©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 2: Comparative Advantage

©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives: Understand 1.The Principle of Comparative Advantage 2.The Principle of Increasing Opportunity Cost (also called the Low-Hanging-Fruit Principle) 3.Factors that shift the menu of production possibilities 4.The role of comparative advantage in international trade

©2012 The McGraw-Hill Companies, All Rights Reserved 3 Do It Yourself? Joe Jamail, a highly successful Lebanese-American trial attorney, employs another attorney to write his will  Writing your own will  Opportunity cost of 2 hours  Hiring someone to spend 4 hours on your will  Making the right economic choice Do It Yourself only when Opportunity cost < hired cost 2 hours $10,000+ $3,200 Priceless

©2012 The McGraw-Hill Companies, All Rights Reserved 4 Production Advantages: Previous Example From the previous example:  Jamail has an absolute advantage at preparing his will  Because he can perform that task than another lawyer  Other lawyer has a comparative advantage at preparing the will  Because his opportunity cost of performing that task is lower than Jamail’s

©2012 The McGraw-Hill Companies, All Rights Reserved 5 Production Advantages Definitions  Absolute advantage  Lowest production cost  one person has an absolute advantage over another if he or she takes fewer hours to perform a task than the other person  Comparative advantage  Lower opportunity cost than someone else  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

©2012 The McGraw-Hill Companies, All Rights Reserved 6 The Principle of Comparative Advantage The Principle of Comparative Advantage Everyone does best when each concentrates on the activity with the lowest opportunity cost Opens doors for specialization  have you ever met an engineer who is also a medical doctor? Or a mechanic who is also a professor?  defines the basis for trade among people and countries

©2012 The McGraw-Hill Companies, All Rights Reserved 7 Comparative Advantage Example Production TimesWeb UpdateBike Repair Ayden20 minutes10 minutes Ghadah30 minutes Ayden and Ghadah can each update web pages and repair bikes but Ayden has an absolute advantage in both  Because it takes Ayden less time to perform each task In an 8 hour day, we can translate this into quantities Production OutputWeb UpdateBike Repair Ayden2448 Ghadah16

©2012 The McGraw-Hill Companies, All Rights Reserved 8 Comparative Advantage Example Opportunity CostWeb UpdateBike Repair Ayden2 repairs0.5 update Ghadah1 repair1 update Production OutputWeb UpdateBike Repair Ayden2448 Ghadah16

©2012 The McGraw-Hill Companies, All Rights Reserved 9 Comparative Advantage Example Production TimesWeb UpdateBike Repair Ayden20 minutes10 minutes Ghadah30 minutes Hourly OutputWeb UpdateBike Repair Ayden3 updates6 repairs Ghadah2 updates2 repairs

©2012 The McGraw-Hill Companies, All Rights Reserved 10 Comparative Advantage Example Assume that 16 web updates are ordered  Ayden spends half his time at each activity: 12 updates and 24 repairs  Ghadah produces the remaining 4 updates and spends the last 6 hours of the day making 12 repairs  Total output 16 updates and 36 repairs If specialization occurs then:16 updates and 48 repairs  12 more repairs for the same inputs! Hourly OutputWeb UpdateBike Repair Ayden3 updates6 repairs Ghadah2 updates2 repairs

©2012 The McGraw-Hill Companies, All Rights Reserved 11 Another Example This table shows output per hour  Principle of Comparative Advantage is the same  Look at opportunity cost per unit Hourly OutputWeb UpdateBike Repair Rasha2 updates1 repair Amr3 updates3 repairs Opportunity CostWeb UpdateBike Repair Rasha½ repair2 updates Amr1 repair1 update

©2012 The McGraw-Hill Companies, All Rights Reserved 12 The Principle of Comparative Advantage Two parties have different opportunity costs for two activities  Concentrate on the activities of your lowest opportunity cost  Identify the task with which the person or country has a comparative advantage in  Total value of output increases with specialization By specializing on producing tasks with which a person or a country has a comparative advantage, the opportunity for trade exists

©2012 The McGraw-Hill Companies, All Rights Reserved 13 Sources of Comparative Advantage Where does comparative advantage come from?  At the individual level  Talent Education, training and experience  At the national level  Natural resources  Cultures or societal norms Languages Institutions -Value placed on craftsmanship -Support for entrepreneurship

©2012 The McGraw-Hill Companies, All Rights Reserved 14 Moroccan Track & Field What has happened to Moroccan Track and Field? Moroccan athletes won gold medals in the following Olympics games: 1984: 2 gold medals 1988: 1 gold medal 1992: 1 gold medal 2004: 2 gold medals Ethiopians specialized in 10,000-meter competition, thus showing unsurpassed domination.

