ec103: lecture 2 comparative advantage: opportunity cost in practice
TRANSCRIPT
EC103: Lecture 2
Comparative Advantage: Opportunity Cost in Practice
Opportunity cost: The highest valued activity sacrificed in making a choice.
The opportunity cost of college:
Opportunity Cost
Opportunity costs are incurred when a choice is made.
They are subjective and vary across persons. If an option becomes more costly, an individual
will be less likely to choose it.
Monetary cost: tuition, books. Non-monetary cost: forgone earnings. If the opportunity cost of college rises
(e.g. tuition rises), then one will be less likely to attend college.
Mutual gain is the foundation of trade. Value can be created by exchanges
that move goods to individuals who value them more.
Trade
Transactions costs: the time, effort, and other resources needed to search out, negotiate, and consummate an exchange. Transactions costs reduce our ability
to produce gains from potential trades.
Comparative Advantage: The Basis for Exchange
What Do You Think?Do the Nepalese perform their own services
because they are poor or are they poor because they perform their own services?
Exchange and Opportunity Cost
Should Joe Jamail write his own will?Jamail is the most renowned trial lawyer in
American HistoryHe is listed 195 on the Forbes list of the 400
richest Americans, with net assets over $1 billion.
Exchange and Opportunity Cost
Absolute AdvantageOne person has an absolute advantage over
another if he takes fewer hours to perform a task than the other person
Exchange and Opportunity Cost
Comparative AdvantageOne person has a comparative advantage over
another if his opportunity cost of performing a task is lower than the other person’s opportunity cost
Exchange and Opportunity Cost
The Principle of Comparative AdvantageShould Paula update her own web page?
Time to updateTime to updateweb pageweb page
Time to complete Time to complete bicycle repairbicycle repair
PaulaPaula 20 minutes20 minutes 10 minutes10 minutes
BethBeth 30 minutes30 minutes 30 minutes30 minutes
Opportunity Costsfor Paula and Beth
The Principle of Comparative AdvantageShould Paula update her own web page?
Opportunity Cost of Opportunity Cost of updating a web pageupdating a web page
Opportunity Cost of a Opportunity Cost of a bicycle repairbicycle repair
PaulaPaula 2 bicycle repairs2 bicycle repairs 0.5 web page updates0.5 web page updates
BethBeth 1 bicycle repair1 bicycle repair 1 web page update1 web page update
Exchange and Opportunity Cost
The Principle of Comparative AdvantageShould Paula update her own web page?
How many web pages and bicycle repairs can Paula and Beth produce a day if they both work eight hour days?
Exchange and Opportunity Cost
The Principle of Comparative Advantage
If Paula spends 4 hours making web pages and 4 hours making bike repairs, while Beth spends 2 hours making web pages and
6 hours making bike repairs
PaulaPaula
BethBeth
Web PagesWeb Pages Bicycle RepairsBicycle Repairs
1212
442424
1212
TotalTotal 1616 3636
Exchange and Opportunity Cost
The Principle of Comparative Advantage
If they specialized in their comparative advantage
PaulaPaula
BethBeth
Web PagesWeb Pages Bicycle RepairsBicycle Repairs
00
16164848
00
TotalTotal 1616 4848
Exchange and Opportunity Cost
The Principle of Comparative AdvantageShould Barb update her own web page?
Productivity in Productivity in programmingprogramming
Productivity inProductivity in
bicycle repairbicycle repair
PatPat 2 web page 2 web page updates per hourupdates per hour
1 repair/hr1 repair/hr
BarbBarb 3 web page 3 web page updates per hourupdates per hour
3 repairs/hr3 repairs/hr
Exchange and Opportunity Cost
The Principle of Comparative AdvantageEveryone does best when each person (or each
country) concentrates on the activities for which his or her opportunity cost is lowest
Exchange and Opportunity Cost
Sources of Comparative Advantage Individual
Inborn talent Education Training Experience
Exchange and Opportunity Cost
Sources of Comparative AdvantageNational Level
Natural resources Cultural Institutions
Exchange and Opportunity Cost
Sources of Comparative AdvantageNoneconomic
Adoption of a language Institutions
Exchange and Opportunity Cost
Economic NaturalistTelevisions 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?
Comparative Advantage and Production Possibilities
The Production Possibilities CurveA graph that describes the maximum amount of
one good that can be produced for every possible level of production of the other good.
Comparative Advantage and Production Possibilities
The Production Possibilities CurveAssume
A small economy that: Produces only two goods - coffee and nuts Has only one worker who works 6 hrs/day
Susan’s Production Possibilities
0
Coffee(lb/day)
Nuts(lb/day)
Opportunity Cost (OC)
1. OC nuts = Loss in coffee/gain in nuts
2. OC coffee = Loss in nuts/gain in coffee16
8
4 8
24
Production Possibilities Curve: Allcombinations of coffee and nuts thatcan be produced with Susan’s labor
A
B
C
D
12
Susan’s Production Possibilities
The scarcity principle: Having more of one good generally means having less of another good.
