Chapter 2: Comparative

Advantage
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 Learning Objectives: Understand

1.  The Principle of Comparative Advantage

2.  The Principle of Increasing Opportunity

Cost (also called the Low-Hanging-Fruit
Principle)

3.  Factors that shift the menu of production

possibilities

4.  The role of comparative advantage in

international trade
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 Comparative Advantage

n  It is common to see in many developing

countries people who are spectacularly
resourceful.
n  Nepalese Birkhaman’s primary duties include
preparing food and maintaining kitchen in
addition to thatching a roof, butchering a goat,
repairing shoes, sewing, fixing a broken alarm
clock, plastering walls, etc.
n  Most people in developed (or wealthier)
economies would hire others to perform such
duties.
n  Why this difference in skills and employment?
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 Comparative Advantage

n Nepal’s income per person is 1/80th of

Qatar’s income and 1/40th of UAE’s
income.
n Economic answer: the Nepalese do not
perform their own services because they
are poor; rather, they are poor largely
because they perform their own services.
n Specialization à productivity à
prosperity
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 Do It Yourself?

n Joe Jamail, a highly successful Lebanese-

American trial attorney, employs another
attorney to write his will
Ø  Writing your own will 2 hours
Ø  Opportunity cost of 2 hours $10,000+
Ø  Hiring someone to spend 4 hours
$3,200
on your will
Ø  Making the right economic choice Priceless

n Do It Yourself only when

Opportunity cost < hired cost
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 Production Advantages: Previous
Example

n From the previous example:

Ø  Jamail
has an absolute advantage at
preparing his will
§  Because he can perform that task better than
another lawyer
Ø  Otherlawyer has a comparative advantage
at preparing the will
§  Because his opportunity cost of performing that
task is lower than Jamail’s

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 Production Advantages

n Definitions
Ø  Absolute advantage
§  Lowest production cost
§  one person has an absolute advantage over another
if he or she takes fewer hours to perform a task than
the other person

Ø  Comparative advantage

§  Lower opportunity cost than someone else
§  one person has a comparative advantage over
another if his or her opportunity cost of performing
a task is lower than the other person’s opportunity
cost

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The Principle of Comparative Advantage

The Principle of Comparative Advantage

Everyone does best when each concentrates
on the activity with the lowest opportunity cost

Opens doors for specialization à have you ever met an

engineer who is also a medical doctor? Or a mechanic
who is also a professor? à defines the basis for trade
among people and countries

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 Comparative Advantage Example

Production Times Web Update Bike Repair

Ayden 20 minutes 10 minutes
Ghadah 30 minutes 30 minutes

n Ayden and Ghadah can each update web

pages and repair bikes but Ayden has an
absolute advantage in both
§  Because it takes Ayden less time to perform each
task
•  In an 8 hour day, we can translate this into quantities

Production Output Web Update Bike Repair

Ayden 24 48
Ghadah 16 16
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 Comparative Advantage Example

Production Output Web Update Bike Repair

Ayden 24 48
Ghadah 16 16

Opportunity Cost Web Update Bike Repair

Ayden 2 repairs 0.5 update
Ghadah 1 repair 1 update

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 Comparative Advantage Example

Production Times Web Update Bike Repair

Ayden 20 minutes 10 minutes
Ghadah 30 minutes 30 minutes

Hourly Output Web Update Bike Repair

Ayden 3 updates 6 repairs
Ghadah 2 updates 2 repairs

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 Comparative Advantage Example

Hourly Output Web Update Bike Repair

Ayden 3 updates 6 repairs
Ghadah 2 updates 2 repairs

n  Assume that 16 web updates are ordered

Ø  Ayden spends half his time at each activity: 12
updates and 24 repairs
Ø  Ghadah produces the remaining 4 updates and spends
the last 6 hours of the day making 12 repairs
Ø  Total output 16 updates and 36 repairs
n  If specialization occurs then: 16 updates and 48
repairs
Ø  12 more repairs for the same inputs!

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The Principle of Comparative Advantage

n Two parties have different opportunity

costs for two activities
Ø  Concentrateon the activities of your lowest
opportunity cost
Identify the task with which the person or
§ 
country has a comparative advantage in
§  Total value of output increases with specialization
•  By specializing on producing tasks with which a person or a
country has a comparative advantage, the opportunity for
trade exists

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 Economic Naturalist

n  What has happened to Moroccan Track and

Field?
n  Moroccan athletes won gold medals in the
following Olympics games:
Ø  1984: 2 gold medals
Ø  1988: 1 gold medal
Ø  1992: 1 gold medal
Ø  2004: 2 gold medals

n  Ethiopians specialized in 10,000-meter

competition, thus showing unsurpassed
domination.

