Chapter 2
The Power of Trade
and Comparative
Advantage
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
 Trade and Preferences
 Specialization, Productivity, and the
Division of Knowledge
 Comparative Advantage
 Trade and Globalization
2
Discussion Question
Think of the last time you bought or sold
something. Why did you make the trade?
Answer: You probably traded because you
preferred what you got over what you gave
up. For example, if you bought a candy bar
for $1, you probably preferred the candy bar
to having $1 in your pocket.
3
Trade and Preferences
 Selling a broken laser pointer on EBay
(1995)
 Offered at $1 and sold for $14.83 to a
collector of broken laser points
 One man’s junk is another man’s treasure
 eBay profits by making buyers and
sellers happy
4
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Introduction
Benefits of Trade
1. Trade makes people better off when
preferences differ.
2. Trade increases productivity through
specialization and the division of knowledge.
3. Trade increases productivity through
comparative advantage.
6
Trade and Preferences
Trade Creates Value
 Trade moves goods from people who value
them less to people who value them more.
 Trade makes people with different
preferences better off.
7
Specialization
Trade Allows Specialization
 With no trade, there is no specialization.
 People will specialize in the production of a
single good only when they can trade for
other goods.
8
Specialization
Increased Productivity
 We can produce more through trade than by
individual production.
• People who specialize have more
knowledge about their field.
• Because they sell large quantities, people
who specialize can take advantage of
large-scale equipment.
9
Specialization
Division of Knowledge
 Without specialization, each person
produces their own food, clothing, and so on.
• Each person has the same knowledge as
everybody else.
• The combined knowledge of a society is
not much more than that of a single
person.
10
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Specialization
Division of Knowledge
 With specialization, much more knowledge is
used than could exist in a single brain.
 Knowledge increases productivity so
specialization increases total output.
 Every increase in world trade is an
opportunity to increase the division of
knowledge.
 When everyone knows something different,
the combined brain power of society is huge
12
Reducing Trade Barriers, Berlin 1989
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Self-Check
One of the benefits of specialization is:
a. Less pollution.
b. More equality.
c. Increased productivity.
Answer: c – increased productivity.
14
Definition
Production Possibilities
Frontier:
Shows all the combinations of goods
that a country can produce given its
productivity and supply of inputs.
15
Production Possibilities Frontier
 PPF is a very simplified and abstract
model representing production and trade
 PPF exists for a given country at a given
point in time
 PPF can be used to demonstrate:
•
•
•
•
Scarcity
Tradeoffs (opportunity costs)
Efficiency (unemployment of resources)
Economic growth
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Production Possibilities Frontier
 Assume that we have a two-country, twogood economic model
 The table shows the labor (resource)
required to produce each good for each
economy
 The PPF
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Production Possibilities Frontier
 The PPF for each economy based on the
output table
 Assuming that each economy has 24 units
of labor as a resource, the PPF shows all
the possible combinations of production for
each country
 The midpoint on each PPF represents
equal division of labor between the two
products (no trade occurring)
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Production – Resource Inputs
Units of Labor
Country
Computers
Shirts
Mexico
12
2
U.S.
1
1
 The U.S. can produce both computers and
shirts at lower cost (less labor).
 The U.S. has an absolute advantage in the
production of both goods.
19
Definition
Absolute advantage:
The ability to produce the same good
using fewer inputs than another
producer.
20
Production Possibilities Frontier
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Martha Stewart: Writing Books vs Ironing
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Comparative Advantage
Absolute and Comparative Advantage
 Another reason to trade is to take advantage
of differences.
 Countries have different climates, levels of
human capital, and so on.
 Different countries are therefore suited to
produce different goods.
23
Definition
Comparative advantage:
Producing goods at the lowest
opportunity cost.
24
Opportunity Costs and the PPF
PPF illustrates the trade-offs or
opportunity costs of producing more
of one good by giving up the production
of the other good.
i.e. What is the cost of changing the
mix of production for a given country?
25
Comparative Advantage
Units of Labor
Country
Computers
Shirts
Mexico
12
2
U.S.
1
1
 Assuming each country has 24 units of labor:
Production Possibilities
Country
Computers
Mexico
2
U.S.
24
Shirts
OR
OR
12
24
26
Comparative Advantage
Units of Labor
Country
Computers
Shirts
Mexico
12
2
U.S.
1
1
Production Possibilities
Country
Computers
Shirts
Mexico
2
12
U.S.
24
24
27
Comparative Advantage
Production Possibilities
Country
Computers
Shirts
Mexico
2
12
U.S.
24
24
 With no trade, each country will produce some
of each good.