©2012 The McGraw-Hill Companies, All Rights Reserved 15 Pearl Diving in the Gulf What happened to pearl diving in the Arabian Gulf? Pearls from the Gulf are known to be the finest in the world. Arabian Gulf had comparative advantage in pearl diving due to arid climate which made sea-related activities the only economically-viable options. Global economic depression of 1930s reduced global demand for pearls, coinciding with the introduction of Japanese cultured pearls. Cultured pearls were mass produced according to specific shape, size, and quality, thereby reducing costs and virtually destroying the natural pearl industry.

©2012 The McGraw-Hill Companies, All Rights Reserved 16 Production Possibilities Curve (PPC) A graph of the combinations of two goods that can be produced with given level of resources Definitions  Unattainable point  Attainable point  Inefficient point  Efficient point Scarcity Principle  Give up one good to get another Nuts (kg/day) A B Unattainable Combination C Inefficient Combination D Coffee (kg/day)

©2012 The McGraw-Hill Companies, All Rights Reserved 17 Fatima’s Production Possibilities Two goods: coffee and nuts  Work 6 hours per day  Has nimble fingers  better for picking coffee 1 hour of labor = 4 kg of coffee OR = 2 kg of nuts  Graph shows options  Negative slope Coffee (kg/day) Nuts (kg/day) A B C D 12

©2012 The McGraw-Hill Companies, All Rights Reserved 18 Fatima’s Opportunity Cost  Moving from A to B:  Marginal cost : – 8 coffee  Marginal benefit: 4 nuts Loss in coffee Gain in nuts Opportunity cost of 1 nut is 2 coffee  Moving from C to A:  Marginal cost: – 8 nut  Marginal benefit: 16 coffee Loss in nuts Gain in coffee Opportunity cost of 1 coffee is ½ nut Coffee (kg/day) Nuts (kg/day) A B C D 12

©2012 The McGraw-Hill Companies, All Rights Reserved 19 PPC and Opportunity Cost Hints:  Since Fatima’s PPC is a straight line, its slope is constant  The absolute value of the slope of Fatima’s PPC is the ratio of its vertical intercept to its horizontal intercept:  (24 kg of coffee/day)/(12 kg of nuts/day) = (2 kg of coffee)/(1 kg of nuts)  This ratio means that Fatima’s opportunity cost of an additional kg of nuts is 2 kg of coffee  To say that Fatima’s opportunity cost of an additional kg of nuts is 2 kg of coffee is thus equivalent to saying that her opportunity cost of a kg of coffee is ½ kg of nuts.

©2012 The McGraw-Hill Companies, All Rights Reserved 20 Kamal 's Production Possibilities  Work 6 hours per day Productivity determines the slope of the PPC  1 hour of labor = 4 kg of nuts OR = 2 kg of coffee Opportunity cost  Marginal cost: – 4 coffee  Marginal benefit: 8 nuts Tom's opportunity cost of 1 coffee is 2 nuts His opportunity cost of 1 nut is ½ coffee Nuts (kg/day) Coffee (kg/day) A B C D 12 24

©2012 The McGraw-Hill Companies, All Rights Reserved 21 Kamal meets Fatima  PPCs show comparative advantage  Fatima's curve is steeper, better for coffee  Kamal's curve is flatter, better for nuts  Comparative advantage is a comparison  To get 1 coffee  Fatima gives up ½ nuts  Kamal gives up 2 nuts Nuts (kg/day) Kamal’s PPC Fatima’s PPC Coffee (kg/day)

