ka-fu wong university of hong kong

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Ka-fu WongUniversity of Hong Kong

Comparative Advantage: The Basis of Exchange

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The Basis of Exchange

Why do people exchange goods and services in the first place?

Why is YAO Ming a top basketball player, Dr. WONG an instructor in a university, and Thomas FRIEDMAN a prominent writer?

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Why not do everything on our own?

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.

Should Ms. Sarah Liao do her own household chores?Secretary for the Environment, Transport and

Works (SETW) of the Hong Kong Special Administrative Region Government

She knows how to do household chores.

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Grow our own food…

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…paint our own houses…

replace our own roofs…?

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We can all have more of every good and service if we specialize in the activities at which we are relatively most efficient.

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Example 2.1. Basis for exchange

Paul is a house painter whose roof needs replacing. Ron is a roofer whose house needs painting.

Although Paul is a painter, he also knows how to install roofing. Ron, for his part, knows how to paint houses.

Should Paul roof his own house? Should Ron paint his own house?

Paul

Ron

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Time required by each to complete each type of job:

Ron has an absolute advantage over Paul at both painting and roofing, which means that Ron takes fewer hours to perform each task than Paul does.

Painting Roofing

Paul

300 hrs 400 hrs

Ron 200 hrs 100 hrs

Should Ron do the roofing and painting jobs for both houses?

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Time required by each to complete each type of job:

However, Paul has a comparative advantage over Ron at painting, which means that he is relatively more efficient at painting than Ron is.

Painting Roofing

Paul

300 hrs 400 hrs

Ron 200 hrs 100 hrs

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Comparative advantage and opportunity cost

“To have a comparative advantage at a task”

“To have a lower opportunity cost of performing it”

(is the same as)

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For Paul, the opportunity cost of painting one house = the number of roofing jobs he could do in the same time.

Paul takes 300 hours to paint a house, 400 hours to roof a house.

So in the time it takes Paul to paint a house, he could complete .75 roofing jobs.

So Paul’s opportunity cost of painting a house is .75 roofing jobs.

Painting Roofing

Paul 300 hrs 400 hrs

Ron 200 hrs 100 hrs

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For Ron, the opportunity cost of painting one house = the number of roofing jobs he could do in the same time.

Ron takes 200 hours to paint a house, 100 hours to roof a house.

So in the time it takes Ron to paint a house, he could complete 2 roofing jobs.

So Ron’s opportunity cost of painting a house is 2 roofing jobs.

Painting Roofing


Ron 200 hrs 100 hrs

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Paul’s opportunity cost of painting a house is .75 roofing jobs.

Ron’s opportunity cost of painting a house is 2 roofing jobs.

Paul thus has a comparative advantage at painting, because his opportunity cost of painting is lower than Ron’s.

Therefore it makes sense for Paul to do both painting jobs and leave both roofing jobs for Ron.

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If each person performed both tasks for himself, the total time spent would be 700 hours for Paul and 300 hours for Ron.

By contrast, when each specializes in his comparative advantage, these totals fall to 600 for Paul and 200 for Ron, a savings of 100 hours each.

Painting Roofing


Ron 200 hrs 100 hrs

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Principle of Comparative Advantage

Everyone does best when each person (or country) concentrates on the activities in which he or she is relatively most efficient.

“Concentrates on the activities in which he or she is relatively most efficient” means specialization.

Specialization by comparative advantage provides the rationale for market exchange.

It explains why each person does not devote 10 percent of her time to producing cars, 5 percent to growing food, 25 percent to building housing, 0.0001 percent to brain surgery….

By performing only those tasks at which we are relatively most efficient, we can produce vastly more than if we each tried to be self-sufficient.

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Caution!!

Pay close attention to the form in which the productivity information is provided.

Your goal in each case is to find each person’s opportunity cost of producing the good in question.