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 Sources of Comparative Advantage

n Where does comparative advantage come

from?
Ø  At the individual level
§  Talent
•  Education, training and experience
Ø  At the national level
§  Natural resources
§  Cultures or societal norms
•  Languages
•  Institutions
-  Value placed on craftsmanship
-  Support for entrepreneurship
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 Economic Naturalist

n  What happened to pearl diving in the Arabian

Gulf?
n  Pearls from the Gulf are known to be the finest in
the world.
n  Arabian Gulf had comparative advantage in pearl
diving due to arid climate which made sea-related
activities the only economically-viable options.
n  Global economic depression of 1930s reduced global
demand for pearls, coinciding with the introduction
of Japanese cultured pearls.
n  Cultured pearls were mass produced according to
specific shape, size, and quality, thereby reducing
costs and virtually destroying the natural pearl
industry.
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 Production Possibilities Curve (PPC)

n A graph of the combinations of two goods

that can be produced with a given level of
resources
24 A Unattainable
n Definitions Combination

Coffee (kg/day)
Ø  Unattainable point B
16
Inefficient
Ø  Attainable point Combination
§  Inefficient point
8 C
§  Efficient point
n Scarcity Principle D

Ø  Give
up one good to get 4 8 12
another Nuts (kg/day)

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 Fatima’s Production Possibilities

n Two goods: coffee and

nuts
24 A
Ø  Work 6 hours per day

Coffee (kg/day)
Ø  Has nimble fingers à B
16
better for picking coffee
n 1 hour of labor 8 C
= 4 kg of coffee OR
D
= 2 kg of nuts
4 8 12
Ø  Graph shows options Nuts (kg/day)

§  Negative slope

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 Fatima’s Opportunity Cost

§  Moving from A to B:

§  Marginal cost : – 8 coffee
§  Marginal benefit: 4 nuts
24 A
Loss in coffee
Gain in nuts

Coffee (kg/day)
•  Opportunity cost of 1 nut is 16
B
2 coffee

§  Moving from C to A: C

8
§  Marginal cost: – 8 nut
§  Marginal benefit: 16 coffee
D
Loss in nuts 4 8 12
Gain in coffee Nuts (kg/day)
•  Opportunity cost of 1 coffee is
1/2 nut

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 PPC and Opportunity Cost

n Hints:
Ø  Since Fatima’s PPC is a straight line, its slope is
constant
Ø  The absolute value of the slope of Fatima’s PPC is
the ratio of its vertical intercept to its horizontal
intercept:
§  (24 kg of coffee/day)/(12 kg of nuts/day) = (2 kg of
coffee)/(1 kg of nuts) à This ratio means that Fatima’s
opportunity cost of an additional kg of nuts is 2 kg of
coffee
§  To say that Fatima’s opportunity cost of an additional
kg of nuts is 2 kg of coffee is thus equivalent to saying
that her opportunity cost of a kg of coffee is 1/2 kg of
nuts.

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 Kamal ’s Production Possibilities

n  Work 6 hours per day

n  Productivity determines the slope of the PPC
Ø  1 hour of labor
= 4 kg of nuts OR A
12
= 2 kg of coffee

Coffee (kg/day)
n  Opportunity cost B
8
Ø  Marginal cost: – 4 coffee
Ø  Marginal benefit: 8 nuts C
4
n  Kamal’s opportunity cost of
1 kg of coffee is 2 kg of nuts D
n  His opportunity cost of 8 16 24
1 kg of nuts is 1/2 kg of coffee Nuts (kg/day)

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 Kamal meets Fatima

§  PPCs show comparative

advantage
§  Fatima’s curve is steeper, 24
Fatima’s PPC
better for coffee

Coffee (kg/day)
§  Kamal’s curve is flatter,
better for nuts
§  Comparative advantage is a 12
comparison Kamal’s PPC
§  To get 1 coffee
§  Fatima gives up 1/2 kg of
nuts 12 24
§  Kamal gives up 2 kg of Nuts (kg/day)
nuts

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 Gains from Specialization and Trade

n Without trade, each person can consume

along his production possibilities curve
Ø  What
you produce determines what you
consume
n With trade, each person’s consumption
can be greater than production
Ø  Produce according to comparative
advantage
Ø  Trade to get what you want

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 Gains from Specialization and Trade

§  Preferred diet is half

24 Fatima and Kamal nuts, half coffee
exchange
Ø  No trade: 8 kg of coffee
Coffee (kg/day)

12 nuts, 12 coffee
and 8 kg of nuts
§  Total output is 32 kg
12
§  Specialization gives each
8
person 12 kg of each
good
8 12 24 Ø  48 total kg
Nuts (kg/day)

