Comparative and Absolute Advantage

In the movie, Castaway, the Tom Hanks character had to do everything himself For the rest of us, labor is shared

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 Focusing on a specialty Individuals and/or firms concentrate on producing a limited number of products/activities

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 5 pounds of salmon 1 pound of coffee Brazilian 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 10 pounds Coffee

Trade Trade enables each Alaskan to consume an additional 4 pounds of coffee per day, and each Brazilian to consume an extra 4 pounds of fish per day. Each group specializes in the form of production in which it enjoys a comparative advantage, and Alaskans and Brazilians both gain from trade.

Opportunity Costs and Efficiency Before Specialization Hours Worked Production and Consumption Alaskan 4 5 pounds of salmon 1 pound of coffee Brazilian 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 10 pounds Coffee

An example Suppose a lawyer, who charges $250 an hour, types twice as fast as her secretary, whose wage is $12 an hour. 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, but they did in the south. Southerners reaped huge profits from cotton and tobacco by the 1790s. The South had very little incentive to industrialize, but the North did. As a result, the North and South developed two distinct economies, including very different agricultural systems.”

Comparative Advantage in Early America What was the comparative advantage for the North? What was the comparative advantage for the South? ---The Americans

Comparative Advantage in Early America What was the comparative advantage for the North? Industry What was the comparative advantage for the South? Cotton and Tobacco production ---The Americans

Cost-Benefit Analysis in Early America Opportunity Cost: Value of the next best alternative Choices: slavery or wage labor North: Why did the benefits of wage labor exceed the opportunity cost of slavery? South: Why did the benefits of slavery exceed the opportunity cost of wage labor?

Factors that influenced the choice Climate Market Wages Fixed Costs

Relatively high wages made renting labor expensive Climate and market promoted large production practices (farms) in the South and small production practices (industry) in the North. Relatively high wages made renting labor expensive 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.

Trade was beneficial to both the north and the south, but separated them from each other Northern farmers traded with Northern manufacturers Southern farmers traded with European manufacturers

Northern farmers traded with Northern manufacturers This facilitated the growth of Northern industry Relative wealth in industry ownership Southern farmers traded with European manufacturers This facilitated growth of Southern plantation system Relative wealth in plantation ownership Less industrial growth in South

The “American System” Tariff (tax) imposed in 1816 on imported manufactured goods from Europe This was designed to make North and South more interdependent Lobbied for by Northern Manufacturers Ushered in the circular flow of income and expenditure One person’s spending becomes another’s income

Tariff of 1816 Shifted Southern trade with Europe to Southern trade with the North Strengthened Northern Manufacturing Limited competitors Influenced outcome of Civil War

Practice: Under current conditions, we can produce either 120 autos OR 3 boats, therefore: 120A = 3 B. Dividing both sides by 3 yields: 120/3 = 3/3 or 40A = 1B 40A = 1B is the number of autos given up to produce one boat or the opportunity cost of one boat

To Find Which Nation has the Comparative Advantage Find opportunity costs for both nations Compare each product’s opportunity cost from nation to nation Nation with the lowest opportunity cost has the comparative advantage

example Country A must give up 3 units of product X for every unit of product Y Country B must give up only 2 units of product X for every unit of product Y both countries would benefit if country B specialized in the production of Y and country A specialized in the production of X. B could then exchange one unit of y for between two and three units of x (before trade, for only two units of x), and A could receive between one-third and one-half unit of y (before trade, only one-third unit of y) for every unit of x. This is true even though B may be absolutely less efficient than A in the production of both commodities.

Importance of Comparative Advantage To benefit from free trade, a nation does not have to be the lowest cost producer in the world A nation only has to have the lowest opportunity cost Remember, opportunity cost is what you give up to do something

Where did the theory of Comparative Advantage originate? David Ricardo, early 1800’s attributed the cause and benefits of international trade to the differences among countries in the relative opportunity costs  of producing the same commodities. The theory of comparative advantage provides a strong argument in favor of free trade and specialization among countries. The issue becomes much more complex, however, as the theory’s simplifying assumptions are replaced by more-realistic parameters.