Economics Principles and Applications

Economics Principles and Applications

Chapter 2: Comparative Advantage A scenario Two sailors are stranded on an island. To survive, they need to undertake some basic economic activities like fishing, cooking, and building shelters, etc. One sailor is much younger and better at all the activities than the other. Questions: Should they try to survive independently on their own or divide the activities between them and work in collaboration? If working together is in the better interest of both sailors, then how should they divide their work? 1 Production Advantages Labor Productivity the number of units of output produced in an hour of labor. or, the number of hours of labor required to produce one unit of output. (unit labor requirement, ULR) Production Hours Clothing

Computers USA 0.8 2.0 China 1.0 4.0 2 Production Advantages Absolute Advantage It takes fewer hours for a person ( a country) to perform a task than another. Comparative Advantage A person ( a country)s opportunity cost of performing a task is lower than that of another.

3 Comparative Advantage Production Time Web Update Bike Repair Paula 20 minutes 10 minutes Beth 30 minutes 30 minutes Who has an absolute advantage in updating websites? Who has an absolute advantage in repairing bikes?

What are the opportunity costs of undertaking each activity for Paula and for Beth? 4 Comparative Advantage Production Time Paula Beth Opportunity Cost Paula Beth Web Update 20 minutes Bike Repair 10 minutes 30 minutes 30 minutes

Web Update 2 repairs Bike Repair 0.5 update 1 repair 1 update 5 Comparative Advantage Hourly Output Paula Beth Web Update 3 updates Bike Repair 6 repairs 2 updates

2 repairs In an 8-hour workday with an order of 16 web updates: Scenario A: - Paula spends half of her time on each activity: 12 updates and 24 repairs; then, Beth produces 4 updates and 12 repairs. So, the total output is 16 updates and 36 repairs. Scenario B: - Specialization: Paula produces 48 repairs and Beth produces 16 updates. 6 Comparative Advantage - 12 more repairs for the same inputs! The principle of Comparative Advantage Everyone is better off when each concentrates on the activity with the lowest opportunity cost. - Specialize in producing the goods in which one has a comparative advantage; - Exchange goods with one another;

- Everyone would enjoy more goods than they would otherwise if they produce everything on their own. 7 Production Possibility Curve 6 working hours per day; PPC is a graph that describes the possible output combinations of two goods that can be produced with given resources. 24 Coffee (lb/day) Susan's Productivities (ULR) Coffee Nuts 0.25 hrs/pound 0.5 hrs/pound 16

8 A B C D 4 8 12 Nuts (lb/day) 8 Production Possibilities Curve Susans Opportunity Cost Oppt. cost of producing one pound of nuts equals 0.5 hrs/0.25 hrs = 2 pounds of coffee Los in Cofe Gain in Nuts = the slope of PPC = 24/12=2 Oppt. cost of producing one pound of coffee equals 0.25 hrs/0.5 hrs = pounds of nuts

Los in Nuts = the reciprocal of PPC slope = 12/24=1/2 Gain in Cofe 9 Production Possibilities Curve Introducing Tom who also works 6 hours a day Production Time Susan Tom Coffee (pound) 0.25 hrs Nuts (pound) 0.5 hrs 0.5 hrs 0.25 hrs Opportunity Cost Coffee (pound)

Susan Tom 0.5 pds of nuts 2 pds of nuts Nuts (pound) 2 pds of coffee 0.5 pds of coffee 10 Susans comparative advantage is on coffee production. Toms comparative advantage is on nuts production. Coffee (lb/day) Production Possibilities Curve 2 4

Susans PPC 12 Toms PPC 1 Nuts 2(lb/day) 24 11 Production Possibilities Curve Gains from specialization and trade Without specialization and trade, Susan and Tom have to produce both coffee and nuts on their own; On her own, Susan would be willing to give up 2 pounds of coffee for 1 pound of nuts; On his own, Tom would be willing to give up 2 pounds of nuts for 1 pound of coffee; 12

PPC Gains from Specialization and Trade Coffee (lb/day) 24 With specialization and trade, would both Susan and Tom be better off if Susan specializes in producing coffee; Susan and Tom exchange 12 nuts, 12 coffee 12 Tom specializes in producing nuts; And, Susan trade one pound of coffee for one pound of nuts with Tom.

Without specialization and trade, the total output and consumption is 16 pounds of coffee and 16 pounds of nuts; With specialization and trade, the total output and consumption is 24 pounds of coffee and 24 pounds of nuts. 8 8 12 Nuts (lb/day) 24 13 Coffee (1000s of lb/day) Production Possibilities Curve for an Economy 100 A

95 90 B C D 20 15 E 20 30 Nuts (1000s of lb/day) 75

80 77 Available resources with different opportunity costs; Starting from complete specialization in coffee production, to produce nuts, the economy should first release resources with lowest opportunity cost of producing nuts so that it will have a minimum effect on the coffee production. As the output of nuts increases, the opportunity cost of producing nuts increases. 14 Decreasing productivity Re so u rc es U sed The Principle of Increasing Opportunity Cost

15 PPC Over Time Dynamic Economy More inputs Investment in physical capital Population growth Technological innovations Increases in knowledge human capital Coffee Technological Improvements Nuts 16

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