Economics 2 Professor Christina Romer Spring 2017 Professor David Romer

LECTURE 2

COMPARATIVE ADVANTAGE AND THE GAINS FROM SPECIALIZATION

January 19, 2017

I. OVERVIEW

II. THE KEY ROLE OF DIFFERENCES IN RELATIVE ABILITY

A. Intuition B. Example: Specialization within a household C. Reciprocal absolute advantage

1. Definition of absolute advantage 2. Comparing outcomes without and with specialization

D. Comparative advantage 1. Definition of comparative advantage 2. Comparing outcomes without and with specialization 3. Reciprocal absolute advantage is just a special case of comparative advantage

III. OPPORTUNITY COST AND COMPARATIVE ADVANTAGE

A. Comparative advantage means that a producer has a lower opportunity cost

B. There are gains from specialization when opportunity cost differs

C. Comparative advantage is a relative concept

IV. SPECIALIZATION AND THE CURVATURE OF THE PRODUCTION POSSIBILITIES CURVE

A. Example: Specialization in a two-person economy

B. Individual PPCs in a two-person economy

C. PPC of two people combined without specialization

D. PPC of two people combined with specialization

E. What do we learn from this example?

F. Will both parties gain from specialization?

V. REAL-WORLD EXAMPLE: SHOULD CALIFORNIA GROW RICE?

A. Facts about California agriculture and water use

B. Relative opportunity cost of growing rice in California and Arkansas

C. Are we specializing along the lines of comparative advantage?

LECTURE 2 Comparative Advantage and the Gains from Specialization

January 19, 2017

Economics 2 Christina Romer Spring 2017 David Romer

Announcements

• It is essential that you attend section this week.

• Some hints on taking notes and reading the textbook.

• Reminder: please put away all electronic devices.

I. OVERVIEW

Two Fundamental Building Blocks

• Scarcity, choice, and opportunity cost.

• Comparative advantage and the gains from specialization.

II. THE KEY ROLE OF DIFFERENCES IN RELATIVE

ABILITY

Example: Specialization within a Household

• Two activities: dishwashing and painting.

• There are 3 walls that need painting (and many dirty dishes).

Reciprocal Absolute Advantage Walls Dishes

Abilities (per hour) C. 4 12 D. 2 20

No Specialization (Each paints ½ hr. and washes ½ hr.) C. 2 6 D. 1 10 3 16

Specialization (C. paints ¾ hr. and washes ¼ hr.; D. washes 1 hr.) C. 3 3 D. 0 20 3 23

Absolute Advantage

• Someone or something can produce more with a given amount of resources.

Comparative Advantage Walls Dishes

Abilities (per hour) C. 4 24 D. 2 20

No Specialization (Each paints ½ hr. and washes ½ hr.) C. 2 12 D. 1 10 3 22

Specialization (C. paints ¾ hr. and washes ¼ hr.; D. washes 1 hr.) C. 3 6 D. 0 20 3 26

Comparative Advantage

• Someone or something is relatively more productive at one activity than at another.

Messages

• Comparative advantage is necessary for there to be gains from specialization.

• Reciprocal absolute advantage is just a special case of comparative advantage.

III. OPPORTUNITY COST AND COMPARATIVE

ADVANTAGE

Opportunity Cost and Comparative Advantage Abilities (per hour)

C. 4 walls or 24 dishes D. 2 walls or 20 dishes

Opportunity Cost of 1 Wall C. 24/4 = 6 dishes D. 20/2 = 10 dishes

Opportunity Cost of 1 Dish C. 4/24 = 1/6 wall D. 2/20 = 1/10 wall Lower opportunity cost implies comparative advantage.

Some Observations

• There are gains from specialization when opportunity cost differs.

• How much we want to specialize depends on how many of the two activities need to be done.

• Comparative advantage is inherently a relative concept.

IV. SPECIALIZATION AND THE CURVATURE OF THE

PRODUCTION POSSIBILITIES CURVE

Example: Specialization in a Two-Person Economy

• Two goods: fish and coconuts.

• Abilities: • In an hour, Robinson can catch 1 fish or

gather 1 coconut. (So Robinson’s opportunity cost of 1 coconut is 1 fish.)

• In an hour, Friday can catch 8 fish or gather 2 coconuts. (So Friday’s opportunity cost of 1 coconut is 4 fish.)

• Each of them works 6 hours a day.

Robinson’s Production Possibilities Curve

6

6 0

0 Coconuts

Fish

PPC

Slope is −1, because the opportunity cost for Robinson of gathering 1 coconut is 1 fish.

Friday’s Production Possibilities Curve

0 0 Coconuts

Fish 48

12

PPC

Slope is −4, because the opportunity cost for Friday of gathering 1 coconut is 1 fish.

Opportunity Cost When Robinson and Friday Allocate Their Time the Same Way

(No Specialization)

• In an hour, they could catch 9 fish (1 from Robinson and 8 from Friday).

• Or they could gather 3 coconuts (1 from Robinson and 2 from Friday).

• So, they trade off 9 fish for 3 coconuts.

• The opportunity cost of 1 coconut is 3 fish.

Combined PPC without Specialization

0 0 Coconuts

Fish 54

18

Slope is −3, because the opportunity cost of gathering 1 coconut for the two combined without specialization is 3 fish.

PPC

Opportunity Costs with Specialization

• In an hour, Robinson could catch 1 fish or gather 1 coconut.

• So, the opportunity cost of having Robinson gather 1 coconut is 1 fish.

• In an hour, Friday could catch 8 fish or gather 2 coconut.

• So, the opportunity cost of having Friday gather 1 coconut is 4 fish.

• Robinson is the low opportunity cost provider of coconuts.

Combined PPC with Specialization

0 0 Coconuts

Fish 54

18

PPC

Slope = −4

Slope = −1 48

6

What Do We Learn from This Example?

• There are gains from specialization when opportunity differs across producers and production is organized according to comparative advantage.

• This explains why the PPC for a country is likely to be bowed out.

• One determinant of the size of the gains from specialization is the difference in opportunity cost.

Gains from Specialization

0 0 Coconuts

Fish 54

18

PPC with Specialization 48

6

PPC without specialization

Will Both Robinson and Friday Benefit from Specialization?

• Simple Answer: As long as there is no coercion, if two parties choose to specialize and trade, both must be benefitting.

• More complicated answer: In a market system, prices will tend to adjust to ensure that both parties gain from specialization and trade.

V. REAL-WORLD EXAMPLE: SHOULD CALIFORNIA

GROW RICE?

Source, Congressional Research Service, “California Agricultural Production and Irrigated Water Use,” 2015.

Source, Congressional Research Service, “California Agricultural Production and Irrigated Water Use,” 2015.

Is California the Low-Opportunity-Cost Rice Producer in the U.S.?

• What does California give up to grow rice?

• What do other rice-compatible states (such as Arkansas) give up to grow rice?

Source, Congressional Research Service, “California Agricultural Production and Irrigated Water Use,” 2015.