9/3: Comparative/Absolute Advantage, Opportunity Costs, Trade

Comparative and Absolute Advantage

  • Absolute advantage: you can produce more of a good with the same resources; higher output with same inputs.
  • Comparative advantage: you have a lower opportunity cost in producing a good than others.
  • Example setup (per hour): Joe can produce up to 66 smoothies or 3030 salads; Liz can produce up to 3030 smoothies or 3030 salads. This setup shows differing efficiencies and opportunity costs.
  • Opportunity costs (OC):
    • Joe: OC{ ext{ smoothie}}^{J} = rac{30}{6} = 5 salads per smoothie; OC{ ext{ salad}}^{J} = rac{1}{5} smoothie per salad.
    • Liz: OC<em>extsmoothieL=1OC<em>{ ext{ smoothie}}^{L} = 1 salad per smoothie; OC</em>extsaladL=1OC</em>{ ext{ salad}}^{L} = 1 smoothie per salad.
  • Determining advantage:
    • Liz has comparative advantage in smoothies (lower OC for smoothies).
    • Joe has comparative advantage in salads (lower OC for salads).
    • Liz has absolute advantage in both goods (higher productivity), but the comparative-cost pattern still drives trade.
  • Takeaway: When each person specializes in the good for which they have a comparative advantage, total output rises relative to independent production.

Opportunity Costs and Trade Bounds

  • Mutual gains from trade rely on terms that lie between the two players’ opportunity costs.
  • For smoothies traded for salads (price in salads per smoothie):
    • Must be between Liz’s OC and Joe’s OC: 1<br/>≤pextsaladspersmoothie<br/>≤5.1 <br /> \le p_{ ext{salads per smoothie}} <br /> \le 5.
    • If price equals 1 salad per smoothie, Liz is just indifferent; if price equals 5 salads per smoothie, Joe is indifferent.
  • Equivalently, for salads traded for smoothies, the price in smoothies per salad must lie between the reciprocal bounds: 15 ≤ pextsmoothiespersalad ≤ 1.\frac{1}{5} \,\le \, p_{ ext{smoothies per salad}} \,\le \, 1.
  • Intuition: the price must not be so favorable to one party that the other would prefer to produce the good themselves.

Specialization and Gains from Trade (Two-Person Example)

  • When each person specializes in their comparative advantage, the economy can produce more of both goods than if they produced both goods in isolation.
  • Trade allows reallocation of production toward the goods each is relatively better at producing.
  • The terms of trade determine who benefits how much; a price within the acceptable range makes both better off than autarky.

Production Possibility and Growth Concepts

  • Production Possibility Frontier (PPF): shows feasible combinations of two goods given resources and technology.
  • With specialization, the economy moves from a mixed-production point toward points on the frontier where each person specializes in their comparative advantage.
  • Growth in an economy occurs via two broad channels:
    • More resources (e.g., larger labor force, more capital) -> outward shift of the entire PPF in both goods.
    • Technological progress (improved productivity) -> outward shift, often along the affected axis; can explain higher output without more resources.
  • Technological change in one sector expands the frontier along that axis; growth is not just more of the same but the ability to produce more efficiently.
  • Increasing opportunity costs can make the frontier bowed outward; with more resources and specialization, the economy tends toward a smoother, more curved expansion.

Economic Growth: Resources vs Technology

  • Growth via more resources: larger workforce, more capital, new inputs -> expand production possibilities for both goods.
  • Growth via technology: better methods, capital goods, automation -> expands potential output, often first in the sector where the technology is applied.
  • Overall intuition: growth raises the maximum attainable outputs; strategic investment in capital, infrastructure, and knowledge drives long-run improvements.

Quick recap of key formulas

  • Opportunity cost (OC) of producing good A in terms of B:
    OCA=units of B forgoneunits of A produced.OC_A = \frac{\text{units of B forgone}}{\text{units of A produced}}.
  • For the Joe-Liz example:
    • OCextsmoothieJ=5 salads per smoothieOC_{ ext{smoothie}}^{J} = 5\ \text{salads per smoothie}
    • OCextsaladJ=15 smoothies per saladOC_{ ext{salad}}^{J} = \tfrac{1}{5}\ \text{smoothies per salad}
    • OCextsmoothieL=1 salad per smoothieOC_{ ext{smoothie}}^{L} = 1\ \text{salad per smoothie}
    • OCextsaladL=1 smoothie per saladOC_{ ext{salad}}^{L} = 1\ \text{smoothie per salad}
  • Trade bounds (per smoothie):
    1≤psalads per smoothie≤5 .1 \le p_{\text{salads per smoothie}} \le 5\,.
  • If we write the Joe-side PPF (salads on x-axis, smoothies on y-axis):
    y=−0.2x+6,extwherex=salads,y=smoothies.y = -0.2x + 6, ext{ where } x = \text{salads}, y = \text{smoothies}.