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Example 2.2.

a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute

advantage in both.c. Arthur has a comparative advantage in shearing sheep and

Ben has a comparative advantage in milking goats.d. Arthur has a comparative advantage in milking goats and

Ben has a comparative advantage in shearing sheep.e. None of the above statements is true.

Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Which statement below is true?

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Example 2.2.

Who has the comparative advantage of milking goats?

Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Arthur’s opportunity cost of milking a goat is 10/4 = 2.5 sheep shorn.

Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Ben’s opportunity cost of milking a goat is 6/3 = 2 sheep shorn.

Who has a comparative advantage at milking goats? Ben, whose opportunity cost of milking a goat is lower.

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Example 2.2.

Who has the comparative advantage of shearing sheep?

Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Arthur’s opportunity cost of shearing a sheep is 4/10 = 0.4 goats milked.

Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Ben’s opportunity cost of shearing a sheep is 3/6 = 0.5 goats milked.

Who has a comparative advantage at shearing sheep? Arthur, whose opportunity cost of shearing a sheep is

lower.

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Example 2.2.





Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes. Which statement below is true?

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Example 2.3.





Arthur can milk 10 goats per hour or shear 4 sheep per hour. Ben can milk 6 goats per hour or shear 3 sheep per hour. Which statement below is true?

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Example 2.3.

Who has the comparative advantage of milking goats?

Arthur can milk 10 goats per hour or shear 4 sheep per hour. So his opportunity cost of milking 1 goat is 0.4 sheep shorn.

Ben can milk 6 goats per hour or shear 3 sheep per hour. So his opportunity cost of milking 1 goat is 0.5 sheep shorn.

Who has a comparative advantage at milking goats? Arthur, whose opportunity cost of milking a goat is

lower.

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Example 2.3.

Who has the comparative advantage of shearing sheep?

Arthur can milk 10 goats per hour or shear 4 sheep per hour. So his opportunity cost of shearing 1 sheep is 2.5 goats milked.

Ben can milk 6 goats per hour or shear 3 sheep per hour. So his opportunity cost of shearing 1 sheep is 2 goats milked.

Who has a comparative advantage at shearing sheep? Ben, whose opportunity cost of shearing sheep is lower.

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Example 2.3.





Arthur can milk 10 goats per hour or shear 4 sheep per hour. Ben can milk 6 goats per hour or shear 3 sheep per hour. Which statement below is true?

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Sources of Comparative Advantage

Individual Inborn talentEducationTrainingExperience

Non-economicAdoption of a language Institutions

National LevelNatural

resourcesCultural Institutions

What can we do to change our comparative advantage?

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Economic Naturalist

Televisions 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?

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The Production Possibilities Curve

A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.

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Example 2.4

Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food.

If Chris is the only person in the economy, describe the economy's production possibilities curve.

Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120

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Example 2.4

Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120

Production Possibilities Curve:All combinations of shelter and food that can be produced with Chris’s labor.The absolute value of

the slope of the production possibility curve is 6/12 = 1/2. For Chris, this means that the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.

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Example 2.4

Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120E

C

D

F

A

B

A, B, C, DAttainable and efficientE Attainable but inefficient

F Unattainable

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Example 2.5

Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Dana is the only one in the economy, describe the economy's production possibilities curve.

For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter.

Food (lb/wk)

Shelter (sq yd/wk)Production Possibilities Curve:All combinations of shelter and food that can be produced with Dana’s labor.

4

4

2

2

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Production Possibilities in a Two-Person Economy

For Chris, the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.

For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter.

Thus, Chris has a comparative advantage in producing food, because the opportunity cost of producing food is only half as large as it is for Dana.

By the same token, Dana has a comparative advantage producing shelter.

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Example 2.6

Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Chris and Dana are the only two people in the economy, describe the economy's production possibilities curve.

Food (lb/wk)

Shelter (sq yd/wk)

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Example 2.6


Food (lb/wk)

Shelter (sq yd/wk)

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Example 2.6


Food (lb/wk)

Shelter (sq yd/wk)

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Example 2.7

Food (lb/wk)

Shelter (sq yd/wk)

12 16

4

6

8

10

Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food.

