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  1. Ka-fu WongUniversity of Hong Kong Comparative Advantage: The Basis of Exchange

  2. The Basis of Exchange • Why do people exchange goods and services in the first place? • Why is YAO Ming a top basketball player, Dr. WONG an instructor in a university, and Thomas FRIEDMAN a prominent writer?

  3. Why not do everything on our own? • Should Joe Jamail write his own will? • Jamail is the most renowned trial lawyer in American History • He is listed 195 on the Forbes list of the 400 richest Americans, with net assets over $1 billion. • Should Ms. Sarah Liao do her own household chores? • Secretary for the Environment, Transport and Works (SETW) of the Hong Kong Special Administrative Region Government • She knows how to do household chores.

  4. Why not do everything on our own? Grow our own food…

  5. Why not do everything on our own? replace our own roofs…? …paint our own houses…

  6. Why not do everything on our own? We can all have more of every good and service if we specialize in the activities at which we arerelatively most efficient.

  7. Example 2.1. Basis for exchange • Paul is a house painter whose roof needs replacing. Ron is a roofer whose house needs painting. • Although Paul is a painter, he also knows how to install roofing. Ron, for his part, knows how to paint houses. • Should Paul roof his own house? Should Ron paint his own house? Paul Ron

  8. Example 2.1. Basis for exchange Time required by each to complete each type of job: Ron has an absolute advantage over Paul at both painting and roofing, which means that Ron takes fewer hours to perform each task than Paul does. Should Ron do the roofing and painting jobs for both houses?

  9. Example 2.1. Basis for exchange Time required by each to complete each type of job: However, Paul has a comparative advantage over Ron at painting, which means that he is relatively more efficient at painting than Ron is.

  10. Comparative advantage and opportunity cost “To have a comparative advantage at a task”  (is the same as) “To have a lower opportunity cost of performing it”

  11. Example 2.1. Basis for exchange • For Paul, the opportunity cost of painting one house = the number of roofing jobs he could do in the same time. • Paul takes 300 hours to paint a house, 400 hours to roof a house. • So in the time it takes Paul to paint a house, he could complete .75 roofing jobs. • So Paul’s opportunity cost of painting a house is .75 roofing jobs.

  12. Example 2.1. Basis for exchange • For Ron, the opportunity cost of painting one house = the number of roofing jobs he could do in the same time. • Ron takes 200 hours to paint a house, 100 hours to roof a house. • So in the time it takes Ron to paint a house, he could complete 2 roofing jobs. • So Ron’s opportunity cost of painting a house is 2 roofing jobs.

  13. Example 2.1. Basis for exchange • Paul’s opportunity cost of painting a house is .75 roofing jobs. • Ron’s opportunity cost of painting a house is 2 roofing jobs. • Paul thus has a comparative advantage at painting, because his opportunity cost of painting is lower than Ron’s. • Therefore it makes sense for Paul to do both painting jobs and leave both roofing jobs for Ron.

  14. Example 2.1. Basis for exchange • If each person performed both tasks for himself, the total time spent would be 700 hours for Paul and 300 hours for Ron. • By contrast, when each specializes in his comparative advantage, these totals fall to 600 for Paul and 200 for Ron, a savings of 100 hours each.

  15. Principle of Comparative Advantage • Everyone does best when each person (or country) concentrates on the activities in which he or she is relatively most efficient. • “Concentrates on the activities in which he or she is relatively most efficient” means specialization. • Specialization by comparative advantage provides the rationale for market exchange. • It explains why each person does not devote 10 percent of her time to producing cars, 5 percent to growing food, 25 percent to building housing, 0.0001 percent to brain surgery…. • By performing only those tasks at which we are relatively most efficient, we can produce vastly more than if we each tried to be self-sufficient.

  16. Caution!! • Pay close attention to the form in which the productivity information is provided. • Your goal in each case is to find each person’s opportunity cost of producing the good in question.

  17. Example 2.2. Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Which statement below is true? a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both. c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats. d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep. e. None of the above statements is true.

