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The Principle of Comparative Advantage

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# The Principle of Comparative Advantage - PowerPoint PPT Presentation

The Principle of Comparative Advantage. Comparative advantage is the ability of a person (or state, region, country) to perform an activity or produce a good or service at a lower opportunity cost than someone else (or some other state, region, or country). Liz’s Smoothie Bar.

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The Principle of Comparative Advantage

Comparative advantage is the ability of a person (or state, region, country) to perform an activity or produce a good or service at a lower opportunity cost than someone else (or some other state, region, or country).

Liz’s Smoothie Bar

Lizzie can make smoothies or salads. Her production possibilities are as follows:

Measuring Liz’s Opportunity Cost

It takes me 90 seconds to do one salad—90 seconds that could have been used to make one smoothie.

Thus:

1 smoothie = 1 salad

and

1 salad = 1 smoothie

Joe’s Smoothie Bar

Joe can make smoothies or salads. His production possibilities are as follows:

Measuring Joe’s Opportunity Cost

It takes me 10 minutes make one smoothie—I could make 5 salads in 10 minutes.

Thus:

1 salad = 1/5 smoothie

and

1 smoothie = 5 salads

Absolute Advantage

Notice that Liz has an absolute advantage over Joe—that is, she can make more salads and smoothies per hour.

Does it follow there would be no advantages to specialization and trade?

Liz has the comparative advantage in smoothies, since she can make them at lower opportunity cost than Joe. Joe has the comparative advantage in salads—since he must sacrifice 1/5 smoothie per salad; whereas Liz must sacrifice 1 smoothie per salad.

Terms of Trade

I am willing to trade if I can get more than one salad in exchange for one smoothie.

I am willing to trade if I can get more than one fifth of a smoothie in exchange for one salad (or pay less than 5 salads 1 smoothie)

1 smoothie buys 2 salads

Or:

2 salads buys one smoothie

These terms are advantageous to both Liz and Joe!!

Complete Practice problem 3.5 on p. 84

Snowboards

25

20

Tony’s PPF

Patty’s PPF

0

10

50

Skis

Calculate Tony’s opportunity cost of a snowboard.

• Calculate patty’s opportunity cost of a snowboard.
• Who has the comparative advantage in producing snowboards?
• Who has the comparative advantage in producing skis?
• If the specialize and trade, how many snowboards and skis will they produce?