Dana and Chris, a married couple, have decided to consume, jointly, 6 sq yd/wk of shelter and 8 lb/wk of food. How should they divide the task of producing these quantities?

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Example 2.7

Food (lb/wk)

Shelter (sq yd/wk)

12 16

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8

10 Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food.

Dana has a comparative advantage in producing shelter, but even if she spends all his time producing shelter, she can make only 4 sq yd/wk.

So Chris will have to produce the additional 2 sq yd/wk for them to achieve the desired 6 sq yd/wk.

Since Chris is capable of producing 6 sq yd/wk of shelter on his own, it will take him only 1/3 of a week to produce 2 sq yd.

This leaves 2/3 of a week for him to produce food, which is exactly how much time he needs to produce the desired 8 lb/wk.

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The Principle of Increasing Opportunity Cost (Also called “The Low-Hanging-Fruit Principle”)

In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs.

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Example 2.8

Chris and Dana are now joined by George, whose production-possibilities curve is shown below. What is the production-possibilities curve for the new economy consisting of Chris, Dana, and George?Shelter (sq yds/wk)

Food(lbs/wk)

2

1

George's production possibility curve

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Production Possibilities Curve with three persons

6

12Food (lb/wk)

Shelter (sq yd/wk) Production Possibilities Curve:

All combinations of shelter and food that can be produced with the labor of Chris, Dana and George.

12

16 17

2

Opportunity cost of producing 1 pound per week of food George's = 2 sq yds/wk of shelter.Chris's = 1/2 sq yd/wk of shelterDana's = 1 sq yd/wk of shelter

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Example 2.9

If the economy consisting of Chris, Dana, and George is to produce 14 lbs/wk of food and 4 sq yds/wk of shelter, how should each person's work time be allocated?

6

12Food (lb/wk)

Shelter (sq yd/wk)

12

16 17

2

4

14

production point

Chris: 0 sq yds/wk of shelter, 12 lbs/wk of food. Dana: 2 sq yds/wk of shelter, 2 lbs/wk of food.

George: 2 sq yds/wk of shelter, 0 lbs/wk of food.

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The Production Possibilities Curve for an Economy with Many Workers

Food (lbs/wk)

Clothing(garments/wk)

Produce the initial units of clothing using the resources that are relatively most efficient at clothing production, and only then turn to those that are relatively less efficient at clothing production.

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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

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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

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How much does specialization matter?

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Example 2.10.How much does specialization matter? (I)

George and Tom are mechanics. Tom can replace 15 clutches per day or 10 sets of brakes, i.e.,

the opportunity cost of replacing a pair of brakes is 1.5 clutches;

George can replace 10 clutches per day or 15 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 2/3 clutches.

At their garage, the number of brake replacements performed each day is the same as the number of clutch replacements.

How much more can they accomplish if they specialize than if each performed an equal number of brake and clutch replacements?

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If he doesn’t specialize, George can replace only 6 clutches per day and 6 sets of brakes.

Clutch replace-ments per day

Brakereplace-ments perday

0

10

15

6

6

George

George’s production possibilities curve: C = 10 - (2/3) B

Want equal number of both types of jobs: C = B

So write C = 10 – (2/3)C and solve for C = 6.

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6

15

Clutch replace-ments per day

Brakereplace-ments perday

0 10

6

Tom

If Tom doesn’t specialize, he too can produce 6 jobs of each type per day.

Tom’s production possibilities curve: C = 15 - (3/2) B

Want equal number of both types of jobs: C = B

So write C = 15 – (3/2)C and solve for C = 6.

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By specializing, they can replace 15 clutches per day (Tom) and 15 sets of brakes (George).

Clutch replacements/day

Brake replacements/day

15

25

2515

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So if neither George nor Tom specializes, the two can produce a total of only 12 jobs of each type per day, .