  18. Example 2.2. Who has the comparative advantage of milking goats? • Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Arthur’s opportunity cost of milking a goat is • 10/4 = 2.5 sheep shorn. • Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Ben’s opportunity cost of milking a goat is • 6/3 = 2 sheep shorn. • Who has a comparative advantage at milking goats? • Ben, whose opportunity cost of milking a goat is lower.

  19. Example 2.2. Who has the comparative advantage of shearing sheep? • Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Arthur’s opportunity cost of shearing a sheep is • 4/10 = 0.4 goats milked. • Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Ben’s opportunity cost of shearing a sheep is • 3/6 = 0.5 goats milked. • Who has a comparative advantage at shearing sheep? • Arthur, whose opportunity cost of shearing a sheep is lower.

  20. Example 2.2. Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Which statement below is true? a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both. c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats. d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep. e. None of the above statements is true.

  21. Example 2.3. Arthur can milk 10 goats per hour or shear 4 sheep per hour. Ben can milk 6 goats per hour or shear 3 sheep per hour. Which statement below is true? a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both. c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats. d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep. e. None of the above statements is true.

  22. Example 2.3. Who has the comparative advantage of milking goats? • Arthur can milk 10 goats per hour or shear 4 sheep per hour. So his opportunity cost of milking 1 goat is • 0.4 sheep shorn. • Ben can milk 6 goats per hour or shear 3 sheep per hour. So his opportunity cost of milking 1 goat is • 0.5 sheep shorn. • Who has a comparative advantage at milking goats? • Arthur, whose opportunity cost of milking a goat is lower.

  23. Example 2.3. Who has the comparative advantage of shearing sheep? • Arthur can milk 10 goats per hour or shear 4 sheep per hour. So his opportunity cost of shearing 1 sheep is • 2.5 goats milked. • Ben can milk 6 goats per hour or shear 3 sheep per hour. So his opportunity cost of shearing 1 sheep is • 2 goats milked. • Who has a comparative advantage at shearing sheep? • Ben, whose opportunity cost of shearing sheep is lower.

  24. Example 2.3. Arthur can milk 10 goats per hour or shear 4 sheep per hour. Ben can milk 6 goats per hour or shear 3 sheep per hour. Which statement below is true? a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both. c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats. d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep. e. None of the above statements is true.

  25. Sources of Comparative Advantage • National Level • Natural resources • Cultural • Institutions • Individual • Inborn talent • Education • Training • Experience • Non-economic • Adoption of a language • Institutions What can we do to change our comparative advantage?

  26. Economic Naturalist • Televisions and videocassette recorders were developed and first produced in the U.S. • Why did the U.S. fail to retain its lead in these markets?

  27. The Production Possibilities Curve • A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.

  28. Example 2.4 • Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. • If Chris is the only person in the economy, describe the economy's production possibilities curve.

  29. Example 2.4 Production Possibilities Curve: All combinations of shelter and food that can be produced with Chris’s labor. The absolute value of the slope of the production possibility curve is 6/12 = 1/2. For Chris, this means that the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.

  30. Example 2.4 A, B, C, D Attainable and efficient Attainable but inefficient E Unattainable F A F C E D B

  31. Example 2.5 • Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Dana is the only one in the economy, describe the economy's production possibilities curve. Shelter (sq yd/wk) Production Possibilities Curve: All combinations of shelter and food that can be produced with Dana’s labor. 4 2 Food (lb/wk) 4 2 For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter.

  32. Production Possibilities in a Two-Person Economy • For Chris, the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter. • For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter. • Thus, Chris has a comparative advantage in producing food, because the opportunity cost of producing food is only half as large as it is for Dana. • By the same token, Dana has a comparative advantage producing shelter.

  33. Example 2.6 • Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Chris and Dana are the only two people in the economy, describe the economy's production possibilities curve. Shelter (sq yd/wk) Food (lb/wk)

  34. Example 2.6 • Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Chris and Dana are the only two people in the economy, describe the economy's production possibilities curve. Shelter (sq yd/wk) Food (lb/wk)

  35. Example 2.6 • Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Chris and Dana are the only two people in the economy, describe the economy's production possibilities curve. Shelter (sq yd/wk) Food (lb/wk)

  36. Shelter (sq yd/wk) 10 6 4 Food (lb/wk) 8 16 12 Example 2.7 Dana and Chris, a married couple, have decided to consume, jointly, 6 sq yd/wk of shelter and 8 lb/wk of food. How should they divide the task of producing these quantities? Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food.

