Absolute Advantage to Comparative Advantage Introducing Opportunity Cost
Suppose we want to look at absolute advantage for the following set of information
Olives
Sheep
Spain
8
4
Portugal
6
8
To ascertain absolute advantage look at the product across the two countries and asked this
question: Who can produce the most?
If we look at olives, Spain can produce 8 whereas, Portugal can produce 6. Therefore we say
that Spain has the absolute advantage in olives.
If we look at sheep, Spain can produce 4 whereas, Portugal can produce 8. Therefore, we say
that Portugal has the absolute advantage in sheep.
But suppose we have the following set of information:
Olives
Sheep
Spain
12
20
Portugal
6
4
To ascertain absolute advantage look at the product across the two countries and asked this
question: Who can produce the most?
If we look at olives, Spain can produce 12 whereas, Portugal can produce 6. Therefore we say
that Spain has the absolute advantage in olives.
If we look at sheep, Spain can produce 20 whereas, Portugal can produce 4. Therefore, we say
that Spain has the absolute advantage in sheep.
What are the ramifications of this? The ramifications are that Spain produces everything while
Portugal sits on its rear end doing nothing. And we know that this is not how the world works.
Absolute advantage has a fundamental flaw. That flaw occurs because it ignores opportunity
cost. So let's introduce comparative advantage which does incorporate opportunity cost into
the calculations.
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Spain
12
20
Olives
Sheep
Portugal
6
4
Who is the Low Spain where 12 olives = 20 Portugal where 6 olives = 4
sheep
sheep
Opportunity
Cost Producer?
Olives
Portugal
Sheep
Spain
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Calculate the opportunity cost
of producing one olive.
Calculate the up to the cost of
producing one olive.
12 olives = 20 sheep
6 olives = 4 sheep
12/12 olives = 20/12 sheep
6/6 olives = 4/6 sheep
1 olives = 1.66 sheep
or the opportunity cost of one
olive is 1.66 sheep
Calculate the opportunity cost
of producing one sheep.
1 olive = 0.66 sheep
or the opportunity cost of one
olive is 0.66 sheep
Calculate the opportunity cost
of producing one sheep.
20 sheep = 12 olives
4 sheep = 6 olives
20/20 sheep = 12/20 olives
4/4 sheep = 6/4 olives
1 sheep = 0.6 olives
or the opportunity cost of one
sheep is 0.6 olives
1 sheep = 1.5 olives
or the opportunity cost of one
sheep is 1.5 olives
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France
4
3
Bread
Wine
U.S.
10
4
To ascertain absolute advantage look at the product across the two countries and asked this
question: Who can produce the most?
If we look at bread, France can produce _____ whereas, the U.S. can produce ______.
Therefore we say that ___________ has the absolute advantage in bread.
If we look at wine, France can produce _____ whereas, the U.S. can produce _______.
Therefore, we say that _____________ has the absolute advantage in wine.
But this leaves us with the U.S. producing both things and France producing nothing. That is not
the real world. So let’s apply Comparative Advantage.
Who is the Low France where 4 breads = 3 U.S. where 10 breads = 4
wines
wines
Opportunity
Cost Producer?
Bread
Calculate the opportunity cost
of producing one bread.
Calculate the up to the cost of
producing one bread.
or the opportunity cost of one
bread is ________ wines.
or the opportunity cost of one
bread is ________ wines.
__________
Who is the Low France where 4 breads = 3 U.S. where 10 breads = 4
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Opportunity
Cost Producer?
Wine
wines
wines
Calculate the opportunity cost
of producing one wine.
Calculate the opportunity cost
of producing one wine.
or the opportunity cost of one
wine is________ breads.
or the opportunity cost of one
wine is________ breads.
__________
Table 2.1 in the textbook already calculates these opportunity costs for you. We can see from
Table 2.1 that the United States has the comparative advantage in the production of computers
whereas Mexico has comparative advantage in the production of shirts.
Figure 2.2 in the textbook shows these opportunity costs in a graph using a Production
Possibilities Frontier.
By definition, under self-sufficiency (autarky) your consumption is limited by your production.
There is no way to ever consume beyond what you directly produce without trade. Your
production possibilities curve defines your available consumption set and it is strictly limited to
what you produce.
Is there a way to consume beyond your own production possibilities curve? The answer is yes
and it occurs through trade. Remember that trade allows people to specialize. Through
specialization we become more efficient and better at what we do. Trade also greatly expands
the scope and types of operations that can occur in complex economy. Think about the
multitude of products that you use on a daily basis that you obtained through trade. As a
thought experiment, simply take everything that you were wearing or you have in your
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possession and ask this simple question: Which of these goods and services did I make? And if I
didn't make them how did I get them? And what would YOUR world the central authorities
banned you from trading?
