Comparative Advantage, Absolute Advantage, Specialization and Trade

1. Comparative Advantage, Absolute Advantage, Specialization and Trade

2. Comparative Advantage • A situation in which a person or country can produce a specific product at a lower opportunity cost than some other person or country • This is the basis for specialization and trade • Example: Tom is on the island and Hank washes ashore! Can they benefit from each other?

3. They can! • If Tom can catch all the fish and Hank gathers all the coconuts, then they can trade! • The most important insight into economics is that there are gains from trade even if one of the trading parties isn’t especially good at anything

4. Comparative Advantage and Gains from Trade (a) Tom’s Production and Consumption (b) Hank’s Production and Consumption Quantity of coconuts Quantity of coconuts 30 Tom’s consumption without trade Hank’s production with trade Tom’s consumption with trade 20 Hank’s consumption with trade Tom’s production with trade 10 Hank’s consumption without trade 10 9 8 Hank's T o m 's PPF PPF 0 28 30 40 0 6 10 Quantity of fish Quantity of fish

5. The next table is showing them living on their own and catching their own fish and gathering their own coconuts. Without trade, this what each consumes per week.

6. Tom and Hank’s Opportunity Costs Now, this isn’t the best way. Each has different opportunity costs and they should strike a deal that makes both better off.

7. Specialization • What is specialization? • The use of the resources of an individual, a firm, or a region, or a nation to concentrate production on one or a small number of goods and services.

8. Specialization • Which does Tom specialize in? Production of fish – catches 40 per week and gives 10 to Hank • Which does Hank specialize in? Gathering of coconuts – gathers 20 per week and gives 10 to Tom • So in the end, both are better off!

9. Comparative Advantage and Gains from Trade (a) Tom’s Production and Consumption (b) Hank’s Production and Consumption Quantity of coconuts Quantity of coconuts 30 Tom’s consumption without trade Hank’s production with trade Tom’s consumption with trade 20 Hank’s consumption with trade Tom’s production with trade 10 Hank’s consumption without trade 10 9 8 Hank's T o m 's PPF PPF 0 28 30 40 0 6 10 Quantity of fish Quantity of fish

10. What does Tom have the comparative advantage in? Catching Fish • What does Hank have the comparative advantage in? Gathering Coconuts

11. Now the point to remember, Tom and Hank will be willing to engage in trade only if the “price” of the good each person is obtaining from the trade is less than his own opportunity cost of producing the same good himself.

12. How the Castaways Gain from Trade • Both Tom and Hank experience gains from trade: • Tom’s consumption of fish increases by two, and his consumption of coconuts increases by one. • Hank’s consumption of fish increases by four, and his consumption of coconuts increases by two.

13. The model also shows that as long as people have different opportunity costs, everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something!

14. Absolute Advantage • With the example, what is Tom actually better at? Producing both goods! • Tom can catch more fish in a week, and he can also gather more coconuts • Tom has absolute advantage in both activities • He can produce more output with a given amount of input than Hank

15. Trading • Now, is trading with Hank helping Tom? • Yes, because comparative advantage, not absolute, advantage is the basis for mutual gains. • It doesn’t matter than it takes Hank more time to gather a coconut; what matters is that for him the opportunity cost of that coconut in terms of fish is lower

16. In the end, Hank, despite his absolute disadvantage, even in coconuts, has a comparative advantage in coconut gathering. Meanwhile Tom, who can use his time better by catching fish, has a comparative disadvantage in coconut-gathering.

17. Comparative Advantage, Absolute Advantage, Specialization and Trade

18. Comparative Advantage • A situation in which a person or country can produce a specific product at a lower opportunity cost than some other person or country • This is the basis for specialization and trade

19. Comparative Advantage • If Tom can catch all the fish and Hank gathers all the coconuts, then they can trade! • The most important insight into economics is that there are gains from trade even if one of the trading parties isn’t especially good at anything

20. Comparative Advantage and Gains from Trade (a) Tom’s Production and Consumption (b) Hank’s Production and Consumption Quantity of coconuts Quantity of coconuts 30 20 10 10 9 8 Hank's T o m 's PPF PPF 0 28 30 40 0 6 10 Quantity of fish Quantity of fish

21. Comparative Advantage The next table is showing them living on their own and catching their own fish and gathering their own coconuts. Without trade, this what each consumes per week.

22. Tom and Hank’s Opportunity Costs

23. Specialization • What is specialization?

24. Specialization • Which does Tom specialize in? • Which does Hank specialize in?

25. Comparative Advantage and Gains from Trade (a) Tom’s Production and Consumption (b) Hank’s Production and Consumption Quantity of coconuts Quantity of coconuts 30 20 10 10 9 8 Hank's T o m 's PPF PPF 0 28 30 40 0 6 10 Quantity of fish Quantity of fish

26. What does Tom have the comparative advantage in? • What does Hank have the comparative advantage in?

27. Now the point to remember, Tom and Hank will be willing to engage in trade only if the “price” of the good each person is obtaining from the trade is less than his own opportunity cost of producing the same good himself.

28. How the Castaways Gain from Trade • Both Tom and Hank experience gains from trade: • Tom’s consumption of fish increases by two, and his consumption of coconuts increases by one. • Hank’s consumption of fish increases by four, and his consumption of coconuts increases by two.

29. The model also shows that as long as people have different opportunity costs, everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something!

30. Absolute Advantage • With the example, what is Tom actually better at? • Tom can catch more fish in a week, and he can also gather more coconuts • Tom has absolute advantage in both activities • He can produce more output with a given amount of input than Hank

31. Trading • Now, is trading with Hank helping Tom? • _____________, because comparative advantage, not absolute, advantage is the basis for mutual gains. • It doesn’t matter than it takes Hank more time to gather a coconut; what matters is that for him the opportunity cost of that coconut in terms of fish is lower

32. In the end, Hank, despite his absolute disadvantage, even in coconuts, has a comparative advantage in coconut gathering. Meanwhile Tom, who can use his time better by catching fish, has a comparative disadvantage in coconut-gathering.