  37. Example 2.7 Shelter (sq yd/wk) 10 Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food. 6 4 Food (lb/wk) 8 16 12 • Dana has a comparative advantage in producing shelter, but even if she spends all his time producing shelter, she can make only 4 sq yd/wk. • So Chris will have to produce the additional 2 sq yd/wk for them to achieve the desired 6 sq yd/wk. • Since Chris is capable of producing 6 sq yd/wk of shelter on his own, it will take him only 1/3 of a week to produce 2 sq yd. • This leaves 2/3 of a week for him to produce food, which is exactly how much time he needs to produce the desired 8 lb/wk.

  38. The Principle of Increasing Opportunity Cost (Also called “The Low-Hanging-Fruit Principle”) • 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 costs.

  39. Example 2.8 • Chris and Dana are now joined by George, whose production-possibilities curve is shown below. What is the production-possibilities curve for the new economy consisting of Chris, Dana, and George?

  40. Production Possibilities Curve with three persons Opportunity cost of producing 1 pound per week of food George's = 2 sq yds/wk of shelter. Chris's = 1/2 sq yd/wk of shelter Dana's = 1 sq yd/wk of shelter

  41. Example 2.9 • If the economy consisting of Chris, Dana, and George is to produce 14 lbs/wk of food and 4 sq yds/wk of shelter, how should each person's work time be allocated? Chris: 0 sq yds/wk of shelter, 12 lbs/wk of food. Dana: 2 sq yds/wk of shelter, 2 lbs/wk of food. George: 2 sq yds/wk of shelter, 0 lbs/wk of food.

  42. The Production Possibilities Curve for an Economy with Many Workers Produce the initial units of clothing using the resources that are relatively most efficient at clothing production, and only then turn to those that are relatively less efficient at clothing production.

  43. Factors Shifting the PPC 1. Increases in productive resources (i.e. labor or capital) 2. Improvements in knowledge and technology New PPC Original PPC Economic Growth: An Outward Shift in the Economy’s PPC Coffee (1000s of lb/day) Nuts (1000s of lb/day)

  44. Factors That Shift The Economy’s Production Possibilities Curve • Increasing Productive Resources • Investment in new factories and equipment • Population growth • Improvements in knowledge and technology • Increasing education • Gains from specialization

  45. How much does specialization matter?

  46. Example 2.10.How much does specialization matter? (I) • George and Tom are mechanics. • Tom can replace 15 clutches per day or 10 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 1.5 clutches; • George can replace 10 clutches per day or 15 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 2/3 clutches. • At their garage, the number of brake replacements performed each day is the same as the number of clutch replacements. • How much more can they accomplish if they specialize than if each performed an equal number of brake and clutch replacements?

  47. Example 2.10.How much does specialization matter? (I) • If he doesn’t specialize, George can replace only 6 clutches per day and 6 sets of brakes. George’s production possibilities curve: C = 10 - (2/3) B Want equal number of both types of jobs: C = B So write C = 10 – (2/3)C and solve for C = 6.

  48. Example 2.10.How much does specialization matter? (I) If Tom doesn’t specialize, he too can produce 6 jobs of each type per day. Tom’s production possibilities curve: C = 15 - (3/2) B Want equal number of both types of jobs: C = B So write C = 15 – (3/2)C and solve for C = 6.

  49. Example 2.10.How much does specialization matter? (I) • By specializing, they can replace 15 clutches per day (Tom) and 15 sets of brakes (George).

  50. Example 2.10.How much does specialization matter? (I) • So if neither George nor Tom specializes, the two can produce a total of only 12 jobs of each type per day, . • If they specialize, they can produce a total of 15 jobs per day. • A 25% increase in output isn’t bad, • but cannot explain why industrialized countries produce so much more than developing countries.