Topic 2 - Comparative Advantage: The Basis for Trade

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Comparative Advantage: The Basis for Free Trade

Opportunity Cost, Comparative Advantage And Specialisation

People within groups can choose to be self sufficient or they can specialise. If comparative advantage exists, specialisation will lead to a higher output for the entire group (the principal of comparative advantage).

  1. Absolute Advantage - when an economic agent can produce more goods and services than another agent (in a given amount of time)
  2. Comparative Advantage - when one economic agent's opportunity cost is lower than another agent's opportunity cost.


This example [1] demonstrates the above principle.

OC2.jpg

  • Diane has absolute advantage over Liz in both tasks
  • Diane has a comparative advantage over Liz in washing (lower opportunity costs)
    • This means Liz has a comparative advantage in cooking

Sources of Comparative Advantage

  • Individual
    1. In born talent
    2. Education and Training
    3. Experience - specialisation in comparative advantage reinforces itself over time
  • National
    1. Natural Resources - Australia has easy access to ores and minerals
    2. Infrastructure, Research and Development, Subsidies
    3. Cultural Institutions & Education Systems + Entrepreneurial Spirit

The Production Possibilities Curve (PPC)

Assumptions

  • Ceteris Paribus - everything else remains unchanged
  • Fixed Technology
  • Resources Fully Employed
  • Only 2 Goods are Produced

PPC Example

This example [2] illustrates the link between specialisation, comparative advantage and a higher total output.

OCN = Opportunity Cost of Nuts, OCC = Opportunity Cost of Coffee

Short Sam can produce 2kg Nuts or 4kg of Coffee, OCN = 2 Coffee kg, OCC = ½ Nut kg (if 0 nuts, 24 coffees) Tall Tim can produce 4kg Nuts or 2kg of Coffee, OCN = ½ Coffee kg, OCC = 2 Nuts kg (if 0 coffee, 24 nuts)

OC3.jpg

The person should specialise in the axis where gradient is flatter for them

  • Flatter gradient = lower opportunity cost
  • Sam & Tim will trade when the terms of trade are lower than their opportunity cost
    • Assuming terms of trade = 1, Sam will trade 1 coffee for 1 nut since he would have to give up 2 coffee to gain 1 nut without trade. Likewise, Tim will trade a nut for a coffee as without trade he would lose 2 nuts to gain 1 coffee
      • This means as a group that can reach points outside of their individual PPC's making everyone at least the same or better off.

Production Possibilities Curve for a Many Person Economy

In an economy, some resources (e.g. labour) are suited to produce good 'A' while others are suited to producing good 'B'. The differing abilities of workers in an economy causes different efficiencies in the production of certain goods.

The Principle of Increasing Opportunity Costs In expanding the production of any good, the economy first employs resources that have the lowest opportunity cost (flat gradient initially). Only afterwards will the economy turn to resources with higher opportunity costs making the slope steeper, and hence outwardly bow shaped.[3]


An analogy used to help understand this concept is the low hanging fruit principle. In picking apples from a tree, you will always go for the lowest (and most easiest to access) apples, and only then will you climb further up the tree.

Factors that Shift an Economy's PPC

Outward Shifts

  • Increases in productive resources
  • Improvement in technology and knowledge - increases productivity of current resources
  • Population growth (does not raise standards of living though)

Inward Shifts are caused by the exact opposite.

Costs And Benefits of Specialisation

Costs:

  • Time and effort to change to specialisation
  • Destroys variety
  • Repetitive
  • Vulnerability - e.g. food during war times

Benefits:

  • Increased total output for the group
  • Increased efficiency
  • The greater the differences in opportunity costs the greater the gains from trade


References

  1. Diane Enahoro, School of Economic Lecture Notes
  2. Diane Enahoro, School of Economic Lecture Notes
  3. Frank, Jennings, Bernanke, R, 2011. Principles of Microeconomics. 3rd ed. Australia: MCGRAW-HILL.
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