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Comparative advantage—the basis for specialization and trade

Comparative advantage—the basis for specialization and trade. Announcement:. Please check the clicker rat at the class website to see that your clicker attendance is being recorded. A few people do not have their correct perm numbers entered.

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Comparative advantage—the basis for specialization and trade

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  1. Comparative advantage—the basis for specialization and trade

  2. Announcement: • Please check the clicker rat at the class website to see that your clicker attendance is being recorded. • A few people do not have their correct perm numbers entered. • Let me know if the ID number entered in your clicker is not your perm number.

  3. A primitive economy • There are two goods, bread and meat, and two people, Alice and Bob. • Alice and Bob both work 12 hours per day. • It takes 2 hours for Alice to make a loaf of bread and 4 hours to catch a rabbit. • It takes 4 hours for Bob to make a loaf of bread and 2 hours to catch a rabbit.

  4. Alice alone • Alice has not yet met Bob. She divides her time between making bread and catching rabbits. What is possible for her? • How long does it take to make B loaves of bread and R rabbits? • 2B+4R • In 12 hours, Alice can produce any combination such that 2B+4R=12

  5. Possible Consumptions for Alice Alone Rabbits For Alice, possibilities are given by the equation 2B+4R=12. If she only made bread, she could have 6 loaves. If she only caught rabbits, she’d catch 3. 3 6 Bread

  6. Alice diversifies Rabbits Alice prefers to have some of each good, rather than to eat only bread. So she spends some time on each. Suppose she wants equal amounts of bread and rabbits. Then 2B+4R=12 and B=R. Solution is B=R=2 3 2 6 2 Bread

  7. Bob alone • Bob divides his time between making bread and catching rabbits. It takes 4 hours to make a loaf of bread and 2 hours to catch a rabbit. • How long does it take to make B loaves of bread and R rabbits? • 4B+2R • In 12 hours, Bob can produce any combination such that 4B+2R=12

  8. Possible Consumptions for Bob Alone Rabbits 6 For Bob, possibilities are given by the equation 4B+2R=12. If he made only bread, he could have 3 loaves. If she only caught rabbits, he’d catch 6. 3 Bread

  9. Bob diversifies Suppose Bob wants equal amounts of bread and rabbits. Then 4B+2R=12 and B=R. Solution is B=R=2 Rabbits 6 2 3 2 Bread

  10. Alice meets Bob • Suppose that Alice meets Bob and they decide to trade. Why might this work? • Alice is relatively good at bread and Bob is relatively good at rabbits. • What if they specialize? • Alice could spend all day making bread. • Bob could spend all day catching rabbits.

  11. Gains from Trade • If Alice makes bread all day, she will make 6 loaves. • If Bob hunts all day, he will catch 6 rabbits. • What if they trade? • Alice could give Bob 3 loaves and Bob give Alice 3 rabbits. • Each would have 3 loaves and 3 rabbits to consume. • Alone, each consumes 2 loaves and 2 rabbits.

  12. Why did trade work? • Because they had different relative skills in producing things they both want. • They specialized according to comparative advantage. • What would have happened if Bob specialized in bread and Alice in rabbits? • Not so good. Total output would be just 3 of each.

  13. The Sources of the Wealth of Nations. • Specialization and division of labor according to comparative advantage. “THE GREATEST improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour.” Adam Smith, 1776

  14. Comparative advantage • It takes Alice twice as long to catch a rabbit as to make a loaf of bread. • It takes Bob twice as long to make a loaf of bread as to catch a rabbit. • Alice is good at bread-making (compared to Bob) • Bob is good at at rabbit-catching(compared to Alice) • We say Alice has comparative advantage in bread and Bob has comparative advantage in rabbits.

  15. Comparative and Absolute Advantage • In this example, Bob can catch more rabbits per day than Alice and Alice can make more loaves of bread per day than Bob. • We say Bob has both comparative and absolute advantage in rabbits and Alice has both comparative and absolute advantage in bread.

  16. Comparative not absolute • But what if Alice is better at both activities. • Suppose that she can catch a rabbit in 1 hour and make a loaf of bread in 1 hour. • It takes Bob 4 hours to make a loaf of bread and 2 hours to catch a rabbit. • Still Bob has comparative advantage in rabbit-catching. (It takes him half as long to catch a rabbit as to make a loaf of bread.) • Alice has comparative advantage in bread.

