Title: Comparative and Absolute Advantage
URL Source: blob://pdf/ce0c490e-888b-4ad8-8758-e2572b912dfb
Markdown Content: Presentation #2: Comparative Advantage & Terms of Trade
AP Classroom Topic 1.3
Textbook Explanation of Comparative Advantage & Terms of Trade
4 min of Mr. Clifford Explaining Comparative Advantage & Terms of Trade
8 min of Mr. Clifford Explaining Comparative Advantage & Terms of Trade
12 min of ReviewEcon.com Explaining Comparative Advantage & Terms of Trade
COMPARATIVE ADVANTAGE
(SPECIALIZATION) is based on who has
the LOWER OPPORTUNITY COST
William has lower Opportunity Cost for Pies
(1/2 < 2/3) and he should specialize in Pies
David has lower Opportunity Cost for Cakes
(1 1/2 < 2) and he should specialize in Cakes
MUTUALLY BENEFIAL
TERMS OF TRADE
1 pie made by William for between
1/2 and 2/3 cakes made by David
1 cake made by David for between
1 1/2 and 2 pies made by William. Absolute Advantage : Ability of a person or country to produce more of a particular good.
Comparative Advantage : Ability of a person or country to produce at a lower opportunity cost than
anotherto be relatively more efficient at production of a certain product.
Opportunity Cost : The numeric value of something a person or country must give up to acquire or
achieve something elsethe value of an economic choice or trade off.
Terms of Trade : The exchange rate for mutually beneficial voluntary exchange between people
or countries. Which party specializes in what and what the terms of mutually beneficial exchange are is
based on Comparative Advantage NOT Absolute Advantage. Mutually beneficial trade allows both
parties to consume beyond their PPC in the short run.
Assume LeBron James is both a great basketball player and a great lawn mower.
However, LeBron has a young neighbor named Scotty who is willing to mow his lawn
(although not as well as LeBron) .
Consider the following facts: LeBron can mow his lawn in 2 hours. He could also film a
Nike commercial in 2 hours and make $100,000. Neighbor Scotty can mow LeBron's
lawn in 4 hours. He could also work at McDonald's for 4 hours for $10 per hour.
What is LeBrons opportunity cost of mowing his lawn?
What is Scotty's opportunity cost of mowing the lawn?
Who has an absolute advantage in mowing the lawn?
Who has comparative advantage (lower opportunity cost) in mowing the lawn ?
What price is good for both Scotty & LeBron to mow the lawn? ( terms of trade )Comparative Advantage Example:
Assume LeBron James is both a great basketball player and a great lawn mower. However, LeBron has a
young neighbor named Scotty who is willing to mow his lawn (although not as well as LeBron) .
Consider the following facts: LeBron can mow his lawn in 2 hours. He could also film a Nike commercial in 2
hours and make $100,000. Neighbor Scotty can mow LeBron's lawn in 4 hours. He could also work at
McDonald's for 4 hours for $10 per hour.
What is LeBrons opportunity cost of mowing his lawn? $100,000
What is Scotty's opportunity cost of mowing the lawn? $40
Who has an absolute advantage in mowing the lawn? LeBron (2 hours vs. 4 hours)
Who has comparative advantage (lower opportunity cost) in mowing the lawn ?
Scotty because he gives up $40 instead of $100,000
More than $40 and less than $100,000. Any rate between $40 & $100,000 is better
for BOTH Scotty and LeBron. In this price range, BOTH people would benefit
from specialization (LeBron in Nike commercials and Scotty in lawn mowing) Calculating Opportunity Cost
Output Problems measure the amount of a output (products) produced from a fixed amount of
inputs (more is better) . To determine Comparative Advantage from an output problem , take
data from a table (see below) and calculate the per unit opportunity cost for each party for both
products so that the Opportunity Cost of 1 A = B A of B (and reciprocal)
Product A Product B
Joe 4 2
Jen 3 5
Based on these per unit opportunity costs, who should specialize in producing Product A?
Joes Opportunity Cost for producing 1 Product A = a Product B
Jens Opportunity Cost producing 1 Product A = 5/3 a Product B
Joe has the lower OC (1/2 < 5/3) in producing Product A, so Joe should specialize in Product A
Based on these per unit opportunity costs, who should specialize in producing Product B?
Joes Opportunity Cost for producing 1 Product B = 2 Product A
Jens Opportunity Cost producing 1 Product B = 3/5 Product A
Jen has the lower OC (3/5 < 2) in Producing Product B, so Jen should specialize in Product B
What are mutually beneficial Terms of Trade for Product A? 1 Product A for > and < 5/3
Joes Opportunity Cost for 1 (4 4) Product A = 2 4 = Product B
Jens Opportunity Cost for 1 (3 3) Product A = 5 3 = 5/3 Product B
Joes Opportunity Cost for 1 (2 2) Product B = 4 2 = 2 Product A
Jens Opportunity Cost of 1 (5 5) Product B = 3 5 = 3/5 Product A SAMPLE Comparative Advantage OUTPUT FRQ
To determine Comparative Advantage from an output problem , take data from a table (see
below) and calculate the per unit opportunity cost so that the
Opportunity Cost of 1 A = B A of B (and reciprocal)
Pittsland Opportunity Cost for 1 (100 100) Steel = 300 100 = 3 Lumber
Portburgh Opportunity Cost for 1 (80 80) Steel = 240 80 = 3 Lumber
Pittsland Opportunity Cost for 1 (300 300) Lumber = 100 300 = 1/3 Steel
Portburgh Opportunity Cost of 1 (240 240) Lumber = 80 240 = 1/3 Steel SAMPLE Comparative Advantage INPUT FRQ
For INPUT problems, LESS is better (typically less time to make a product). You still need to
calculate the per unit opportunity cost, but reverse the denominator (and reciprocal), so the
Opportunity Cost of 1 A = A B of B
Kellys Opportunity Cost for 1 (8 8) Table = 8 16 = 1/2 Chair
Taylors Opportunity Cost for 1 (4 4) Table = 4 16 = 1/4 Chair
Kellys Opportunity Cost for 1 (16 16) Chair = 16 8 = 2 Tables
Taylors Opportunity Cost of 1 (16 16) Chair = 16 4 = 4 Tables Terms of Trade
Terms of Trade is Exchange Rate for two goods between two producers
Mutually Beneficial Terms of Trade are determined by calculate opportunity
costs and determine if the proposed exchange rate is between the opportunity
costs for both producers. If so, trade is mutually beneficial. Benefits of Specialization & Trade on the PPC
When mutually beneficial terms of trade exist, BOTH parties benefit from trade and can
expand their productive capacity . This concept is illustrated in the two PPC curves below.
Point C is outside the PPC of both nations without trade, but both nations could
achieve Point C by specializing in one product and trading for the other.
This is why economist argue specialization & trade can be mutually beneficial with
appropriate terms of trade. Still confused? Need more review?