©2012 The McGraw-Hill Companies, All Rights Reserved 22 Gains from Specialization and Trade Without trade, each person can consume along his production possibilities curve  What you produce determines what you consume With trade, each person's consumption can be greater than production  Produce according to comparative advantage  Trade to get what you want

©2012 The McGraw-Hill Companies, All Rights Reserved 23 Gains from Specialization and Trade Fatima and Kamal exchange 12 nuts, 12 coffee 8 8 Nuts (kg/day) Coffee (kg/day)  Preferred diet is half nuts, half coffee  No trade: 8 kg of coffee and 8 kg of nuts  Total output is 32 pounds  Specialization gives each person 12 kg of each good  48 total kg

©2012 The McGraw-Hill Companies, All Rights Reserved 24 Gains from Specialization and Trade  Benefits increase when differences in opportunity cost increase  Fatima's opportunity cost of nuts increase to 6 coffee  Kamal's opportunity cost of coffee increases to 6 nuts  No trade: 3.4 nuts and 3.4 coffee each  With trade: 12 nuts and 12 coffee each Trade benefits No trade Fatima's PPC 12 Coffee (kg/day) Nuts (kg/day) Kamal's PPC With trade

©2012 The McGraw-Hill Companies, All Rights Reserved 25 Production Possibilities for an Economy  Two goods: coffee and nuts  Multiple people  Different opportunity costs  Intercepts show maximum production of one good  Some resources better at coffe, some better at nuts Nuts (1000s of kg/day) Coffee (1000s of kg/day) E A B C D

©2012 The McGraw-Hill Companies, All Rights Reserved 26 The Principle of Increasing Opportunity Cost Maximum coffee: 100,000 kg / day  Give up 5,000 kg coffee, get 20,000 kg of nuts (A  B)  Give up another 5,000 kg of coffee, get an 10,000 additional kg of nuts (B  C) Nuts (1000s of kg/day) Coffee (1000s of kg/day) E A B C D

©2012 The McGraw-Hill Companies, All Rights Reserved 27 The Principle of Increasing Opportunity Cost Start with resources with lowest opportunity cost Then move to next highest opportunity cost And still higher opportunity cost Decreasing productivity Resources Used

©2012 The McGraw-Hill Companies, All Rights Reserved 28 The Principle of Increasing Opportunity Cost PPC is bow-shaped because of increasing opportunity cost  Also known as the “low-hanging-fruit principle”  1 st : It is easier to pick the low-hanging-fruit  2 nd : if the fruit picker does not want to pick the whole tree then it is still a better choice since the high-hanging-fruit are more difficult to get to  3 rd : if the fruit picker wants to pick the whole tree then it is still a better choice since he can enjoy some fast revenue from the sales of the easy to pick sooner

©2012 The McGraw-Hill Companies, All Rights Reserved 29 The Dynamic Economy What shifts the PPC?  A PPC represents current choices  Changes in choices occur over time due to More resources -Investment in capital -Population growth Improvements in technology -More specialization: start-up and switching costs Increases in knowledge

©2012 The McGraw-Hill Companies, All Rights Reserved 30 Shifts in PPC Nuts Coffee Neutral Technical Change Nuts Coffee Technical Change in Nuts Technical Change in Coffee Nuts Coffee

©2012 The McGraw-Hill Companies, All Rights Reserved 31 Some Countries Resist Specialization Specialization is easier when  Population density passes a threshold  Markets are connected  Transportation for goods  Communications for services  Legal framework supports business  Financial markets enable start-ups

©2012 The McGraw-Hill Companies, All Rights Reserved 32 Too Much Specialization? Imagine this:  Your hair stylist only cuts blonde hair  A professor for each chapter!  Seven bookstores, each open a different day of the week  A grocery store for every type of food

©2012 The McGraw-Hill Companies, All Rights Reserved 33 Comparative Advantage and International Trade Principle of Comparative Advantage and gains from trade apply worldwide  Potentially large gains from trading with different and distant countries Controversial trade  Benefits the society broadly  Costs are concentrated  Some industries  People who lose their jobs