Focus: How do the concepts of comparative and absolute

advantage help explain why nations trade?

AP MacroeconomicsAugust 2014

Why do nations trade?

• “You could say…that globalization, driven not by human goodness but by the profit motive, has done far more good for far more people than all the foreign aid and soft loans ever provided by well-intentioned governments and international agencies.”

Paul Krugman, “The Magic Mountain,” New York Times, January 23, 2001

Adam Smith, The Wealth of Nations(often called the Father of Modern Economics)

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. The taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a taylor. The farmer attempts to make neither the one nor the other…

What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we can make it, better buy it of them with some part of the produce of our own industry;…. (Book IV, Section ii, 12)

Why do nations trade?

• Nearly all economic theories suggest that the benefits of international trade far exceed the costs.

• “Specialization and international trade increase the productivity of a nation’s resources and allow for greater total output than would otherwise be possible. “

McConnell and Brue, 16th edition

Important Terms to Know

• Trade• Specialization• Gains from Trade• Comparative Advantage• Absolute Advantage

Absolute Advantage

• Individual – exists when a person can produce more of a certain good/service than someone else in the same amount of time (or can produce a good using the least amount of resources.)

• National – exists when a country can produce more of a good/service than another country can in the same time period.

Absolute Advantage & Trade

What if a person or a nation has an absolute advantage in producing

everything….would there still be a reason to specialize and trade?

YES!

David Ricardo

Classical Economist who promoted the idea of comparative advantage as the basis for trade.

Comparative Advantage

A person or a nation has a comparative advantage in the production of a product when it can produce the product at a lower opportunity cost than another person or nation.

Comparative advantage as the basis for trade

is one of the most important ideas in economics.

It is also one of the least intuitive.

Comparative Advantage

• A person or nation should specialize in the production of a good for which it has a lower opportunity cost and trade to obtain those goodsts for which its opportunity cost is higher.

Specialization and Trade

• Gains from trade are based on comparative advantage, not absolute advantage

• Specialization and trade increase productivity, national output, & standard of living.

• Everyone can benefit: – a greater quantity of goods and services– a greater variety of goods.

What should a nation produce?

• The goods for which it has the lowest OPPORTUNITY COSTS!

BakeCakes

MakePizza

Ms.Gray

2 cakes/hr. 6 pizzas/hr.

Mr.Pinson

4 cakes/hr. 8 pizzas/hr.

Who has the absolute advantage in producing cakes? Mr. PinsonWho has the absolute advantage in producing pizza? Mr. PinsonWould Mr. Pinson be better off to specialize and trade?

BakeCakes

MakePizza

Ms.Gray

2 cakes/hr.(1c = 3p)

6 pizzas/hr.(1p = 1/3c)

Mr.Pinson

4 cakes/hr.(1c = 2p)

8 pizzas/hr.(1p = 1/2c)

Mr. Pinson should specialize and trade if he has acomparative advantage (lower opportunity cost)in the production of one of the products.

Mr. Pinson has a lower opportunity cost in producing cakes; therefore, he should specialize in the production of cakes. Ms. Gray has a lower opportunity cost in producing pizza; therefore, she should specialize in the production of pizza.

Terms of trade

BakeCakes

Pinson will specialize in cakes.

Make Pizza Gray will specialize in pizzas.

Ms. Gray 1c = 3pFor one cake, Gray would be willing to pay anything up to 3 pizzas.

1p = 1/3cFor one pizza, Gray will want more than 1/3 cakes.

Mr. Pinson 1c = 2pFor one cake, Pinson will want more than 2 pizzas.

1p = 1/2cFor one pizza, Pinson would be willing to pay anything up to ½ cake.

Tom’s PPF Hank’s PPF

Q of Coconuts Q of Coconuts

Q of Fish Q of Fish

30

40

20

10

9

28

8

6

Will the Castaways Gain From Trade?

Coconuts Fish

Tom 1 C = 1 1/3 F

1 F = ¾ C

Hank 1 C = ½ F 1 F = 2 C

Tom has the lower opportunity cost in fishing and Hank has the loweropportunity cost gathering coconuts. Therefore, Tom should specialize in fishing and Hank should specialize in gathering coconuts.

Tom’s PPF Hank’s PPF

Q of Coconuts Q of Coconuts

Q of Fish Q of Fish

30

40

20

10

9

28

8

6

11

31

9

9

After specialization and trade, Tom and Hank can consume outside their PPCs.

Benefits from Specialization and Trade

• Specialization and trade increase productivity and the standard of living within a nation.

• Because of specialization and trade, there will be a larger global output of goods and services.

• Everyone can benefit when people trade with one another. Not only can people enjoy a greater quantity of goods and services, but they can also enjoy a greater variety of goods.