If they specialize, they can produce a total of 15 jobs per day.

A 25% increase in output isn’t bad, but cannot explain why industrialized

countries produce so much more than developing countries.

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Example 2.11. How much does specialization matter? (II)

George and Tom are mechanics. Tom can replace 30 clutches per day or 6 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 5 clutches.

George can replace 6 clutches per day or 30 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 0.2 clutches.

At their garage, the number of brake replacements performed each day is the same as the number of clutch replacements.

Note that the difference in opportunity cost (5 vs. 0.2) is larger than that in Example 2.10 (3/2 vs. 2/3).

How much more can they accomplish if they specialize than if each performed an equal number of brake and clutch replacements?

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30

Clutchreplace-ments perday

Brakereplace-mentsper day

0

36

3630

By specializing, they can replace 30 clutches per day (Tom) and 30 sets of brakes (George)

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Clutchreplace-ments perday


0

6

30

30

Clutchreplace-mentsper day


0 6

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GeorgeTom

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If they don’t specialize, each can replace only 5 clutches per day and 5 sets of brakes, for a total of 10 daily replacements of each type.

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By specializing, they can replace 30 clutches per day (Tom) and 30 sets of brakes (George), i.e., 30 daily replacement of each type.

If they don’t specialize, each can replace only 5 clutches per day and 5 sets of brakes, for a total of 10 daily replacements of each type.

The gain in output is three fold.

The gains from specialization are larger when differences in opportunity cost are larger, and when individuals enjoy absolute advantage in their respective specialties.

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Gains from specialization will often be far more spectacular!

Division of labor according to talent and temperament

Learning by doing

Specialized capital equipment

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Specialization can further shift comparative advantage

manufacturing

Service

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Adam Smith on specialization:

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Adam Smith on specialization:

“One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations... I have seen a small manufactory of this kind where only ten men were employed... [who] could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day...”

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Too much specialization?

Specialization boosts productivity, but it also entails costs.

Variety is one of the first casualties.

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Karl Marx

“[A]ll means for the development of production ... mutilate the laborer into a fragment of a man, degrade him to the level of an appendage of a machine, destroy every remnant of charm in his work and turn it into hated toil..”

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Example 2.12. Which job should Jane choose?

Suppose Jane is a factory worker who must choose between two jobs:1. $1000/wk, little variety, or2. $800/wk, high variety.

If Jane values the additional variety offered by the second job at $400 per week, which job should she choose?

Although the first job pays $200 more than the second, the second is actually worth more to Jane because its additional variety is worth $400, or $200 more than necessary to compensate for its lower salary. Therefore, Jane should choose the second job.

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Example 2.13. Why does excessive specialization create profit opportunities?

Suppose Jane is forced to move to the more specialized firm at a salary of $1000 per week when her original employer dies.

Explain how a new firm could lure her away from this job and make additional profit for itself in the process.

Her original employer was breaking even by paying Jane $800 per week.

She would be indifferent between working at the more specialized job at a salary of $1000 and working at the less specialized job at a salary of $600.

So a new firm could offer her $700 per week for the less specialized job.

She would accept and the new firm would earn a profit of at least $100 per week.

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Example 2.13. Why does excessive specialization create profit opportunities?

1. Because people are willing to pay for variety in their jobs, firms that are willing to provide jobs with greater variety may be able to earn additional profit.

2. The emergence of firms to offer jobs of variety benefits also the workers.

3. Additional economic surplus is resulted.

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Efficiency of specialization and variety

A situation is efficient if it results in the largest possible economic surplus.

A situation is inefficient if it fails to achieve the largest possible economic surplus.

Specialization brings additional output. People like more output and also variety in their

jobs. There is a trade-off between output and variety.

Too much specialization could be inefficient.

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The Efficiency Principle

Efficiency is a good thing, because when the economic pie is larger, everyone can have a larger slice.

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Specialization vs. variety

Why don’t people just choose the level of simplicity that seems to work best for them? Possible answers:

Spending is tempting.Hard to cut back when others don’t.

