3.1. Comparative Advantage & Opportunity Cost Flashcards
Comparative advantage
Trade between two countries can benefit both countries if each country exports the good in which they hold a comparative advantage.
The comparative advantage is held by the country who’s opportunity cost of producing a good, in terms of other goods, is less than the other country’s opportunity cost of producing the same good.
Comparative advantage is the economy’s ability to produce a certain good or service at a lower opportunity cost than its trading partners.
Roses vs computers
The UK can produce 10 million roses or 100,000 computers.
Colombia can produce 10 million roses or 30,000 computers.
The UK’s opportuity cost of roses is 100,000 computers.
Colombia’s opportunity cost of roses is 30,000 computers.
Colombia has a lower opportunity cost of producing roses than the UK.
Colombia holds the comparative advantage in rose production.
The UK holds the comparative advantage in computer production.
One factor economy
Home produces cheese and wine.
Labour productivity of Home is constant and is expressed in terms of unit labour requirement (i.e. the number of hours required to produce one unit).
aLW: unit labour requirement in wine.
aLC: unit labour requirement in cheese.
A higher unit labour requirement indicates low labour productivity.
QW and QC indicate how many total units of wine and cheese are produced.
Production possibilities
An economy has limited resources.
To produce more of one good, an economy must sacrifice some production of another good.
Trade-offs are represented graphically through a production possibilities frontier (PPF), that show maximum production of either good.
aLWQW + aLCQC < L:
- Maximum home wine production, QW=L/aLW.
- Maximum home cheese production, QC=L/aLC.
PPF example
If Home has 1,000 labour hours and it takes 2 hours to produce one gallon of wine and 1 hour to produce one pound of cheese:
2QW + QC < 1,000.
Max wine: 1000/2 = 500 gallons.
Max cheese: 1000/1 = 1,000 pounds.
Also, any combination in between.
Opportunity cost
When the PPF is a straight line, the opportunity cost is constant.
In the case of home, it is the number of gallons of wine the economy would have to give up in order to produce an extra pound of cheese.
The opportunity cost of a pound of cheese, in terms of wine, is aLC / aLW = 1 / 2 = 0.5 gallons of wine.
The opportunity cost is the absolute value of the slope of the PPF.
Relative prices
Workers choose to work where they get the highest wages.
PW: $7.00 / gallon.
PC: $4.00 / pound.
The hourly wage is calculated through Px/aLX:
- Wine: 7/2=$3.50 / hour.
- Cheese 4/1=$4.00 / hour.
The economy will specialise in:
- Wine, if Pc / Pw < aLC / aLW.
- Cheese, if Pc / Pw > aLC / aLW.
- Neither (autarky), if Pc / Pw = aLC / aLW.
Calculate where production lies if:
- Goods hold current prices.
- Cheese falls in price by $1 per pound.
- Wine rises in price by $0.50 per gallon.
Supply / specialisation considering realtive prices
An economy will specialise in the production of a good if the relative price of that good exceeds the opportunity cost of producing that good, in terms of another good.
For example, if the relative price of cheese exceeds the opportunity cost of cheese, in terms of wine, then the economy will specialise in cheese production.
If the relative price of cheese does not exceed the opportunity cost of cheese, in terms of wine, then the economy will specialise in wine production.
The relative price is taken to be the wage received by the workers.