Coffee(lb/day)
Nuts(lb/day)
A
B
C
D
24
0
16
8
4 8 12
Attainable and Efficient Points on Susan’s Production Possibilities
Nuts(lb/day)
A
B
Combination F: Unattainable
C
Combination E: Inefficient
D
Combinations A, B, C, and D: Efficient
Coffee(lb/day)
24
0
16
8
4 8 12
Comparative Advantage and Production Possibilities
The Production Possibilities CurveAttainable Point:
Any combination of goods that can be produced using currently available resources
Unattainable Point: Any combination that cannot be produced using
currently available resources
Comparative Advantage and Production Possibilities
The Production Possibilities CurveEfficient Point
Any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other
Comparative Advantage and Production Possibilities
The Production Possibilities Curve Inefficient Point
Any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other
Tom’s ProductionPossibilities Curve
0
Nuts(lb/day)
How Individual Productivity Affects the Slope and Position of the Production Possibilities Curve
Tom’s Production Possibilities Curve for a 6 hour day
Coffee(lb/day)
4
8
8 16
A
B
C
D
12Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor
24
Individual Production Possibilities Curves Compared
Nuts(lb/day)0
12
24
Tom’s PPC
Tom has an absolute and comparative advantage in
gathering nuts
24
12
Susan’s PPC
Susan has an absolute and comparative advantage in gathering coffee
Coffee(lb/day)
Production Without Specialization
Nuts(lb/day)0
12
24
12 24
Susan’s Production Possibilities Curve
Assume: Susan and Tom allocate their time so each person’s output is half nuts and half coffee
•Tom’s Output = 2 hrs picking nuts = 8 lbs 4 hrs picking coffee = 8 lbs
•Susan’s Output = 2 hrs picking coffee = 8 lbs4 hrs picking nuts = 8 lbs
Total Output = 16 lbs each
8
8
BTom’s Production Possibilities Curve
Coffee(lb/day)
Production With Specialization
Nuts(lb/day)0
12
24
12 24
Susan’s Production Possibilities Curve
Tom’s comparative advantage is in nuts so he specializes in nuts and produces 24 lbs
Susan’s comparative advantage is in coffee so she specializes in coffee and produces 24 lbs
Susan gives Tom 12 lbs of coffee for 12 lbs of nuts
E
Tom’s Production Possibilities Curve
Coffee(lb/day)
The gains from specialization grow larger as the difference in opportunity cost increasesFor Example
Susan: 5 lb coffee/hr 1 lb nuts/hrTom: 1 lb coffee/hr 5 lb nuts/hr
Comparative Advantageand Production Possibilities
The gains from specialization grow larger as the difference in opportunity cost increasesWithout Specialization
Susan: 1 hr coffee = 5 lb 5 hrs nuts = 5 lb Tom: 5 hrs coffee = 5 lb 1 hr nuts = 5 lbTotal: 10 lb 10 lb
Comparative Advantage and Production Possibilities
The gains from specialization grow larger as the difference in opportunity cost increasesWith Specialization
Susan: 30 lb coffee 0 lb nuts Tom: 0 lb coffee 30 lb nuts Total: 30 lb coffee 30 lb nuts
Comparative Advantageand Production Possibilities
Production PossibilitiesCurve For a Large Economy
Nuts(1000s of lb/day)
Assume: An economy that produces only two goods, coffee and nuts
100
80
Why would the Production Possibilities Curve have an outward
bow?
Coffee(1000s of lb/day)
E
AB
C
D
1520
9095
20 30 75
77
PPF with No Specialized Resources
D
C
B
A
Brown Shoes
Bla
ck S
ho
es
50
40
30
20
10
0 50 40 30 20 10
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
Resources are scarce for the entire society.
Choices must be made: More of one good implies less of another.
Production possibilities frontier applicable to the economy as a whole.
Scarcity and Choice for the Entire Society
PPF for Entire Economy
Th
ou
san
ds
of
Au
tom
ob
iles
per
Yea
r
Missiles per Year
C
F
E
D
B
500 400 300 200 100
0
100
200
300
400
500
600
700
G
Copyright© 2006 South-Western/Thomson Learning. All rights reserved.
The Principle of Increasing Opportunity Cost (“The Low-Hanging-Fruit Principle”) In expanding the production of any good, first employ those
resources with the lowest opportunity costs, and only afterward turn to resources with higher opportunity costs
Productivity constant along a production possibilities frontier. productivity shift of the frontier
Skills Technology Capital stock
Comparative Advantage and Production Possibilities
Economic Growth: An Outward Shift in the Economy’s PPC
Coffee(1000s of lb/day)
Nuts(1000s of lb/day)
Original PPC
New PPC
Factors Shifting the PPC1. Increases in productive resources
(i.e. labor or capital)
2. Improvements in knowledge and technology
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 educationGains from specialization
Factors That Shift The Economy’s Production Possibilities Curve
Why Have Countries Like Nepal Been So Slow to Specialize?Low population density Isolation
Factors that my limit specialization in other countriesLawsCustoms
Factors That Shift The Economy’s Production Possibilities Curve
Can we have too much specialization?
