1. MBMC Comparative Advantage: The Basis for Exchange Comparative Advantage: The Basis for Exchange

2. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 2 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?

3. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 3 Exchange and Opportunity Cost Should Johnnie Cochran write his own will? Cochran earns more than $1,000 per hour The cost of having a will prepared is less than $800

4. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 4 Exchange and Opportunity Cost Absolute Advantage One person has an absolute advantage over another if he or she takes fewer hours to perform a task than the other person

5. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 5 Exchange and Opportunity Cost Comparative Advantage One 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

6. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 6 Exchange and Opportunity Cost The Principle of Comparative Advantage Should Paula update her own web page? Time to update web page Time to complete bicycle repair Paula 20 minutes 10 minutes Beth 30 minutes

7. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 7 Exchange and Opportunity Cost The Principle of Comparative Advantage Should Paula update her own web page? Opportunity Cost of updating a web page Opportunity Cost of a bicycle repair Paula 2 bicycle repairs 0.5 web page updates Beth 1 bicycle repair 1 web page update

8. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 8 Exchange and Opportunity Cost The Principle of Comparative Advantage Should 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?

9. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 9 Exchange and Opportunity Cost The Principle of Comparative Advantage If Paula splits her time evenly and both produce 16 web pages Paula Beth Web Pages Bicycle Repairs 1242412 Total 1636

10. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 10 Exchange and Opportunity Cost The Principle of Comparative Advantage If they specialized in their comparative advantage Paula Beth Web Pages Bicycle Repairs 016480 Total 1648

11. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 11 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?

12. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 12 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!

13. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 13 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!

14. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 14 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.

15. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 15 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 updating a web page Opportunity Cost of a bicycle repair Paula 2 bicycle repairs 0.5 web page updates Beth 1 bicycle repair 1 web page update

16. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 16 Exchange and Opportunity Cost The Principle of Comparative Advantage Should Barb update her own web page? Productivity in programming Productivity in bicycle repair Pat 2 webs/hr 1 bike/hr Barb 3 webs/hr 3 bikes/hr

17. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 17 Exchange and Opportunity Cost Productivity in programming Productivity in bicycle repair Pat 2 webs/hr OC (web) = 0.5 bikes 1 bike/hr OC (bike) = 2 webs Barb 3 webs/hr OC (web) = 1 bike 3 bikes/hr OC (bike) = 1 web

18. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 18 Exchange and Opportunity Cost The Principle of Comparative Advantage Everyone does best when each person (or each country) concentrates on the activities for which his or her opportunity cost is lowest

19. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 19 Exchange and Opportunity Cost Economic Naturalist Where have all the.400 hitters gone? Ted Williams (Red Sox), last man to hit over 400 in a season (.406, in 1941)

20. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 20 Exchange and Opportunity Cost Sources of Comparative Advantage Individual  Inborn talent  Education  Training  Experience

21. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 21 Exchange and Opportunity Cost Sources of Comparative Advantage National Level  Natural resources  Cultural institutions

22. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 22 Exchange and Opportunity Cost Economic Naturalist Televisions 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?

23. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 23 Comparative Advantage and Production Possibilities 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 another good.

24. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 24 Comparative Advantage and Production Possibilities The Production Possibilities Curve Assume  A small economy that oProduces only two goods - coffee and nuts oHas only one worker who works 6 hrs/day

25. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 25 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 48 24 Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Susan’s labor A B C D 12

26. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 26 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 4812

27. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 27 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 4812

28. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 28 Comparative Advantage and Production Possibilities The Production Possibilities Curve Attainable Point  Any combination of goods that can be produced using currently available resources Unattainable Point  Any combination that cannot be produced using currently available resources

29. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 29 Comparative Advantage and Production Possibilities The Production Possibilities Curve Efficient 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

30. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 30 Comparative Advantage and Production Possibilities The Production Possibilities Curve Inefficient 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

31. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 31 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 8 816 A B C D 12 Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor 24

32. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 32 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)

33. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 33 Production Without Specialization Nuts (lb/day) 0 12 24 1224 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 lbs 4 hrs picking nuts = 8 lbs Total Output = 16 lbs each 8 8 B Tom’s Production Possibilities Curve Coffee (lb/day)

34. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 34 Production With Specialization Nuts (lb/day) 0 12 24 1224 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)

35. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 35 The gains from specialization grow larger as the difference in opportunity cost increases For Example Susan: 5 lb coffee/hr 1lb nuts/hr Tom: 1 lb nuts/hr 5 lb coffee/hr Comparative Advantage and Production Possibilities

36. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 36 The gains from specialization grow larger as the difference in opportunity cost increases Without 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

37. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 37 The gains from specialization grow larger as the difference in opportunity cost increases With Specialization Tom: 30 lb coffee 0 lb nuts Susan: 0 lb coffee 30 lb nuts Total: 30 lb 30 lb Comparative Advantage and Production Possibilities

38. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 38 Production Possibilities Curve 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 A B C D 15 20 90 95 203075 77

39. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 39 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

40. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 40 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 PPC 1. Increases in productive resources (i.e., labor or capital) 2. Improvements in knowledge and technology

41. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 41 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

42. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 42 Factors That Shift The Economy’s Production Possibilities Curve Why have countries Like Nepal been So slow to specialize? Low population density Isolation Some factors that may limit specialization in other countries: Laws Customs

43. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 43 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?

44. MBMC Copyright c 2004 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 2: Comparative Advantage: The Basis for ExchangeSlide 44 Comparative Advantage and International Trade Economic Naturalist If trade between nations is so beneficial, why are free-trade agreements so controversial?

45. MBMC End of Chapter End of Chapter