Chapter 2: Comparative Advantage: The Basis for Exchange

Scarcity, Choice, and Opportunity Cost Production Possibility Curve Absolute & Comparative Advantage Specialization

Case 2.4: Should Abe and Sarah Marry ?

A few facts: Both Abe and Sarah work 12 hours a day. Each splits his/her time between work at home and in the market.

Case 2.4: A few facts

Home Goods (per hour) Market Goods (per hour)

Sarah

10

Abe

Case 2.4: Analysis

A person (or country, or firm) has an Absolute Advantage if they can produce more per unit of input (e.g. time).

Case 2.4: Analysis Each person working alone

Sarahs PPF: Maximum she can produce at home: 12 hours * 5= 60 Maximum she can produce in the market: 12 hours * 10= 120

Case 2.4: Analysis Each person working alone

Abes PPF: Maximum he can produce at home: 12 hours * 2= 24 Maximum he can produce in the market: 12 hours * 8= 96

Case 2.4: Analysis Married Life

Maximum production of home goods: 12 *5 + 12 *2 = 84

Maximum production of market goods: 12 *10 + 12 *8 = 216

Case 2.1: Analysis Married Life

Who Should go out to work first? If Sarah goes: ratio 10 to 5, or 2 to 1 O.C. of 1 HG=2 MKTG O.C. of 1 MKTG=1/2 HG If Abe goes: ratio 8 to 2, or 4 to 1 O.C. of 1 HG=4 MKTG O.C. of 1 MKTG=1/4 HG Abe is relatively more efficient in market work lower O.C. for MKT goods.

Case 2.4: Analysis

A person or nation has a Comparative Advantage in an activity if he/she/it can perform an activity at a lower opportunity cost than others.

Case 2.4: Analysis Married Life

Sarahs vow: To give Abe 10 units of HG & 56 MG.
Production with Full Specialization Home Goods Market Goods 12*5=60 Abes share 10 Sarahs Share 60-10=50

12*8=96

56

96-56=40

Case 2.4: Analysis Married Life

Sarahs vow: To give Abe 10 units of HG & 56 MG. This leaves her 60-10=50 HG & 96-56=40 MG. Alone this would take her: 50/5=10 hours plus 40/10=4 hours, or a total of 14 hours!

Case 2.4: Analysis

Principle of comparative advantage: specialize good with the lowest opportunity cost of production. Comparative advantage specialization

Case 2.5: Analysis Must they tie the knot?

Can Abe & Sarah achieve efficiency without marriage? At what prices would they agree to trade?

Case 2.5: The facts:

Home Goods (per hour) Sarah 5 Market Goods (per hour) 10 O.C. of 1 Market Good

1/2

Abe

1/4

Case 2.5: Analysis Must they tie the knot?

Trading ratio will be set between the parties Opportunity Costs. Here: 2MKT<1HG<4MKT or 1/4HG<1MKT<1/2HG Allows the Consumption Possibilities Frontier (CPF) or Trade Line to be different from the PPF. The CPF must: intersect with the PPF in at least one point. never be inside the PPF. Specialization & trade according to comparative advantage increases consumption.

CHAPTER 2: Comparative Advantage The Basis for Exchange

Specialization requires exchange Trading leads to increased production because it permits specialization