 The opportunity cost of a good is the amount
of the other good that is given up.
28
Comparative Advantage
Production Possibilities
Country
Computers
Shirts
Mexico
2
12
U.S.
24
24
 In Mexico, 1 computer will cost 6 shirts, while 1
shirt will cost 1/6 of a computer.
 In the U.S., 1 computer will cost 1 shirt, and 1
shirt will cost 1 computer.
29
Comparative Advantage
Opportunity Cost
Country
1 Computer
1 Shirt
Mexico
6 shirts
1/6 computer
U.S.
1 shirt
1 computer
 Mexico has a comparative advantage (lowest
opportunity cost) in shirts.
 U.S. has a comparative advantage (lowest
opportunity cost) in computers.
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Self-Check
If country A is able to produce furniture at a
lower cost than country B, we would say that
country A has a(n):
a. Absolute advantage.
b. Comparative advantage.
c. No advantage.
Answer: a – absolute advantage means
producing a good with fewer inputs (lower cost).
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Comparative Advantage
Absolute and Comparative Advantage
 To benefit from trade, a country doesn’t need
to have an absolute advantage.
 A country can benefit from trade if it has a
comparative advantage.
 Comparative advantage can be illustrated
with a production possibilities frontier.
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Trade Increases Productivity
 If each country produces some of each good
and only consumes what it produces:
Production Possibilities (no trade)
Country
Computers
Shirts
Mexico
1
6
U.S.
12
12
TOTAL:
13
18
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Trade Increases Productivity
 If each country specializes and trades, there is
more of everything:
Production Possibilities (before trade)
Country
Computers
Shirts
Mexico
0
12
U.S.
14
10
TOTAL:
14
22
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Trade Increases Productivity
 If each country specializes and trades, there is
more of everything (Mexico is giving 3 shirts for
1 computer):
Production Possibilities (after trade)
Country
Computers
Shirts
Mexico
1
9
U.S.
13
13
TOTAL:
14
22
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Trade Increases Productivity
36
Comparative Advantage
Comparative Advantage and Wages
 Differences in wages reflect differences in
productivity.
 Wages will be higher in high-productivity
countries than in low-productivity countries.
 Trade raises wages to the highest levels
allowed by a country’s productivity.
37
Trade and Globalization
Globalization and Wages
 Wages will rise in high-demand industries
and fall in low-demand industries.
 Workers will move from low-wage industries
to high-wage industries until wages equalize.
 The transition isn’t always quick or easy.
38
Trade and Globalization
More on Globalization and Wages
• While trade will improve worker’s standard
of living, domestic wages are determined
by labor productivity
• Simply increasing wages by government
dictate will not make workers better off
unless there is, somehow, an increase in
productivity and output,
• i.e. raising wages will likely result in
inflation
39
Trade and Globalization
“Tariffs and import quotas usually reduce the
general welfare of a society.”

% of American Economics Association
members
 Agree
 Disagree
92%
6%
“The U.S. should eliminate remaining tariffs
and other barriers to trade.”

% of AEA members
 Agree
 Disagree
88%
8%
40
Example 1
Erin has a choice between two activities: She
can repair one transmission per hour or she
can repair two fuel injectors per hour. What is
the opportunity cost of repairing one fuel
injector?
a) 1 transmission
b) ½ transmission
c) 2 transmissions
41
Example 2
Deirdre has a choice between writing one
more book this year or five more articles this
year. What is the opportunity cost of writing
half of a book this year, in terms of articles?
a) 1/5 article
b) 1 article
c) 2.5 articles
d) 10 articles
42
Example 3
Which country has the absolute advantage in
producing high-quality cars? Low-quality cars?
a)
b)
c)
d)
North has absolute advantage in both
South has absolute advantage in both
North: high-quality, South: low-quality
South: high-quality, North: low-quality
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Example 4
What is the opportunity cost of each high-quality
car (HQ) in the South?
a)
b)
c)
d)
½ of a low-quality (LQ) car
1 LQ car
2 LQ cars
1.5 LQ cars
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Example 5
What is the opportunity cost of each high-quality
car (HQ) in the NORTH?
a)
b)
c)
d)
½ of a low-quality (LQ) car
1 LQ car
2 LQ cars
1.5 LQ cars
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Takeaway
 Trade makes people better off when
preferences differ.
 With specialization and trade, the total sum of
knowledge used in an economy increases
tremendously.
 A country can increase its standard of living by
specializing in what it can make at low
(opportunity) cost and trading.
 "When goods don't cross borders,
armies will.“ - attributed incorrectly to
Frederic Bastiat, but it sounds a lot like
Bastiat
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