What do you think?What are the costs of specialization?
Comparative Advantage and International Trade
Economic Naturalist If trade between nations is so beneficial, why
are free-trade agreements so controversial?
for Susan’s grades in English and Economics (10 hrs of study)
A
AB
B
C
CD
D
Expected grade in Economics 101
Expected grade in English 101
Production Possibilities Curve
• Susan is a student who only has 10 hours of study to divide between her economics and English classes.
FF
Production PossibilitiesCurve ( PPC )• If she spends most of her time
studying economics, she can earn an A in economics … and a D in her English class.
• If she splits her time between the two, she can earn a B in economics … and a B in her English class.• If she spends most of her time studying English, she can earn a D in economics … and an A in her English class.
• Mapping out all the possibilities of how Susan can divide her time (limited resources) between these activities shows us her Production Possibilities Curve ( PPC ).
- Inefficiency -
Output of clothing
Outputof food
A
DB
C
T
S
Production Possibilities Curve for a nation’s economy (given limited resources)
Production PossibilitiesCurve ( PPC )Only clothing
is produced
Only foodis produced
All output combinations on the frontier curve are efficient.
• Consider an economy which has limited resources to divide between the production of clothing and food.
• If it allocates all of its resources toward the production of clothing, then it can produce at point S.
• If the it allocates all of its resources toward the production of food, then it can produce at point T.
• Mapping out all the possibilities of how an economy can divide the use its resources gives us the economy’s Production Possibilities Curve.
• Output combinations A, B, & C are all on the PPC and are, therefore, efficient allocations of resources.
• D is within the PPC and represents an inefficient resource allocation. Combination B delivers more food with the same output of clothing.
Shifting the Production Possibilities Curve Outward
An increase in the economy’s resource base would expand our ability to produce goods and services.
Advancements in technology can expand the economy’s production possibilities.
By working harder and giving up current leisure, we could also increase our production of goods and services. This requires us to give up something else we
value: leisure.
An improvement in the rules (laws, institutions, and policies) of the economy can increase output.
Investmentgoods
Consumptiongoods
IA
CA
A
Investment and Production Possibilities in the Future
PPC 2005
PPC 2015 with A
• The long-term benefits of investment include greater output in the future. Thus, decisions we make today regarding how much to save (investment) and consume determine the shape of the PPC 10 years from now.
• If we choose to produce a mixture of consumption and investment goods which corresponds to bundle A …
then the future PPC might move out to PPC 2015 with A – due to the new buildings, equipment, training, and other forms of investment goods that IA represents.
Investmentgoods
Consumptiongoods
IA
CA
A
Investment and Production Possibilities in the Future
PPC 2015 with B
PPC 2005
PPC 2015 with A
BIB
CB
• If we choose to produce a mixture of consumption and investment goods which corresponds to bundle B, with fewer consumption goods (CB < CA) and more investment (IB > IA) …
• The level of investment (savings) in an economy is only one determinant of the movement outward (or inward) of the production possibilities curve.
then the future PPC might move out to PPC 2015 with B instead.
Law of comparative advantage: The proposition that the joint output of trading partners will be greatest when each good is produced by the low opportunity cost producer.
Implies that trading partners can gain by specializing in the production of goods they can produce at a relatively low opportunity cost and trade for goods they could only produce at a relatively high opportunity cost.
The principle of comparative advantage is universal as it applies across individuals, firms, regions and countries.
Law of Comparative Advantage
Economic Organization:Markets vs. Political Planning
Market organization: A method or organization that allows for unregulated prices and the decentralized decisions of private property owners to resolve the basic economic problems. Sometimes called capitalism.
Market Organization
Political Planning Political organization is the major
alternative to the use of markets.
Political organization involves the use of collective decision making (government) to decide what, how, and for whom goods and services will be produced. An economic system in which the government
owns the income-producing assets and directly determines what goods they produce is called socialism.
In a democracy, political decision makers have to consider how their actions will influence their election prospects.
Questions for Thought:
1. Suppose Amy is a doctor who has records that need to be entered. Doing this work herself would take 10 hours per week. She is thinking about hiring an assistant who could do the same work in 40 hours. If Amy can make $80 per hour seeing patients, should she hire the assistant at $10 an hour?
2. Do you make the food that you consume and clothing you wear for yourself? What are the sources of gains from trade? Would modern living standards be possible without trade?
Questions for Thought:
3. What does a production-possibilities curve demonstrate? Can the production possibilities of an economy be increased? If so, how?
4. “Modern living standards are primarily the result of brain power, capital formation, and the quality of institutions.” What is the meaning of this statement? Is it true?