Distinguishing:

Input/Output Problems

Distinguishing input from output problems.

• An OUTPUT problem presents the data as products produced given a set of resources. (ex. Number of pens produced)

• An INPUT problem presents the data as amount of resources needed to produce a fixed amount of output. (ex. Number of labor hours to produce 1 bushel)

• When identifying absolute advantage, input problems change the scenario from who can produce the most to who can produce a given product with the least amount of resources.

Which type of problem?• Acres to produce one unit of each.

• Input problem

Apples Pears

Tom 10 5

Sam 6 2

Absolute Advantage?• Acres to produce one unit of each.

• Who has the absolute advantage in apples and pears?

Sam

Apples Pears

Tom 10 5

Sam 6 2

Explanation• Acres to produce one unit of each.

• Sam has an absolute advantage in both pears and apples because he can produce 1 unit of each in fewer acres than Tom. Absolute advantage in INPUT problems is based on using the LEAST amount of resources to produce the given unit(s) of product.

Apples Pears

Tom 10 5

Sam 6 2

Input or Output problem?• Number caught per day.

Output problem

Trout Bass

Tom 4 6

Sam 24 12

Absolute Advantage?• Number caught per day.

• Which guy has the absolute advantage in the production of each product?

Sam

Trout Bass

Tom 4 6

Sam 24 12

Explanation:• Number caught per day.

• Sam has an absolute advantage in catching both trout and bass as he can

catch more of each than Tom in one day’s time.

Trout Bass

Tom 4 6

Sam 24 12

Input or Output Problem?• Days to produce one unit of each.

• Input problem

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Explanation:• Days to produce one unit of each.

• This is an input problem as it refers to how many days (work days for labor) will be needed to produce 1 unit. The problem is phrased in terms of resources used rather than products

produced.

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Absolute Advantage?• Days to produce one unit of each.

• Which corporation has an absolute advantage in the production of both

products?XYZ

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Explanation:• Days to produce one unit of each.

• XYZ has an absolute advantage in producing both cars and planes because it can produce 1

unit of each in less time (days) than QKFX. This means that QKFX has an absolute

disadvantage in producing both products. QKFX uses more days to produce both

products.

Cars Planes

XYZ Corp. 8 10

QKFX Corp.

15 12

Input or Output Problem?• To produce the following from one ton

of olives.

Output problem

Canned Olives

Olive Oil

Namibia 60 10

Colombia 24 8

Explanation?• To produce the following from one ton of

olives.

• This is an output problem because it is the number produced (output in canned olives and olive oil) from a given unit of

resources (1 ton of olives)

Canned Olives

Olive Oil

Namibia 60 10

Colombia 24 8

Absolute Advantage?• To produce the following from one ton

of olives.

• Which nation has the absolute advantage in both products?

Namibia

Canned Olives

Olive Oil

Namibia 60 10

Colombia 24 8

Explanation:• To produce the following from one ton of

olives.

• Namibia has an absolute advantage in producing both products because it can

produce more given the unit of resources available (1 ton of olives).

Canned Olives

Olive Oil

Namibia 60 10

Colombia 24 8

How to Handle a Comparative Advantage Problem

on the AP Exam

1. The question will have information about two nations producing two of the same products. This information will be given to you in a Production Possibilities table or on a Production Possibilities curve or maybe a word problem form.

2. Ask what type of problem: Output or input?

2. Determine which nation or person has the absolute advantage in producing each of the two goods or services.

3. Determine which nation or person has the comparative advantage in producing each of the two goods or services.

– For each nation, determine the opportunity cost of producing one unit of each good.

– Identify the nation that has the lowest opportunity cost of producing one unit of each good. That nation has the comparative advantage.

4. Determine the terms of trade. Each country will specialize in the production of the good in

which it has the comparative advantage and will export that good. It will import the other good. The terms of trade will be whatever is mutually beneficial to the two countries. (They will want to be better off after trade than before trade.)• If the country exports Good A, it will want more of

Good B than it would get before specialization.• If the country imports Good A, it will want to pay

less in terms of Good B than it would have to pay before specialization and trade.

Corn SunscreenMexico 300 150

France 200 150

1. Type of problem (output or input)?: 2. Which nation has the absolute advantage in

producing corn? Sunscreen?3. Which nation has the comparative advantage in

the production of each good? (What is the opportunity cost for each nation of producing one unit of corn and sunscreen ?)

4. What would be a favorable term of trade?

Wheat ClothUnited States 1 hour 2 hoursCanada 3 hours 4 hours

1. What type of problem is this? (output/input)2. Who has the absolute advantage in producing

wheat? In producing cloth?3. Who has the lowest opportunity cost producing

wheat? In producing cloth?4. Favorable terms of trade?