Comparative Advantage and The Basis of Trade
What is economics?

Economics? the study of human behaviour in a world with scarce resources.

The problem? we (families, businesses and society) want more than we can afford or have
time for


Understand
o
Ways businesses are structured and compete
o
Ways people interact and make decisions
o
Choice, scarcity, opportunity, impact of decisions on society
The economy: the state of a country or region in terms of the production and consumption
of goods and services and the supply of money

Microeconomics: study of how households and firms make decisions and how they interact
in markets

Macroeconomics: the study of economy-wide phenomena (inflation, unemployment,
economic growth)
Economic Models and Assumptions

Economic models: stylised representations of the world in diagrams or equations

Use assumptions to simplify, determine key features and understand fundamental economic
forces

Only how the assumption affects the answer matters
Model 1: Production Possibilities

Assumptions

2 possible activities

2 individuals

In trade: no transaction costs (negotiations/transportation costs) & no other barriers
(import quotas, tariffs)

One agent PPC

2 productive activities (e.g. collecting bananas and catching rabbits)

Use of resources (e.g. 1 kg banana takes 1 hour, 1 kg rabbit takes 2 hours)

Productivity determined by amount of resources used to perform the productive activity
(e.g. time)

Resources are scare (e.g. 16 hours)
1. Extreme scenarios (16h collecting bananas= 16 kg banana, 0 kg rabbit)
(16h collecting rabbits= 0 kg banana, 8 kg rabbit)
2. Intermediate scenarios (16h collecting bananas and rabbits= 8kg banana, 4 kg rabbit)
(16h collecting bananas and rabbits= 4kg banana, 6kg rabbit)

PPC and PPF

Production possibility curve PPC: represents all possible combinations of product 1 and 2
that can be produced with the maximum resources attainable

Production Possibility Frontier PPF: represents all maximum output possibilities for two or
more goods, given a set of inputs or resources if inputs are used efficiently

Efficient production point: represents a combination of goods for which currently available
resources do not allow an increase in the production of one good without a reduction in the
production of the other  all the points on the PPC are efficient (resources used to max.)

Inefficient production point: represents a combination of goods for which currently
available resources allow an increase in the production of one good without a reduction in
the production of the other  all the points below and to the left of the PPC are inefficient

Attainable production point: represents any combination of goods than can be produced
with the currently available resources  all the points on the PPC or below and to the left of
the PPC are attainable

Unattainable production point: represents any combination of goods that can not be
produced with the currently available resources  all the points that lie outside of the PPC
are unattainable

Two agent economy
Absolute Advantage

Absolute Advantage: occurs when an agent (or an economy) can carry the productive
activity with less resources than another agent
Opportunity Cost in Action

Opportunity cost of a action: the value of the next best alternative (cost in terms of what
you give up for a given action)

OCproduct1 = (loss in product 2/gain in product 1)

OCproduct2 = (loss in product 1/gain in product 2)
Lower OC for 1kg rabbit
Leo OC 1 kg rabbit= 1 kg banana/1 kg
rabbit
= 1 kg banana
Lower OC for 1kg banana
Alberto OC 1 kg banana= 0.5 kg
rabbit/1 kg banana
= 0.5 kg rabbit
Comparative Advantage

Comparative advantage: occurs when an agent (or an economy) has lower opportunity cost
of carrying the productive activity than another agent

(e.g. although Alberto had Absolute Advantage in both the production of 1kg banana and
1kg rabbit, he only has comparative advantage in 1kg banana and Leo in 1kg rabbit)

Specialisation in a two-agent economy- gains from specialisation in production of good with
comparative advantage in

Each agent (or country) is better off specialising in the activities they have comparative
advantage in

Gains from specialisation increases as the difference in opportunity cost increases (what is
given up for a given action)

Economy-wide PPC in two-agent economy
Alberto (comparative
advantage in banana
production) starts producing
bananas first until exhausted
then move to Leo
PPC is a curve bowing out
from origin  more people=
more curved
Gradient= ½- Albert’s
OC 1kg banana
Gradient= 1- Leo’s OC
1kg rabbit

principle of increasing opportunity cost: increasing the production of any good  employ
resources with lowest OC first then once exhausted employ resources with higher OC

Economic growth (push PPC out and to the right)  increase infrastructure (factories,
equipment)
 increase population (labour force)
 advancement in knowledge and technology (education, IT, communications tech etc.)
Trading between economies

A countries economic welfare does not depend on what it produces (PPC) but what it
consumes (CPC)

Consumption possibility curve CPC: represents all possible combinations of two goods that
the agents in an economy can feasibly consume when it is open to international trade

What should we produce to trade on the international market?
C= country’s
opportunity cost
1kg banana= 0.5
rabbit

Say 1kg bananas = 0.2 rabbit (international world price)
o
Specialised consumption possibilities: 20 kg banana  4 kg rabbit vs.
12 kg rabbit  60 kg banana

Closed economy (no trade)  PPC and CPC identical

Open economy (trade on international market)  CPC above and to the right of PPC

Consumption possibilities in an open economy always larger than a closed one

Economy wide PPC in a many agent economy
PPC is a curve bowing out
from origin  more people=
more curved
The slope is increasing- the
OC of bananas in terms of
forgone rabbits is rising
Classic Critiques to the Model
assumptions

no psychological cost associated to performing the same activity the entire day 
boredom

no transaction costs connected with trading (i.e., negotiation costs, transportation
costs, etc.)

no import quotas or tariffs  would limit the gains from specialization by making
specialization (beyond a certain level) pointless

no change in preferences for goods/services in which a country specializes in and no
accounting for social norms that might prevent trading