Economic Principles I

Lecture 2:
The Concept of Comparative
Advantage
Introduction
This lecture will extend the idea of opportunity
cost to examine a topic right at the foundation of
all thinking about economics: interdependence
and trade
In setting out the theory of comparative
advantage, it will ask
What do people gain when they trade with each
other?
Why do people choose to become economically
interdependent?
Trade can make people better
off
Kathleen MacMahons forthcoming novel, So This
Is How It Ends, attracted an advance of 600K
Should she pay a student 25/hour to mow her
lawn?
If it takes 2 hours to mow the lawn, the cost is
50
At 2000 hours per novel, the opportunity cost for
MacMahon to mow her own lawn is 300 per
hour; i.e. 600
Ricardos original illustration
Two countries: England (large
and cold) and Portugal (small
and hot)
Two goods: cloth and wine
Production possibility frontiers
80
40
Metres
of cloth
Barrels of wine
0
England
40
20
A
4
30
Metres
of cloth
Barrels of wine
0
Portugal
2
15
B
Autarchy or trade?
Without trade these countries consume
what they produce self-sufficiency
Points A and B show what would happen if
each country divides its available labour
(time) equally between the two goods
Should they trade?
One possible scenario
Suppose that Portugal decides to specialise
entirely in wine and trade wine for cloth
This would allow England to specialise more in
the production of cloth
The next slide sets out a possible trading
arrangement
Note that the price of 6 metres of cloth is 8 wine
barrels (or a relative price of )
Production, trade, consumption
and gains
Produce Trade Consume Gain from
trade
(compared to
self-sufficiency)
England 48 metres of
cloth
16 barrels of
wine
Sell 6 metres
of cloth for 8
wine barrels
42 metres of
cloth
24 barrels of
wine
2 metres of
cloth
4 barrels of
wine
Portugal 0 metres of
cloth
30 barrels of
wine
Sell 8 wine
barrels for 6
metres of
cloth
6 metres of
cloth
22 barrels of
wine
4 metres of
cloth
7 barrels of
wine
New consumption levels after
trade
Metres
of cloth
Barrels of wine
40
80
0
20 40
England
A
42
24
A*
Metres
of cloth
Barrels of wine
4
2
15 30 0
Portugal
B
B*
6
22
Absolute advantage
Note that England had an absolute
advantage in the production of both goods,
because of its size
If England produced only cloth it would
produce more than Portugal; and if it
produced only wine it would still produce
more
Comparative advantage
Considering the opportunity costs:
For England to produce an extra metre of cloth the
opportunity cost is half a barrel of wine
For Portugal to produce an extra metre of cloth the
opportunity cost is 7.5 barrels of wine
So the opportunity cost of producing cloth in
Portugal is much higher than in England
The producer with the smaller opportunity cost has
a comparative advantage
Conclusion
Trade can benefit all because it allows
individuals/countries to specialise in activities in
which they have a comparative advantage
So is free trade always a good idea?
In principle, yes, but:
Some may exercise excessive power over the setting of the
relative prices at which trade occurs
Trade may benefit an economy, but will result in adjustment
costs in this example Portuguese cloth workers would have
to retrain to tend vineyards
Summary
This lecture has looked at interdependence and
trade
Production possibilities
Self-sufficiency and gains from trade
Absolute and comparative advantage
Trade illustrates the concept of opportunity cost
Lecture 3 will begin looking at supply and demand
Economic Principles I
Lecture 2:
The Concept of Comparative
Advantage