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McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

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Page 1: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved

Lecture 2Comparative Advantage

Required Text:

Franks and Bernanke – Chapter 2

Page 2: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-2LO 2- All

Learning Objectives: Understand

1. The Principle of Comparative Advantage

2. The Principle of Increasing Opportunity Cost

3. Factors that shift the menu of production possibilities

4. The role of comparative advantage in international trade

5. Why some jobs are more vulnerable to outsourcing than others

Page 3: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-3LO 2 - 1

Do It Yourself?

Joe Jamail, a highly successful trial attorney, employs another attorney to write his will Writing your own will Opportunity cost of 2 hours Hiring someone to spend 4 hours

on your will Making the right economic choice

Do It Yourself only when

Opportunity cost < hired cost

2 hours

$10,000+

$3,200

Priceless

Page 4: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-4LO 2 - 1

Production Advantages

Definitions Absolute advantage

Lowest production cost

Comparative advantage Lower opportunity cost than someone else

Page 5: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-5LO 2 - 1

Everyone does best when each concentrates

on the activity with the lowest opportunity cost

The Principle of Comparative Advantage

Page 6: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-6LO 2 - 1

The Principle of Comparative Advantage

Two parties have different opportunity costs for two activities Concentrate on the activities of your lowest

opportunity cost Total value of output increases with specialization and

trade

Page 7: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-7LO 2 - 1

Comparative Advantage Example

Production Times Web Update Bike Repair

Paula 20 minutes 10 minutes

Beth 30 minutes 30 minutes

Paula and Beth can each update web pages and repair bikes

Paula has an absolute advantage in both Comparative advantage drives specialization

Page 8: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-8LO 2 - 1

Comparative Advantage Example

Production Times Web Update Bike Repair

Paula 20 minutes 10 minutes

Beth 30 minutes 30 minutes

Opportunity Cost Web Update Bike Repair

Paula 2 repairs 0.5 update

Beth 1 repair 1 update

Page 9: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-9LO 2 - 1

Comparative Advantage Example

Production Times Web Update Bike Repair

Paula 20 minutes 10 minutes

Beth 30 minutes 30 minutes

Hourly Output Web Update Bike Repair

Paula 3 updates 6 repairs

Beth 2 updates 2 repairs

Page 10: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-10LO 2 - 1

Comparative Advantage Example

16 web updates are ordered Paula spends half her time at each activity: 12

updates and 24 repairs Beth produces 4 updates and 12 repairs Total output 16 updates and 36 repairs

Specialization produces 16 updates and 48 repairs 12 more repairs for the same inputs!

Hourly Output Web Update Bike Repair

Paula 3 updates 6 repairs

Beth 2 updates 2 repairs

Page 11: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-11LO 2 - 1

Another Example

This table shows output per hour Principle of Comparative Advantage is the same

Look at opportunity cost per unit Pat repairs bikes and Barb updates web pages

Hourly Output Web Update Bike Repair

Pat 2 updates 1 repair

Barb 3 updates 3 repairs

Opportunity Cost Web Update Bike Repair

Pat ½ repair 2 updates

Barb 1 repair 1 update

Page 12: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-12LO 2 - 1

0.400 Hitters None since 1941 Not a decline in athletic ability

Specialization keeps averages lower Pitching and fielding skills have improved

Pitchers specialize in starters, middle relievers, and closers; right- or left-handedbatters; strike outs

Fielders play one position Specialized coaches Detailed analysis of hitters'

weaknesses

Page 13: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-13LO 2 - 1

Sources of Comparative Advantage

Talent Natural resources Cultures or societal norms Languages Institutions

Value placed on craftsmanship Support for entrepreneurship

Page 14: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-14LO 2 - 2

Production Possibilities Curve

A graph of the combinations of two goods that can be produced with given resources

Definitions Unattainable point Attainable point

Inefficient point Efficient point

Scarcity Principle Give up one good to get

anotherNuts (lb/day)

A

B

UnattainableCombination

C

Inefficient Combination

DC

offe

e (

lb/d

ay)

24

16

8

4 8 12

Page 15: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-15LO 2 - 2

Susan's Production Possibilities

Two goods: coffee and nuts Work 6 hours per day

1 hour of labor

= 4 pounds of coffee OR

= 2 pounds of nuts Graph shows options

Negative slope

Cof

fee

(lb/d

ay)

Nuts (lb/day)

16

8

4 8

24 A

B

C

D12

Page 16: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-16LO 2 - 2

Susan's Opportunity Cost

Marginal cost: – 8 coffee Marginal benefit: 4 nuts

Loss in coffeeGain in nuts

Opportunity cost of 1 nut is 2 coffee

Marginal cost: – 8 nut Marginal benefit: 16 coffee

Loss in nutsGain in coffee

Opportunity cost of 1 coffee is ½ nut

Cof

fee

(lb/d

ay)

Nuts (lb/day)

16

8

4 8

24 A

B

C

D12

Page 17: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-17LO 2 - 2

Tom's Production Possibilities

Work 6 hours per day Productivity determines the slope of the PPC 1 hour of labor

