Focus: How do the concepts of
comparative and absolute advantage
help explain why nations trade?
AP Macroeconomics
August 2014
Why do nations trade?
• “You could say…that globalization, driven not
by human goodness but by the profit motive,
has done far more good for far more people
than all the foreign aid and soft loans ever
provided by well-intentioned governments
and international agencies.”
Paul Krugman, “The Magic Mountain,” New York Times,
January 23, 2001
Adam Smith, The Wealth of Nations
(often called the Father of Modern Economics)
It is the maxim of every prudent master of a family, never
to attempt to make at home what it will cost him more to
make than to buy. The taylor does not attempt to make his
own shoes, but buys them of the shoemaker. The shoemaker
does not attempt to make his own clothes, but employs a
taylor. The farmer attempts to make neither the one nor the
other…
What is prudence in the conduct of every private family,
can scarce be folly in that of a great kingdom. If a foreign
country can supply us with a commodity cheaper than we can
make it, better buy it of them with some part of the produce
of our own industry;…. (Book IV, Section ii, 12)
Why do nations trade?
• Nearly all economic theories suggest that the
benefits of international trade far exceed the
costs.
• “Specialization and international trade
increase the productivity of a nation’s
resources and allow for greater total output
than would otherwise be possible. “
McConnell and Brue, 16th edition
Important Terms to Know
•
•
•
•
•
Trade
Specialization
Gains from Trade
Comparative Advantage
Absolute Advantage
Absolute Advantage
• Individual – exists when a person can produce
more of a certain good/service than someone
else in the same amount of time (or can
produce a good using the least amount of
resources.)
• National – exists when a country can produce
more of a good/service than another country
can in the same time period.
Absolute Advantage & Trade
What if a person or a nation has an
absolute advantage in producing
everything….would there still be a
reason to specialize and trade?
YES!
David Ricardo
Classical
Economist who
promoted the
idea of
comparative
advantage as
the basis for
trade.
Comparative Advantage
A person or a nation has a comparative
advantage in the production of a product
when it can produce the product at a lower
opportunity cost than another person or
nation.
Comparative advantage as
the basis for trade
is one of the most important ideas in
economics.
It is also one of the least intuitive.
Comparative Advantage
• A person or nation should specialize in the
production of a good for which it has a lower
opportunity cost and trade to obtain those
goodsts for which its opportunity cost is
higher.
Specialization and Trade
• Gains from trade are based on comparative
advantage, not absolute advantage
• Specialization and trade increase productivity,
national output, & standard of living.
• Everyone can benefit:
– a greater quantity of goods and services
– a greater variety of goods.
What should a nation produce?
• The goods for which it has the lowest
OPPORTUNITY COSTS!
Bake
Cakes
Make
Pizza
Ms.
Gray
2 cakes/hr.
6 pizzas/hr.
Mr.
Pinson
4 cakes/hr.
8 pizzas/hr.
Who has the absolute advantage in producing cakes? Mr. Pinson
Who has the absolute advantage in producing pizza? Mr. Pinson
Would Mr. Pinson be better off to specialize and trade?
Mr. Pinson should specialize and trade if he has a
comparative advantage (lower opportunity cost)
in the production of one of the products.
Bake
Cakes
Make
Pizza
Ms.
Gray
2 cakes/hr.
(1c = 3p)
6 pizzas/hr.
(1p = 1/3c)
Mr.
Pinson
4 cakes/hr.
(1c = 2p)
8 pizzas/hr.
(1p = 1/2c)
Mr. Pinson has a lower opportunity cost in producing cakes; therefore, he should
specialize in the production of cakes. Ms. Gray has a lower opportunity cost in
producing pizza; therefore, she should specialize in the production of pizza.
Terms of trade
Bake
Cakes
Pinson will specialize in
cakes.
Ms. Gray
Mr. Pinson
Make
Pizza
Gray will specialize in pizzas.
1c = 3p
1p = 1/3c
For one cake, Gray would be
willing to pay anything up to
3 pizzas.
For one pizza, Gray will want
more than 1/3 cakes.
1c = 2p
1p = 1/2c
For one cake, Pinson will
want more than 2 pizzas.
For one pizza, Pinson would
be willing to pay anything up
to ½ cake.
Hank’s PPF
Tom’s PPF
Q of Coconuts
Q of Coconuts
30
20
9
8
28
40
Q of Fish
6
10
Q of Fish
Will the Castaways Gain From Trade?
Coconuts
Fish
Tom
1 C = 1 1/3 F
1F=¾C
Hank
1C= ½ F
1F=2C
Tom has the lower opportunity cost in fishing and Hank has the lower
opportunity cost gathering coconuts. Therefore, Tom should
specialize in fishing and Hank should specialize in gathering
coconuts.
Hank’s PPF
Tom’s PPF
Q of Coconuts
Q of Coconuts
30
20
11
9
9
8
28
31
40
Q of Fish
6
9 10
Q of Fish
After specialization and trade, Tom and Hank can consume outside their PPCs.
Benefits from
Specialization and Trade
• Specialization and trade increase productivity and
the standard of living within a nation.
• Because of specialization and trade, there will be a
larger global output of goods and services.
• Everyone can benefit when people trade with one
another. Not only can people enjoy a greater
quantity of goods and services, but they can also
enjoy a greater variety of goods.