We might, as did 19th century economist Carl Menger, refer to this as a “round-about method
of production.” Here is a famous example out of Stephen Landsburg’s book The Armchair
Economist.
[T]here are two technologies for producing automobiles in America. One is to manufacture
them in Detroit, and the other is to grow them in Iowa.
Okay… how does that work?
First you plant seeds, which are the raw material from which automobiles are constructed.
You wait a few months until wheat appears. Then you harvest the wheat, load it onto ships,
and sail the ships eastward into the Pacific Ocean. After a few months, the ships reappear
with Toyotas on them.
Now your book introduces labor into the equation, and allows for specialization and trade.
Assume that there are 24 units of labor in both countries, and that both countries assigned 12
units of labor to shirts and 12 units of labor to computers.
QLMEX = 24, QLUS = 24
QLMEX,shirts = 12, QLMEX,computers = 12
QLUS,shirts = 12, QLUS,computers = 12
Production
MEXICO
U.S.
WORLD
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No Specialization with No Trade
Computers
Shirts
1
6
12
12
13
18
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Production
MEXICO
U.S.
WORLD
Specialization with No Trade
Computers
Shirts
0
12
14
10
14
22
Note here that just through specialization in PRODUCTION we increase the
number of computers in the world by one while simultaneously increasing the
number of shirts by four.
Why did this occur? Because we increase efficiency by moving production to the
low opportunity cost producers. Net world production rises and the world is
made better off!
Now let's allow the two countries to trade and focus for a moment on
consumption. Let's s introduce trade and allow the United States to give up one
computer in exchange for three shirts from Mexico. Now the production is the
same BUT CONSUMPTION is divorced from PRODUCTION!
Consumption
MEXICO
U.S.
WORLD
Specialization with Trade
Computers
Shirts
0+1=1
12 – 3 = 9
14 -1 = 13
10 + 3 = 13
14
22
Now we can introduce wages. Wages are already included really within the model
but we can become a bit more specific here. One assumption we have to make to
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simplify our analysis is that there is an average wage in each industry and some
price.
We will also assume a price of shirts relative to computers that is 3 to 1 to match
the trade we show in the table above. To do this we set:
Pshirts = $100 and Pcomputers = $300
We can then calculate the average wage in each country by finding out the total
consumption and dividing by the number of workers.
No Specialization and No Trade (Autarky)
Consumption for Mexico = [(Q computers X Pcomputers) + (Q shirts X Pshirts)]
Consumption for Mexico = [(1 computers X $300) + (6 shirts X $100)]
Consumption for Mexico = $300 + $600 = $900
Avg Wage for Mexico = $900/QL = $900/24 = $37.50
Consumption for U.S. = [(Q computers X Pcomputers) + (Q shirts X Pshirts)]
Consumption for U.S. = [(12 computers X $300) + (12 shirts X $100)]
Consumption for U.S. = $3,600 + $1,200 = $4,800
Avg Wage for Mexico = $4,800/QL = $4,800/24 = $200.00
Specialization AND Trade (Autarky)
Consumption for Mexico = [(Q computers X Pcomputers) + (Q shirts X Pshirts)]
Consumption for Mexico = [(1 computers X $300) + (9 shirts X $100)]
Consumption for Mexico = $300 + $900 = $1,200
Avg Wage for Mexico = $1,200/QL = $1,200/24 = $50.00
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Consumption for U.S. = [(Q computers X Pcomputers) + (Q shirts X Pshirts)]
Consumption for U.S. = [(13 computers X $300) + (13 shirts X $100)]
Consumption for U.S. = $3,900 + $1,300 = $5,200
Avg Wage for Mexico = $5,200/QL = $5,200/24 = $216.66
COMPARE NO-TRADE (AUTARKY) to TRADE
What happened to the wages in Mexico?
They rose from $37.50 to $50.00
What happened to the wages in the U. S.?
They rose from $200.00 to $216.67
Both sets of workers are better off and both countries are better off.
The argument that small countries cannot trade with large countries is wrong.
The argument that workers (generally) lose through trade, is also wrong. It is true
that there are sectors of our economy – and their workers - that will be hurt by
the opening up trade. This is always true when a group or sector has protected
status and they lose that privilege (in this case, protection from the competition
of foreign firms.)
But, workers, on average in the U.S. will be made better off by being allowed to
purchase and consume low opportunity cost goods (that now happen to be
imported.) Note – there will be job losses in high opportunity cost industries.
And from an efficiency stand point this is a good thing!
What is the major argument we hear about competing with Mexican labor? That
there is no way that American workers can compete with those low-wage workers
in Mexico.
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What do you think is the major argument that Mexicans here about competing
with American labor? That there is no way that Mexican workers can compete
with those high-productivity workers in America!
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