Introduction to microeconomics
Chapter 2
Comparative advantage
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Learning goals
1. Understand the principles of trade (bilateral and
multilateral)
2. Learn the principle of comparative advantage.
3. Show why opportunity cost is the basis for comparative
advantage.
4. Understand the principle of increasing opportunity cost.
5. Show how to illustrate the menu of goods and services
produced by an economy is determined.
6. Understand what factors change an economy’s menu of
goods and services.
7. Show how the transactions of goods and services is a
circular flow of income and expenditures in an economy.
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Our goods and services (Stuff)
• Exchanging goods and services is a basic
economic process
• This starts as children when we exchanged less
valued items in out lunches for the more valued
items in someone else`s lunch
• For bilateral trade, the key is the reciprocity of
intersecting values – my valued items must match
my partners less valued items.
• For multilateral trade, the group must have
reciprocal intersecting values
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Rationale for the fair trade
• It seems apparent that trading items that are
less preferred (but valued by someone else)
for items you value (but less so by the trading
partner) will increase welfare
– Example: I will always trade chocolate cake for
apple pie (bilateral)
– Example: I can trade cake for licorice with Leslie,
and then I can trade the licorice for apple pie with
Jean (multilateral)
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Exchange and Comparative Advantage
• Absolute advantage:
– Jill is better at everything than Jack
• Comparative advantage:
– Depends on opportunity cost
– Jill starts with the activity she is least productive (but still more
than Jack)
– She spends no time on that, preferring to work on what she is
best at.
– The opportunity cost of her time in completing her least
productive activity, is the lost (foregone) gain had she spent that
time doing what she is best at.
– Jill continues to eliminate activities in ascending productivity
until the gain from switching equals the loss from not.
The marginal gain from switching = marginal loss from not
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Summary
• Absolute advantage
– One person has an absolute advantage over
another if he or she takes fewer hours to perform
a task than the other person does
• Comparative advantage
– 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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TABLE 2.1: Productivity Information for Rikke and Beth
TABLE 2.2: Opportunity Costs for Rikke and Beth

Rikke has comparative advantage in updating webpage

Beth has comparative advantage in repairing bicycle
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Implications
• Gains from trading exist when trading partners
each have a comparative advantage in
different things.
– Poor societies can gain even in trading with rich societies.
It can pay to trade even it do not have an absolute
advantage.
– The principle of comparative advantage states that a
trading partner should specialize in those areas where they
have the lowest opportunity cost (they do not give up a lot
in stopping)
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David Ricardo
1772 –1823
• English landowner who developed
the theory of comparative
advantage
• Believed in free trade
• Advocated against the Corn Laws
(trade barriers to stop corm
imports, thereby enriching land
owners at the expense of
consumers).
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Assumptions of free trade argument
• After specialization, we ignore the possibility that the
output of one service decreases while the output of the
other increases.
• Both before and after specialization, Beth and Rikke each
work eight hours per day. Neither is underemployed or
unemployed.
• Beth and Rikke produce their services with only their
labour. Usually, however, goods and services are produced
using at least some machinery and equipment.
• The comparative advantages of Beth and Rikke are static
and difficult to change - education can change human skill
and change the scenario
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• The output of an
economy includes many
goods and services.
• Let us assume there are
only two options
• The production
possibility “curve”
shows how we can
trade off one good for
another.
• We assume only one
factor of production –
labour time
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Production Possibilities
The “cost” of 2 kg
of nuts is 1 kg of
sugar cane and
vice versa
2
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Problem
If Helen can cut four heads of hair every hour
and bake 8 loaves of bread. What does the PPC
look like?
Haircuts
per day
Which are efficient points, which
are attainable
a. 28 hc/day; 16 loaves/day
b. 16 hc/day; 32 loaves/day
c. 18 hc/day; 24 loaves/day
32
0
Loaves of bread
64
per day
What would shift the PPC out?
What would move it in? Which
change results in a parallel
movement of the PPC (in or out)
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Attainable and
efficient
Unattainable
Attainable and
inefficient
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• Susan gives up 2kg nuts/day
to get 1 kg of cane
• Tom gives up 1 kg of
nuts/day to get 1 kg of cane
• Susan is absolutely more
productive than Tom
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Production possibilities in the
Susan/Tom economy
• Assumption
– Susan and Tom, both work 8 hours per day
– Susan can harvest 1.5kg and Tom can harvest 0.75kg of
sugar canes
– If they only harvest sugar cane, they can harvest total of
(1.5 +0.75) × 8 = 18kg per day
– Susan can harvest 3kg and Tom can harvest 0.75kg of nuts
– If they only harvest nuts, they can harvest total of
(3 +0.75) × 8 = 30kg per day
• The PPC for the two-person economy is not a straight
line joining the two extreme points.
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The Susan/Tom economy
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The PPC is concave to the origin
Concave “in”
•
Downward sloping (scarcity
principle ands resource
constraints)
•
Increasing opportunity cost
as one move to extremes
•
Falling economies of scale (as
production rises the marginal
productivity falls)
Greater production of one good results in rising opportunity cost of
producing more of that good
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Technology and changes in resources
affect PPC
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Events that may affect Canada’s PPC
• Discovery of shale gas
– What is shale gas?
– Where has it been discovered
• What are the implications for
– Manitoba (think Hydro)
– Oil sands in Alberta
• What could/should we do about it?
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Circular Flow
wages received (labour income)
wages paid
goods and services
supplied
household spending on goods
and services (consumer expenditure)
firm revenue from sale of
goods and services
Labour markets (services) and goods/services markets
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