  17. Cora can catch 4 rabbits per hour and Don can catch 1. Cora can bake 4 loaves of bread per hour and Don can bake 2. • Cora has comparative advantage in both activities. • Don has comparative advantage in bread-baking and Cora has comparative advantage in rabbit-catching • Don has comparative advantage in rabbit-catching and Cora has comparative advantage in bread-baking. • Don has comparative advantage in both activities.

  18. Why is that? • In an hour Don can bake 2 loaves of bread or catch 1 rabbit. The ratio of Don’s productivity at bread-baking to his productivity at rabbit-catching is 2/1=2 • In an hour Cora can bake 4 loaves of bread for every 4 rabbits she catches. The ratio of her productivity at bread-baking to her productivity at rabbit-catching is 4/4=1. • Since 2>1, Don has comparative advantage in bread.

  19. Continued • The ratio of Don’s productivity at rabbit-catching to his productivity at bread-baking is ½. • The ratio of Cora’s productivity at rabbit-catching to her productivity at bread-baking is 4/4=1. • Since 1>1/2, Cora has comparative advantage in rabbit-catching.

  20. Farmers Alf and Barney can plant wheat or hay. Alf’s land yields 60 bushels of wheat per acre and Barney’s yields 30. Alf’s land yields 3 tons of hay per acre and Barney’s yields 2 • Alf has comparative advantage in both crops. • Barney has comparative advantage in hay. • Barney has comparative advantage in wheat.

  21. Why is that? • The ratio of Alf’s productivity in hay to his productivity in wheat is • 3 tons/ 60 bushels =1/20 tons/bushel • The ratio of Barney’s productivity in hay to his productivity in wheat is • 2 tons/30 bushels=1/15 tons/bushel • 1/15>1/20 so Barney has comparative advantage in hay.

  22. Alf has 100 acres. He can get 60 bushels of wheat per acre or 3 tons of hay per acre. The following equation shows the combinations of bushels of wheat (W) and tons of hay (H) that he can grow on his farm. • 60W+3H=100 • (W/60)+(H/3)=100 • 3W=60H • 60W=3H

  23. Why is that? • He gets 60 bushels of wheat from every acre planted in wheat and three tons of hay from every acre in hay. • To get W bushels of wheat he needs to plant W/60 acres in wheat. To get H tons of hay, he needs to plant H/3 acres in hay. • He has 100 acres to plant in one or the other so he can choose any combination where (W/60)+(H/3)=100.

  24. The ratio of productivity in hay to productivity in wheat for Alf is 1/20 ton per bushel, and for Barney it is 1/15 ton per bushel. The price of wheat is $1 per bushel. If the price of hay is $18 per ton • Alf will specialize in wheat and Barney in hay. • Both will produce wheat. • Both will produce hay. • Alf will specialize in hay and Barney in wheat.

  25. Why is that? • By switching his cropland from hay to wheat, Alf gets 20 bushels of wheat for every ton of hay he gives up. 20 bushels of wheat are worth $20. A ton of hay is worth $18. • By switching cropland from wheat to hay, `Barney gets 1 ton of hay for every 15 bushels of wheat that he gives up. 15 bushels of wheat are worth $15. A ton of hay is worth $20.

  26. . Alf’s Options Gold line shows production possibilities. 1 ton of hay “costs” 20 bushels of wheat. 6000 bushels Pink line shows combinations Attainable by specializing in wheat And trading at price $18 per ton for Hay and $1 per ton for wheat. . 5400 bushels Dotted pink line shows Combinations available to Alf If he specializes in Hay. (Bad Choice) H 333.3 300 tons

  27. .. Barney’s Options W 3600 The green line shows combinations of Hay and wheat that Barney could produce On his 100 acre farm. 3000 bushels The pink line shows combinations he Could obtain by specializing in hay And trading at “world price” of $18/per Ton of hay, $1 per bushel of wheat. Dotted pink line shows combos Available by specializing in wheat (Bad idea) H 200 tons

  28. Commuter winners: Please come forward to accept your prizes 5 winners went right way every time. • Kirk Galvin • Alan Romero • Desene Lachelier • Haley Hansen • Mark Agor

  29. Let’s call it a day…

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