= 4 pounds of nuts OR

= 2 pounds of coffee Opportunity cost Marginal cost: – 4 coffee Marginal benefit: 8 nuts Tom's opportunity cost of

1 coffee is 2 nuts His opportunity cost of

1 nut is ½ coffee Nuts (lb/day)

Cof

fee

(lb

/day

)4

8

8 16

A

B

C

D

12

24

Page 18: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-18LO 2 - 2

Tom, Meet Susan

PPCs show comparative advantage Sue's curve is steeper,

better for coffee Tom's curve is flatter,

better for nuts Comparative advantage

is a comparison To get 1 coffee

Sue gives up ½ nuts Tom gives up 2 nuts

Nuts (lb/day)

12

24

Tom’s PPC

24

12

Susan’s PPC

Cof

fee

(lb

/day

)

Page 19: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-19LO 2 - 2

Gains from Specialization and Trade

Without trade, each person can consume along his production possibilities curve What you produce determines what you

consume With trade, each person's consumption can

be greater than production Produce according to comparative

advantage Trade to get what you want

Page 20: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-20LO 2 - 2

Gains from Specialization and Trade

Preferred diet is half nuts, half coffee

No trade: 8 pounds of coffee and 8 pounds of nuts Total output is 32

pounds Specialization gives

each person 12 pounds of each good

48 total pounds

Susan and Tom exchange

12 nuts, 12 coffee

8

8

Nuts (lb/day)

12

24

24

12

Cof

fee

(lb

/day

)

Page 21: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-21LO 2 - 2

Gains from Specialization and Trade

Benefits increase when differences in opportunity cost increase

Sue's opportunity cost of nuts increase to 6 coffee

Tom's opportunity cost of coffee increases to 6 nuts

No trade: 3.4 nuts and 3.4 coffee each

With trade: 12 nuts and 12 coffee each

Trade benefitsTrade

benefits

No tradeNo trade

24

244

4

12

Sue's PPC

12

Cof

fee

(lb/d

ay)

Nuts (lb/day)

Tom's PPC

With tradeWith trade

Page 22: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-22LO 2 - 2

Production Possibilities for an Economy

Two goods: coffee and nuts Multiple people

Different opportunity costs

Intercepts show maximum production of one good

Some resources better at coffe, some better at nuts

Nuts (1000s of lb/day)

100

80Cof

fee

(10

00s

of lb

/day

)

E

A B C

D1520

9095

20 30 7577

Page 23: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-23LO 2 - 2

The Principle of Increasing Opportunity Cost

Maximum coffee: 100,000 lb / day Give up 5,000 pounds coffee, get 20,000 pounds of nuts Give up another 5,000 pounds of coffee, get an 10,000

additional pounds of nuts

Nuts (1000s of lb/day)

100

80Cof

fee

(10

00s

of lb

/day

)

E

A B C

D1520

9095

20 30 7577

Page 24: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-24LO 2 - 2

The Principle of Increasing Opportunity Cost

Dec

reas

ing

prod

uctiv

ity

Res

ourc

es U

sed

Page 25: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-25LO 2 - 3

The Dynamic Economy

A PPC represents current choices Changes in choices occur over time due to

More resources Investment in capital Population growth

Improvements in technology More specialization: start-up and switching costs

Increases in knowledge

Page 26: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-26LO 2 - 3

Shifts in PPC

Nuts

Cof

fee

Neutral Technical Change

Nuts

Cof

fee

Technical Change in Nuts

Technical Change in Coffee

Nuts

Cof

fee

Page 27: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-27LO 2 - 4

Some Countries Resist Specialization

Specialization is easier when Population density passes a threshold Markets are connected

Transportation for goods Communications for services

Legal framework supports business Financial markets enable start-ups

Page 28: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-28LO 2 - 4

Too Much Specialization?

Imagine this: Your hair stylist only cuts blonde hair An expert in tropical diseases opens a practice in a

town of 500 people in Wisconsin Seven bookstores, each open a different day of the

week

Page 29: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-29LO 2 - 4

Comparative Advantage and International Trade

Principle of Comparative Advantage and gains from trade apply worldwide Potentially large gains from trading with different and

distant countries Controversial trade Benefits the society broadly Costs are concentrated

Some industries People who lose their jobs

Page 30: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-30LO 2 - 5

Outsourcing

Service work can be performed overseas Medical transcription ▪ Medical tourism

Customer call centers ▪ Technical writing Limits to outsourcing

Quality control Physical presence (haircuts) Complex communications Understand nuance

Greatest security for workers is the ability to adapt quickly to changing circumstances

Page 31: McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Lecture 2 Comparative Advantage Required Text: Franks and Bernanke – Chapter 2

2-31LO 2- All

Comparative Advantage

Comparative Advantage

Specialization and Gains from Trade

Increasing Opportunity

Cost

Shift PPC

Production Possibilities

Curve

Individual

Economy

Outsourcing


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