+ - 0:00:00
Notes for current slide
Notes for next slide

1.3 — Comparative Advantage

ECON 324 • International Trade • Fall 2020

Ryan Safner
Assistant Professor of Economics
safner@hood.edu
ryansafner/tradeF20
tradeF20.classes.ryansafner.com

The Origins of Exchange I

  • Why do we trade?

  • Resources are in the wrong place!

  • People have better uses of resources than they are currently being used!

The Origins of Exchange II

  • Why are resources in the wrong place?

  • We have the same stuff but different preferences

The Origins of Exchange III

  • Why are resources in the wrong place?

  • We have different stuff and/or different preferences

Transaction Costs and Exchange I

  • But Transaction costs!
    • Search costs: cost of finding trading partners
    • Bargaining costs: cost of reaching an agreement
    • Enforcement costs: trust between parties, cost of upholding agreement, dealing with unforeseen contingencies, punishing defection, using police and courts

Transaction Costs and Exchange II

  • With high transaction costs, resources cannot be traded

  • Resources cannot be switched to higher-valued uses

  • If others value goods higher than their current owners, resources are inefficiently allocated!

Transaction Costs and Exchange III

  • Markets are institutions that facilitate voluntary impersonal exchange and reduce transaction costs

  • There's a lot of institutions in the "bundle" we call "markets":

    • Prices, profits and losses, property rights, rule of law, contract enforcement, dispute resolution, protection, trust

Transaction Costs and Exchange III

  • All of those things are assumed when we draw nice supply & demand graphs on the blackboard

  • How do various political institutions enable these market institutions to succeed?

Comparative Advantage

Specialization

Adam Smith

1723-1790

"It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy...If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry, employed in a way in which we have some advantage." (Book I, Chapter 2).

Smith, Adam, 1776, An Enquiry into the Nature and Causes of the Wealth of Nations

Specialization in the Presence of Absolute Advantage

  • Martha Stewart is a world renowned decorator and designer

  • She also claims to be able to iron a shirt better and faster than anyone else

  • Should she iron her own shirts?

“I don’t always do all of my own ironing, even though I wish that I could.”

Specialization in the Presence of Absolute Advantage

  • Even in the presence of absolute advantage (one party is more efficient at producing all goods), it still often is better for them to specialize

    • A high opportunity cost of producing everything
  • Pay others to perform a task, or purchase a good, and specialize in producing goods where you have the lowest opportunity cost

  • This is the principle of comparative advantage

Comparative Advantage

Paul Samuelson

1915-2009

Economics Nobel 1970

  • Sanislaw Ulam once challenged Samuelson to “name me one proposition in all of social sciences which is both true and non-trivial

  • Samuelson’s answer: comparative advantage

“That it is logically true need not be argued before a mathematician; that is is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them,”

Samuelson, Paul A, 1969, “The Way of an Economist,” in P.A. Samuelson, ed. International Economic Relations: Proceedings of the Third Congress of the International Economic Association, London: Macmillan, p.11

Ricardian Comparative Advantage

David Ricardo

1772-1823

“To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.”

Ricardo, David, 1817, Principles of Political Economy and Taxation

Ricardian Comparative Advantage

David Ricardo

1772-1823

  • Sought to explain an apparent paradox: countries often produce & export goods they don’t seem to be “good at producing!”

  • Answer: citizens of the importing country are even better at producing something else (in relative terms)

    • Worthwhile for the exporting country to buy this from abroad (with exports as payment)

Ricardo, David, 1817, Principles of Political Economy and Taxation

A Simple Example of Comparative Advantage

A Simple Example of Comparative Advantage

  • Start with the simplest model of exchange

  • A single person (Robinson Crusoe) marooned on a deserted island

  • Autarky: complete self-sufficiency (no exchange)

    • Must produce everything one consumes

A Simple Example of Comparative Advantage

  • Crusoe’s production set represents the set of all possible production opportunities

  • Production possibilities frontier (PPF) represents the subset of production opportunities that use all available resources