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 Gains from Specialization and Trade

§  Benefits increase when

Fatima’s PPC
24 differences in opportunity
cost increase
Trade
benefits Ø  Fatima’s opportunity cost of
Coffee (kg/day)

nuts increase to 6 kg of coffee

12 With
trade Ø  Kamal’s opportunity cost of
coffee increases to 6 kg of
4 Kamal’s PPC nuts
§  No trade: 3.4 kg of nuts and
4 12 24 3.4 kg of coffee each
No trade
Nuts (kg/day) §  With trade: 12 kg of nuts and
12 kg of coffee each

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Production Possibilities for an Economy

§  Two goods: coffee and nuts §  Intercepts show maximum
§  Multiple people production of one good
§  Different opportunity costs §  Some resources better at
coffee, some better at nuts

100 A B
Coffee (1000s of kg/day)

95 C
90

20 D
15 E

20 30 75 80
77
Nuts (1000s of kg/day)

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The Principle of Increasing Opportunity Cost

n  Maximum coffee: 100,000 kg / day

Ø  Give up 5,000 kg coffee, get 20,000 kg of nuts (A à B)
Ø  Give up another 5,000 kg of coffee, get an 10,000 additional
kg of nuts (B àC)

100 A B
Coffee (1000s of kg/day)

95 C
90

20 D
15 E

20 30 75 80
77
Nuts (1000s of kg/day)
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The Principle of Increasing Opportunity Cost

Start with resources

with lowest

Decreasing productivity
opportunity cost
Then move to next
highest opportunity
cost

And still higher

opportunity cost

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 The Principle of Increasing Opportunity Cost

n  PPC is bow-shaped because of increasing opportunity

cost
Ø  Also known as the “low-hanging-fruit principle”
§  1st: It is easier to pick the low-hanging-fruit

§  2nd: if the fruit picker does not want to pick the
whole tree then it is still a better choice since the
high-hanging-fruit are more difficult to get to

§  3rd: if the fruit picker wants to pick the whole

tree then it is still a better choice since he can
enjoy some fast revenue from the sales of the
easy to pick sooner
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 The Dynamic Economy

n What shifts the PPC?

Ø  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 eliminates start-up and
switching costs
•  Increases in knowledge

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 Shifts in PPC

Technical Change
in Coffee

Coffee
Neutral Technical
Change

Nuts
Coffee

Technical Change
in Nuts
Nuts

Coffee
Nuts
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 Some Countries Resist Specialization

n Specialization is easier when

Ø  Population density passes a threshold
§  Work tends to be more specialized in large
cities than in rural areas
§  30 people per sq mile in Nepal
Ø  Markets are connected
§  Transportation for goods
§  Communications for services
Ø  Legalframework supports business
Ø  Financial markets enable start-ups
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 Too Much Specialization?

n Karl Marx criticizes specialization

Ø  “Allmeans 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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 Too Much Specialization?

n Imagine these scenarios:

Ø  Your hair stylist only cuts blonde hair
Ø  A professor for each chapter!
Ø  Seven bookstores, each open a different day
of the week
Ø  A grocery store for every type of food

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Comparative Advantage and International
Trade

n Principle of Comparative Advantage

and gains from trade apply worldwide
Ø  Potentially
large gains from trading with
different and distant countries
n Controversial trade
Ø  Benefits the society broadly
Ø  Costs are concentrated
§  Some industries
§  People who lose their jobs

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 Economic Naturalist

n If trade between nations is so beneficial,

why are free-trade agreements so
controversial?
n WTO is responsible for promoting free
trade, enforcing free trade agreements,
and settling disputes among its 159
members.
n WTO conferences generate massive
anti-globalization demonstrations.
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 Economic Naturalist

n  WTO is blamed for being undemocratic and for

lack of transparency and accountability because
its meetings are closed to the media and public.
n  WTO is viewed as serving the interests of
powerful interest groups and the wealthy by
involving them heavily in bilateral negotiations.
n  WTO is also accused of using its power to
influence law and regulations in member
countries, widening the social gap between rich
and poor and harming the environment and
health
Ø  For
example: Privatization of essential services
typically provided by governments
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 Economic Naturalist

n  There is empirical evidence supporting

convergence across countries in a number of
measures of quality of life covering health,
education, and infrastructure.
n  There are also a number of studies showing
positive correlation between globalization and
worsening conditions for the less fortunate
members of society.
n  Trade and Foreign Direct Investment have also
been linked to increased inequality between
skilled and unskilled workers.
n  Despite this lack of consensus, trade generally
remains a better choice than autarky.
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End of Chapter 2