McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 2 Comparative Advantage

2-2 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 2- All Learning Objectives: Understand 1.The Principle of Comparative Advantage 2.The role of comparative advantage in international trade 3.The Principle of Increasing Opportunity Cost 4.Factors that shift the menu of production possibilities

2-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Production Advantages  Definitions  Absolute advantage  Lowest production cost  Comparative advantage  Lower opportunity cost than someone else

2-4 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO U.S. has absolute advantage in both car and computer production. Should U.S. produce everything and India produce nothing? Production Times1 car1 computer U.S.3 hours2 hours India8 hours4 hours Example

2-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO  Which country has comparative advantage in computer production? Look at opportunity cost per unit Opportunity Cost1 Car1 Computer U.S.1.5 computers2/3 car India2 computers1/2 car Comparative Advantage

2-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Principle of Comparative Advantage Everyone does best when each concentrates on the activity with the lowest opportunity cost The Principle of Comparative Advantage

2-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Suppose the demand of two countries are 8 cars and 6 computers per day. Other than specialization, there is no way of satisfying such a demand! Production Times1 car1 computer U.S.3 hours2 hours India8 hours4 hours Comparative Advantage Example

2-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Comparative Advantage and International Trade  Principle of Comparative Advantage and gains from trade apply worldwide  Controversial trade  Benefits the society broadly  Costs are concentrated  Some industries  People who lose their jobs

2-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Another Comparative Advantage Example Hourly OutputCoffeeNuts Susan4 pounds2 pounds Tom2 pounds4 pounds

2-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO  Look at opportunity cost per unit  Comparative advantage is a comparison. To get 1 coffee, Sue gives up ½ nuts, Tom gives up 2 nuts. Opportunity Cost CoffeeNuts Susan½ nut2 coffee Tom2 nuts½ coffee Comparative Advantage

2-11 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Production Possibilities Curve  A graph of the combinations of two goods that can be produced with given resources  Definitions  Unattainable point  Attainable point  Inefficient point  Efficient point  Scarcity Principle  Give up one good to get another Nuts (lb/day) A B Unattainable Combination C Inefficient Combination D Coffee (lb/day)

2-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Susan's Production Possibilities  Two goods: coffee and nuts  Work 6 hours per day  1 hour of labor = 4 pounds of coffee OR = 2 pounds of nuts Coffee (lb/day) Nuts (lb/day) A B C D 12

2-13 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Susan's Opportunity Cost  Marginal cost: – 8 coffee  Marginal benefit: 4 nuts Loss in coffee Gain in nuts  Opportunity cost of 1 nut is 2 coffee  Marginal cost: – 8 nut  Marginal benefit: 16 coffee Loss in nuts Gain in coffee  Opportunity cost of 1 coffee is ½ nut Coffee (lb/day) Nuts (lb/day) A B C D 12

2-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Tom's Production Possibilities  Work 6 hours per day  Productivity determines the slope of the PPC Nuts (lb/day) Coffee (lb/day) A B C D 12 24

2-15 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Tom, Meet Susan  PPCs show comparative advantage  Sue's curve is steeper, better for coffee  Tom's curve is flatter, better for nuts Nuts (lb/day) Tom’s PPC Susan’s PPC Coffee (lb/day)

2-16 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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 coffee, some better at nuts Nuts (1000s of lb/day) Coffee (1000s of lb/day) E A B C D

2-17 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity cost. The Principle of Increasing Opportunity Cost

2-18 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Principal of Increasing Opportunity Cost Nuts (1000s of lb/day) Coffee (1000s of lb/day) E A B C D

2-19 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 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

2-20 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO The Dynamic Economy  A PPC represents current choices  Changes in choices occur over time due to  More resources  Investment in capital  Population growth  Improvements in technology  Increases in knowledge

2-21 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO Shifts in PPC Nuts Coffee Neutral Technical Change Nuts Coffee Technical Change in Nuts Technical Change in Coffee Nuts Coffee