of goods is efficient. For instance, starting at a given basket A, if there is another feasible basket B to the north, east, or northeast of A, then basket A must be inefficient, because basket B features more production of one or both of the goods for the same set of resources (or inputs).
- The PPC might be thought of as an ideal, target, or goal, and that it would not be a surprise to find that some producers are not being efficient due to shirking of duties, long conversations with colleagues around the water cooler, spending time on Facebook, or Web surfing during the workday. Inefficiency may be intentional (e.g., due to laziness) or unintentional (e.g., an inexperienced plant manager makes poor production decisions). There might also be regulations that could frustrate production; imagine a law that required all workers to stop working at the top of each hour in order to sing the national anthem.
- Think about how PPC shifts. This is discussed later in Exhibit 8.8 on page 181. The PPC shifts out due to an expansion in resources (inputs), improved worker productivity (due to education or health), or better production technology.
- Calculating Opportunity Cost—
- One can think of the implications of moving between any two combinations of goods on the PPC, which will necessarily involve a trade-off: to get more of good X, we must give up some good Y. We compute the opportunity cost (OC) using the slope of the PPC between the two points, noting that slope = rise/run or change in they-axis good divided by the change in the x-axis good. The PPC slopes downward, so the two changes will have opposite signs. Intuitively, we give up (a negative change) some of one thing to get more (a positive change) of the other.
- One might choose to compare the PPC to the budget constraint introduced back in Chapter 1. The PPC is the set of combinations of goods that one can produce with a given set of inputs and technology. The budget constraint (or budget line when graphed) is the set of combinations of goods one can purchase with a given income and prices. The PPC constrains producers, while the budget line constrains consumers.
- For extra clarity, one might show all of the steps in the opportunity cost computation:
8.2 The Basis for Trade: Comparative Advantage
- A producer has a comparative advantage (CA) in making widgets if it can produce them at a lower opportunity cost than other producers. Intuitively, the producer with the lower opportunity cost sacrifices less to make one more widget, which is a good thing if one is concerned about making the most from scarce resources.
- For instance, the OC of creating a computer program is the reciprocal of the OC of creating a Web site. In the chapter, these values are ½ and 2, respectively. This is useful in explaining that as long as the OC’s are different for two parties, one party will always have a comparative advantage in producing one good and a comparative disadvantage in producing the other. For example, suppose your OC for producing a widget is 2 and my OC for producing a widget is X. Then we know the following:
- If there are two downward-sloping, linear PPCs that are not parallel, then one must be flatter, and that PPC corresponds to the producer with the comparative advantage in producing the good on thex-axis. Because slope equals rise (change in the y-axis good) over run (change in the x-axis good), the flatter slope reflects a smaller change in the y-axis good (computer programs) for a given change in the x-axis good (Web sites). If the two PPCs are parallel, then the producers will have identical opportunity costs of producing a given good, and neither firm will have a comparative advantage.
Complete specialization means producing only the good for which a producer has a comparative advantage.
- A well-developed nation in a modern economy produces many goods, but to make the conceptual point, the authors focus on the two-good case.
- Exhibit 8.4 shows all of the combinations of Web sites and computer programs that can be produced when you and Olivia combine your productive efforts, whether you both produce only Web sites, both produce only computer programs, both completely specialize (one produces only Web sites while the other produces only computer programs), or at least one of you produces both goods.
- Graphically, the collective PCC (in red) is found by summing the two individual PPCs (in blue and gold). Another way of thinking about the collective PPC is the feasible set of consumption possibilities. This kinked red collective PPC is defined by three interesting points. Start with your PPC (in blue) and think about adding Olivia’s PPC (in gold). Add production horizontally (rightwards): if you produce 8 Web sites and Olivia produces 16 Web sites, then together you produce 24 Web sites. Next, add the extremes vertically (upwards): if you produce 16 computer programs and Olivia produces 8, then together you could produce 24. Finally, if the two of you completely specialize in the goods for which you have comparative advantages, then you could produce 16 Web sites and 16 computer programs, but if the two of you completely specialized in the goods for which you have comparative disadvantages, then you could produce only 8 Web sites and 8 computer programs.
- Another way to think of constructing the collective PPC is to imagine Olivia’s golden PPC defining a right triangle that is 16 Web sites wide and 8 computer programs tall, starting from the origin. Suppose one made such a triangle out of cardboard. Now take this 16 x 8 cardboard triangle and place its origin on your blue PPC at the lower right end, the combination with coordinates (8, 0). Without tilting it, slide it up the blue PPC, letting the cardboard triangle’s origin rest at every point on the blue PPC. You will find that if you always think about the northeasterly most points, this process will exactly map out the red collective PPC. Intuitively, you are adding Olivia’s productive capabilities (the gold cardboard triangle) to your productive capabilities (the blue PPC).
For the prompt, Determine if there is any benefit (in terms of increased consumption possibilities, refer to Figure 8.4) for Sri Lanka and Kenya if they trade with each other.
- Apply your knowledge of opportunity cost to identify the comparative advantage enjoyed by each country. Now using your knowledge of specialization and trade, show that the two countries can benefit by consuming more of both goods after trade.
- Develop a multi-paragraph response with a introduction, main section, and conclusion that includes examples and evidence to support your ideas.
- Organize your response in a clear and logical manner using proper economic reasoning. Use well-structured sentences, audience-appropriate language, and correct conventions of standard American English.
- The response must be in your own words. Do not use quotes or references.
- For a high score, you must properly use economic concepts and terms.
- Identify the basic principles of economics and explain how opportunity cost determines comparative advantage.
- Apply the concepts of opportunity cost and marginal analysis to make decisions that gain comparative advantage.
- Please writing your paper in MS Word.