    • i.e. Crusoe uses all his available time to produce a combination on his PPF

A Simple Example of Comparative Advantage

  • Points on the frontier are efficient (uses all available labor supply)
    • Points A-F

A Simple Example of Comparative Advantage

  • Points on the frontier are efficient (uses all available labor supply)

    • Points A-F
  • Points beneath the frontier are feasible (in production set) but inefficient (does not use all available labor supply)

    • Point G

A Simple Example of Comparative Advantage

  • Points on the frontier are efficient (uses all available labor supply)

    • Points A-F
  • Points beneath the frontier are feasible (in production set) but inefficient (does not use all available labor supply)

    • Point G
  • Points above the frontier are impossible with current constraints (endowment, technology, trading opportunities)

    • Point H

A Simple Example of Comparative Advantage

  • Slope of PPF: marginal rate of transformation (MRT)

  • Rate at which (domestic) market values tradeoff between goods x and y

  • Relative price of x (in terms of y), or opportunitiy cost of x: how many units of y must be given up to produce one more unit of x

A Numerical Example

  • Suppose the two goods on the island are fish (f) and berries (b)

A Numerical Example

  • Suppose the two goods on the island are fish (f) and berries (b)

  • Can represent the PPF as a linear function:

b=102f

A Numerical Example

  • Suppose the two goods on the island are fish (f) and berries (b)

  • Can represent the PPF as a linear function:

b=102f

  • Slope: 2
  • Opportunity cost of 1f: 2b

A Numerical Example

  • Suppose the two goods on the island are fish (f) and berries (b)

  • Can represent the PPF as a linear function:

b=102f

  • Slope: 2
  • Opportunity cost of 1f: 2b
  • Opportunity cost of 1b: 12f
  • Hint: use the endpoints!

A Numerical Example

  • Suppose the two goods on the island are fish (f) and berries (b)

  • Can represent the PPF as a linear function:

b=102f

  • Slope: 2
  • Opportunity cost of 1f: 2b
  • Opportunity cost of 1b: 12f

Meeting Friday

Crusoe

Friday

Meeting Friday

Crusoe

Crusoe’s PPF: b=102f

Friday

Meeting Friday

Crusoe

Crusoe’s PPF: b=102f

Friday

Friday’s PPF: b=212f

Meeting Friday

Crusoe

Crusoe’s PPF: b=102f

Crusoe’s opportunity cost of 1f: 2b

Friday

Friday’s PPF: b=212f

Friday’s opportunity cost of 1f: 12b

Meeting Friday

Crusoe

Crusoe’s PPF: b=102f

Crusoe’s opportunity cost of 1f: 2b

Crusoe’s opportunity cost of 1b: 12f

Friday

Friday’s PPF: b=212f

Friday’s opportunity cost of 1f: 12b

Friday’s opportunity cost of 1b: 2f

Production Potentials

Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12

Production Potentials

Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12
  • Why should Crusoe trade with Friday? Crusoe has an absolute advantage in everything!

Production Potentials

Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12

Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f
  • Different opportunity costs imply differing comparative advantages!

Production Potentials

Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12

Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f
  • Different opportunity costs imply differing comparative advantages!

  • Person (country) with lower opportunity cost of a particular good should specialize in producing that good

Current Production & Consumption

Crusoe

Fish Berries
Crusoe 2 6
Friday 2 1

Friday

  • Each is producing & consuming at an (arbitrary) point on their PPFs (A and A')

Specialization in Production

Crusoe

Fish Berries
Crusoe 0 10
Friday 4 0
TOTAL 4 10

Friday

  • Each then specializes in their comparative advantage (B and B')

Specialization in Production

Crusoe

Fish Berries
Crusoe 0 10
Friday 4 0
TOTAL 4 10

Friday

  • Each then specializes in their comparative advantage (B and B')

  • Suppose they agree on the following terms of trade: 1 fish for 1 berry

    • Crusoe gives Friday 2 berries for 2 fish

The Terms of Trade

  • The “terms of trade” are also known as exchange rates or relative prices

  • (Without money), there are two prices here:

    • (berry) price of fish, pf: amount of berries given up for 1 fish
    • (fish) price of berries, pb: amount of fish given up for 1 berry

The Terms of Trade

  • Each party wants to buy at a relative price lower than their own opportunity cost

    • Otherwise, “cheaper” to produce it yourself!
  • Each party wants to sell at a relative price higher than their own opportunity cost

    • Otherwise, keep it!

Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f

The Terms of Trade

  • Each party wants to buy at a relative price lower than their own opportunity cost

    • Otherwise, “cheaper” to produce it yourself!
  • Each party wants to sell at a relative price higher than their own opportunity cost

    • Otherwise, keep it!

12 berry <pf<2 berries

12 fish <pb<2 fish

Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f

Improvements in Post-Trade Consumption

Crusoe

Fish Berries
Crusoe 2 8
Friday 2 2
TOTAL 4 10

Friday

  • Gains from exchange: both Crusoe and Friday can comume more than they could possibly produce!

  • At points above their PPFs

How Division of Labor Deepens Comparative Advantage

Friday’s Productivity Increase

  • Recall, Crusoe specialized in berry-gathering and Friday specialized in fishing

  • Suppose Friday becomes better at fishing (Smith’s reasons):

    • Lower switching costs
    • Learning by doing
    • Creating specialized tools (a net)

New Opportunity Costs

Original Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12

New Opportunity Costs

Original Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12

New Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 8 2
TOTAL 13 12

New Opportunity Costs

Original Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12

Original Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f

New Opportunity Costs

Original Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 4 2
TOTAL 9 12

Original Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f

New Maximum Possible Production

Fish Berries
Crusoe 5 10
Friday 8 2
TOTAL 13 12

New Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.25b 4f

New Opportunity Costs Lead to New Prices

Original Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f

12 berry <pf<2 berries

12 fish <pb<2 fish

New Opportunity Costs Lead to New Prices

Original Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.5b 2f

12 berry <pf<2 berries

12 fish <pb<2 fish

New Opportunity Costs

1 Fish 1 Berry
Crusoe 2b 0.5f
Friday 0.25b 4f

14 berry <pf<2 berries

12 fish <pb<4 fish

New Post-Trade Consumption

Crusoe

Fish Berries
Crusoe 3 7
Friday 5 3
TOTAL 8 10

Friday

  • Keep same terms of trade (1b:1f)

  • Crusoe gives Friday 3 berries for 3 fish

Gains from Exchange and Productivity

  • Both exchange and increasing productivity here are Pareto improvements

    • At least one person made better off, and nobody worse off
  • Friday, by becoming more productive, has more fish

    • by becoming comparatively better at catching fish, becomes comparatively worse at gathering berries
  • Trade becomes more important

  • Crusoe better off too, getting more fish in exchange for his berries!

Trade as a Production Technology

Two ways to produce a car:

Trade as a Production Technology

Two ways to produce a car:

Trade as a Production Technology

Two ways to produce a car:

Trade as a Production Technology

Two ways to produce a car:

Trade as a Production Technology

Two ways to produce a car:

Trade as a Production Technology

Two ways to produce a car:

Trade as a Production Technology

Two ways to produce a car:

Trade as a Production Technology

  • Trade is only a more roundabout way of producing for consumption

Trade as a Production Technology

  • Trade is only a more roundabout way of producing for consumption

  • Direct: increase own productivity & production

Trade as a Production Technology

  • Trade is only a more roundabout way of producing for consumption

  • Direct: increase own productivity & production

  • Indirect: specializing in production & exchanging with others

  • Extends division of labor & extent of the market!

The Origins of Exchange I

  • Why do we trade?

  • Resources are in the wrong place!

  • People have better uses of resources than they are currently being used!

Paused

Help

Keyboard shortcuts

, , Pg Up, k Go to previous slide
, , Pg Dn, Space, j Go to next slide
Home Go to first slide
End Go to last slide
Number + Return Go to specific slide
b / m / f Toggle blackout / mirrored / fullscreen mode
c Clone slideshow
p Toggle presenter mode
t Restart the presentation timer
?, h Toggle this help
Esc Back to slideshow