Economics Chapter 2: Comparative Advantage

COMPARATIVE ADVANTAGE: STUDY NOTES

INTRODUCTION: BIRKHAMAN'S STORY

  • While volunteering in rural Nepal, an economic naturalist hired Birkhaman, a cook from Bhutan.

  • Despite lacking formal education, Birkhaman demonstrated high resourcefulness:

    • Skills included thatching roofs, butchering goats, repairing shoes, carpentry, clock repair, and plastering walls.

    • He was also knowledgeable in home remedies.

  • The variety of skills possessed by Birkhaman speaks to the broader observation that:

    • In Nepal, villagers perform many services themselves rather than hiring out due to economic conditions.

  • Interesting assertion:

    • Poverty does not cause self-reliance on services; rather, performing one's own services contributes to economic poverty.

LEARNING OBJECTIVES (LO)

  • LO1: Explain and apply the Principle of Comparative Advantage and distinguish it from absolute advantage.

  • LO2: Explain and apply the Principle of Increasing Opportunity Cost (Low-Hanging-Fruit Principle) and illustrate it using a Production Possibilities Curve (PPC).

  • LO3: Identify factors that can shift the menu of production possibilities.

  • LO4: Explain the role of comparative advantage in international trade and the vulnerability of jobs to outsourcing.

CHAPTER 2: COMPARATIVE ADVANTAGE

SPECIALIZATION AND TRADE

  • Alternatives:

    • Individualistic approach (jack-of-all-trades) vs. specialization in goods and services via trade.

  • Productivity:

    • Systems emphasizing specialization tend to yield higher productivity.

  • Comparative Advantage defined:

    • A person has a comparative advantage in producing a good or service if they can produce it at a lower opportunity cost than someone else.

OPPORTUNITY COST AND EXCHANGE

  • Scarcity Principle:

    • Emphasizes that dedicating time to one activity limits availability for others, reinforcing why concentrating on advantageous tasks improves outcomes.

  • Example: Kelly Wearstler, an influential interior designer, illustrates this:

    • Can design a web page in 300 hours (half the time needed by others).

    • Her annual earnings imply an opportunity cost of $500/hr for time devoted to web design.

    • Conclusion:

    • It is more beneficial for her to hire a web designer than to design it herself despite her capabilities.

PRINCIPLES OF COMPARATIVE ADVANTAGE

  1. Absolute Advantage: The ability to produce a good or service more efficiently (in less time) than others.

    • Ex: If Ana can fix a bike faster than Xin, she has an absolute advantage in bicycle repair.

  2. Comparative Advantage: A person has this advantage if their opportunity cost of producing a task is lower than another's.

  3. Trade Benefit: If Ana specializes in bicycle repairs while Xin focuses on web design, the overall productivity increases.

  4. Opportunity Cost Calculation:

    • Xin's opportunity cost of updating a web page equals the time taken divided by time spent on bike repair.

    • Ana’s: If it takes her 20 minutes to update and 10 minutes to repair, her cost is reflected by 2 repairs forsaken.

PRODUCTION POSSIBILITIES CURVE (PPC)

  • Graphically represents trade-offs between two goods—describes maximum production combinations.

  • If Krisha dedicates 6 total hours, she can either:

    • Produce 24 pounds of coffee (4 pounds/hour) or 12 pounds of nuts (2 pounds/hour).

  • Slope Interpretation:

    • The slope of the PPC indicates opportunity costs (e.g., she could gain 2 pounds of coffee but lose 1 pound of nuts).

OPPORTUNITY COSTS AND EFFICIENCY

  • Attainable Points: Any combination of goods that can be produced with available resources.

  • Efficient Points: Points lying along the PPC where maximum output of one good requires sacrificing the other.

  • If working inefficiently (like at point E), gains could be made by reallocating efforts to the productive capacity.

FACTORS THAT SHIFT THE PPC

  • Economic growth can often originate from:

    • Increases in available resources (labor, machinery).

    • Innovations enhancing productivity.

  • Example: Higher investment in equipment can significantly improve productivity and standards of living.

    • In the U.S. the value of capital investment per worker is vastly higher, affecting economic dynamics.

COMPARATIVE ADVANTAGE AND OUTSOURCING

  1. International Trade: Operates on the principle that nations will specialize in fields of comparative advantage regardless of absolute efficiency.

    • E.g., NAFTA allowed cross-border specialization, despite fears of job loss among U.S. workers.

  2. Outsourcing: Trend of transferring jobs to countries with lower labor costs:

    • Example: Transcription services moving to India for cost efficiency, impacting U.S. employment opportunity.

SUMMARY

  • Comparative Advantage: Essential for maximization of output through specialization.

  • Production Possibilities Curve: Represents maximum outputs; bow-shaped indicating increasing opportunity costs.

  • Impact of Specialization: Heightened productivity allows societies to thrive economically, while outsourcing can be controversial due to job security concerns.

KEY TERMS

  • Absolute Advantage: Producer can generate more output than another.

  • Comparative Advantage: Lower opportunity cost of producing a good.

  • Production Possibilities Curve (PPC): Maximum production combinations of two goods.

  • Outsourcing: Utilizing foreign labor to reduce costs for services.