Distinguishing:
Input/Output Problems
Distinguishing input from output
problems.
• An OUTPUT problem presents the data as
products produced given a set of
resources. (ex. Number of pens
produced)
• An INPUT problem presents the data as
amount of resources needed to produce
a fixed amount of output. (ex. Number of
labor hours to produce 1 bushel)
• When identifying absolute advantage,
input problems change the scenario from
who can produce the most to who can
produce a given product with the least
amount of resources.
Which type of problem?
• Acres to produce one unit of each.
Apples
Pears
Tom
10
5
Sam
6
2
• Input problem
Absolute Advantage?
• Acres to produce one unit of each.
Apples
Pears
Tom
10
5
Sam
6
2
• Who has the absolute advantage in
apples and pears?
Sam
Explanation
• Acres to produce one unit of each.
Apples
Pears
Tom
10
5
Sam
6
2
• Sam has an absolute advantage in both pears and
apples because he can produce 1 unit of each in
fewer acres than Tom. Absolute advantage in INPUT
problems is based on using the LEAST amount of
resources to produce the given unit(s) of product.
Input or Output problem?
• Number caught per day.
Trout
Bass
Tom
4
6
Sam
24
12
Output problem
Absolute Advantage?
• Number caught per day.
Trout
Bass
Tom
4
6
Sam
24
12
• Which guy has the absolute advantage
in the production of each product?
Sam
Explanation:
• Number caught per day.
Trout
Bass
Tom
4
6
Sam
24
12
• Sam has an absolute advantage in
catching both trout and bass as he can
catch more of each than Tom in one
day’s time.
Input or Output Problem?
• Days to produce one unit of each.
Cars
Planes
XYZ Corp.
8
10
QKFX Corp.
15
12
• Input problem
Explanation:
• Days to produce one unit of each.
Cars
Planes
XYZ Corp.
8
10
QKFX Corp.
15
12
• This is an input problem as it refers to how
many days (work days for labor) will be
needed to produce 1 unit. The problem is
phrased in terms of resources used rather
than products produced.
Absolute Advantage?
• Days to produce one unit of each.
Cars
Planes
XYZ Corp.
8
10
QKFX Corp.
15
12
• Which corporation has an absolute
advantage in the production of both
products?
XYZ
Explanation:
• Days to produce one unit of each.
Cars
Planes
XYZ Corp.
8
10
QKFX Corp.
15
12
• XYZ has an absolute advantage in producing
both cars and planes because it can
produce 1 unit of each in less time (days)
than QKFX. This means that QKFX has an
absolute disadvantage in producing both
products. QKFX uses more days to produce
both products.
Input or Output Problem?
• To produce the following from one ton of
olives.
Canned
Olive Oil
Olives
Namibia
60
10
Colombia
24
Output problem
8
Explanation?
• To produce the following from one ton of
olives.
Canned
Olive Oil
Olives
Namibia
60
10
Colombia
24
8
• This is an output problem because it is the
number produced (output in canned
olives and olive oil) from a given unit of
resources (1 ton of olives)
Absolute Advantage?
• To produce the following from one ton of
olives.
Canned
Olive Oil
Namibia
Colombia
Olives
60
10
24
8
• Which nation has the absolute
advantage in both products?
Namibia
Explanation:
• To produce the following from one ton of
olives.
Canned
Olive Oil
Namibia
Colombia
Olives
60
10
24
8
• Namibia has an absolute advantage in
producing both products because it can
produce more given the unit of resources
available (1 ton of olives).
How to Handle a
Comparative Advantage Problem
on the AP Exam
1. The question will have information about
two nations producing two of the same
products. This information will be given to
you in a Production Possibilities table or on a
Production Possibilities curve or maybe a
word problem form.
2. Ask what type of problem: Output or input?
2. Determine which nation or person has the
absolute advantage in producing each of the
two goods or services.
3. Determine which nation or person has the
comparative advantage in producing each of
the two goods or services.
– For each nation, determine the opportunity cost
of producing one unit of each good.
– Identify the nation that has the lowest
opportunity cost of producing one unit of each
good. That nation has the comparative
advantage.
4. Determine the terms of trade. Each country
will specialize in the production of the good in
which it has the comparative advantage and will
export that good. It will import the other good.
The terms of trade will be whatever is mutually
beneficial to the two countries. (They will want to
be better off after trade than before trade.)
• If the country exports Good A, it will want more of
Good B than it would get before specialization.
• If the country imports Good A, it will want to pay
less in terms of Good B than it would have to pay
before specialization and trade.
Mexico
Corn
300
France
200
Sunscreen
150
150
1. Type of problem (output or input)?:
2. Which nation has the absolute advantage in
producing corn?
Sunscreen?
3. Which nation has the comparative advantage in the
production of each good? (What is the
opportunity cost for each nation of producing one
unit of corn
and sunscreen
?)
4. What would be a favorable term of trade?
United States
Canada
Wheat
1 hour
3 hours
Cloth
2 hours
4 hours
1. What type of problem is this? (output/input)
2. Who has the absolute advantage in producing
wheat?
In producing cloth?
3. Who has the lowest opportunity cost producing
wheat?
In producing cloth?
4. Favorable terms of trade?