Bottom line: Life entails compromise. Specialization may be unpleasant, but those who don’t specialize at all must accept low wages or work extremely long hours.

We can expect to meet life’s financial obligations in the shortest time—thereby freeing up more time to do whatever else we wish—if we concentrate at least a significant proportion of our efforts on those tasks for which we have a comparative advantage.

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Comparative Advantage and International Trade

The same logic that leads the individuals in an economy to specialize and exchange goods with one another also leads nations to specialize and trade among themselves.

As with individuals, each trading partner can benefit from exchange, even though one may be more productive than the other in absolute terms.

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Example 2.14. How does international trade expand domestic consumption possibilities?

Elizabeth and Dennis are the only two workers in Islandia, a small island nation, and their production possibilities curve is as shown.

100

100120

120

Bananas(lb/day)

Tea(lb/day)

EIn a closed economy,consumption possibilities = production possibilities

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In the world market, tea can be purchased or sold at a price of $2 per pound and bananas can be bought or sold at a price of $1 per pound.

How does the opportunity to trade in the world markets for bananas and tea affect consumption opportunities in Islandia?

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If Islandians specialized at the point E and sold all their produce in the world market, they would earn $200 +$100 = $300 per day.

100

100120

120

Bananas(lb/day)

Tea(lb/day)

E

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100

100120

120

Bananas(lb/day)

Tea(lb/day

E

150

300 F

G

They could buy as many 300 pounds of bananas per day (point F) or as many as 150 pounds per day of tea (point G). Islandia could also consume any combination of tea and bananas on the line FG.

1x300 + 2x0 = 300

1x0 + 2x150 = 300

1x150 + 2x75 = 300

1x100 + 2x100 = 300

In a open economy,consumption possibilities > production possibilities

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In the world market, tea can be purchased or sold at a price of $20 per pound and bananas can be bought or sold at a price of $10 per pound.

How does the opportunity to trade in the world markets for bananas and tea affect consumption opportunities in Islandia?

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If Islandians specialized at the point E and sold all their produce in the world market, they would earn $2000 +$1000 = $3000 per day.

100

100120

120

Bananas(lb/day)

Tea(lb/day)

E

Although their income is 10 times as large as before, so are the prices of all goods.

The relative prices has not changed.

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100

100120

120

Bananas(lb/day)

Tea(lb/day

E

150

300 F

G

The relative price has not changed. So the menu of consumption possibilities is unchanged.

They could buy as many 300 pounds of bananas per day (point F) or as many as 150 pounds per day of tea (point G). Islandia could also consume any combination of tea and bananas on the line FG.

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Same as the preceding example, except now the prices of both tea and bananas are $2 per pound.

If Islandians again specialized at the point E and sold all their produce in the world market, they would earn $200 +$200 = $400 per day.

100

100120

120

Bananas(lb/day)

Tea(lb/day)

E

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100

100120

120

Bananas(lb/day)

E

200

200 F

G Tea(lb/day)

They could buy as many 200 pounds of bananas per day (point F) or as many as 200 pounds per day of tea (point G).

Islandia could also consume any combination of tea and bananas on the line FG.

Relative price has changed. So, is the consumption possibilities.

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True or false:

There is no way the United States can gain by trading with a nation whose workers are less productive than theirs, in absolute terms, for every production process.

False. Each country can gain by specializing in the products for which it is relatively more efficient, then exporting those products and importing the products for which it is relatively less efficient.

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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 may limit specialization in other countriesLawsCustoms

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Economic Naturalist

If trade between nations is so beneficial, why are free-trade agreements so controversial?

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Alan Blinder

"... one true test of whether a person is an economist is how devoutly he or she lives by the principle of comparative advantage."

--- Central Banking in Theory and Practice (1998, p.1)

http://en.wikipedia.org/wiki/Alan_Blinder

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End

ka-fu wong university of hong kong

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