Chapter 8: Comparative Advantage and Gains from Trade

Gains from Trade

• Definition: Gains from trade = the benefits created when resources, goods, or services are reallocated to better uses.
  • In essence, everyone is better off after voluntary exchange.
• Core intuition
  • You possess some items/services; others possess different ones.
  • They value your items more than you do, and you value their items more than they do.
  • Swap → both parties end up with higher overall satisfaction (economic surplus).
• Subleasing example
  • You hold a 12-month apartment lease at college but plan to be home for the summer.
  • A student with a summer internship in Atlanta needs housing for exactly those months.
  • You sublease via Facebook Marketplace.
  • For the summer, they value the apartment more than you; you value cash more than the unused apartment.
  • Trade (apartment ⇄ money) → mutual gain.

Absolute Advantage vs. Comparative Advantage

• Absolute Advantage

  • Ability to produce a good/service using fewer inputs.
  • If two people use identical inputs, the one who produces more output has the absolute advantage.
  • Hat illustration: If you can make 10 hats with fewer materials or less time than another person, you hold an absolute advantage in hat-making.
  • Limitation: Tells who is best, not who should do the task.
  • Researcher story
  • Lead professor (PhD) writes papers and codes/cleans data better than the RA.
  • Yet society gains more if the professor writes & ideates while the RA cleans data, because the professor’s opportunity cost of data cleaning is extremely high.

• Comparative Advantage

  • Ability to perform a task at a lower opportunity cost.
  • Opportunity cost principle → always ask “or what?” (what must be given up?).
  • Task allocation rule: Assign each job to the person who gives up the least valuable alternative (the lowest OC).
  • Everyone possesses a comparative advantage in something, even if they lack absolute advantage anywhere.

Opportunity Cost: Formal Steps

1. List productivities (time per task) for every individual.
2. Convert to opportunity cost \text{OC}{i,\;task\;1}=\frac{\text{Time}{i,\;task\;1}}{\text{Time}_{i,\;task\;2}}
   • Interprets how many units of task 2 are foregone when performing task 1.
3. Compare OCs → lower OC ⇒ comparative advantage.
   • Reallocate tasks accordingly to maximize total output.

Accounting Example: Natalie & Ryan

• Raw productivity (minutes per task)
  • Balance an account: Natalie 30, Ryan 40
  • Process a customer payment: Natalie 10, Ryan 10
• Opportunity-cost table
  • Balance an account
    OC{Natalie}=\frac{30}{10}=3 \text{ payments} OC{Ryan}=\frac{40}{10}=4 \text{ payments}
  • Process a payment
    OC{Natalie}=\frac{10}{30}=\tfrac{1}{3} \text{ account} OC{Ryan}=\frac{10}{40}=\tfrac{1}{4} \text{ account}
• Comparative-advantage conclusions
  • Balancing accounts → Natalie (3 < 4)
  • Processing payments → Ryan (1/4 < 1/3)
• Specialization impact (120-minute reallocation)
  • Natalie: +120 min balance ⇒ +4 accounts; −120 min payments ⇒ −12 payments
  • Ryan: −120 min balance ⇒ −3 accounts; +120 min payments ⇒ +12 payments
  • Net result: +1 balanced account with the same labor hours

Specialization & Gains From Trade

• “Same inputs → more output” once tasks match comparative advantage.
• Practical illustrations
  • Dentist office: Hygienist handles x-rays & cleanings, freeing dentist for surgeries/fillings.
  • Toyota: Design in Japan (designers’ CA), production in Kentucky (manufacturing CA).
• Key principle: Reallocate work from high-OC producers to low-OC producers to minimize total resources spent.

Comparative Advantage & International Trade

• The identical logic applies regardless of borders.
  • Produce what you’re relatively good at; buy the rest.
  • Whether trading with a neighbor or another nation, the driver is opportunity-cost minimization.
• Vocabulary
  • Goods bought from abroad → imports
  • Goods sold abroad → exports
• Dan’s lawn allegory
  • Young Dan mowed neighbors’ yards for cash.
  • As a successful plumber, his opportunity cost of yardwork skyrocketed.
  • He hires Karla (teenager) to mow.
  • Dan earns more from plumbing than the cost of Karla’s service; Karla earns more than alternative jobs.
  • Critics claim a “trade deficit” for “Country Dan,” but overlook the wider gains: larger plumbing income + maintained yard.

The Power of Prices

• Prices = signals, incentives, and information bundles.
• Signals
  • To sellers: how much buyers value a good (buyers’ marginal benefit).
  • To buyers: how costly it is for producers to expand supply (sellers’ marginal cost).
• Incentives
  • High price encourages sellers to produce more (profit motive) & buyers to conserve/seek substitutes.
  • Facilitates coordination among strangers; market quantity adjusts until plans align.
• Information aggregation
  • Markets synthesize dispersed knowledge.
  • Prediction markets: contract prices incorporate new information (e.g., injured quarterback lowers a team’s odds).

Key Takeaways & Study Tips

• Comparative Advantage
  • Allocate each task to the lowest-OC producer, not necessarily the most productive one.
• Gains from Trade
  • Reallocating according to CA allows the economy to achieve greater output with unchanged resources.
• Specialization
  • Focus on the activity where your OC is lowest; purchase other goods/services.
• Prices
  • Act as decentralized guides, motivating mutually beneficial specialization & trade.
• Exam tip
  • Draw two-person, two-task tables; practice computing OCs and identifying CA.
  • Remember: Everyone has CA somewhere, even if one party is universally slower.