Microeconomics Topic 2: “Explain the principle of comparative advantage and how it leads to specialization and gains from trade.” Reference: Gregory Mankiw’s Principles of Microeconomics, 2nd edition, Chapter 3. Why People and Countries Trade This section lays the foundation for why countries and individuals gain from trade. Countries usually trade to buy goods that are produced at a lower cost elsewhere. Countries and people have different costs of production or (to put it differently) different abilities in producing goods. They can take advantage of their differences in order to make themselves better off. When they do this, they experience gains from trade. The following concepts are important in understanding gains from trade: • Opportunity cost: a cost that is measured in terms of what you give up of some other good. Time spent producing cars is time taken away from producing bread, and vice versa. Note that when we discuss gains from trade, the opportunity cost is not measured in dollars but in units of some good or activity that is given up. For a review of opportunity cost, see the notes for Micro Topic 1. Absolute advantage: The person or country that produces a good with a smaller quantity of inputs, or that produces more output per unit of input, is said to have an absolute advantage in producing that good. Comparative advantage: The person or country that has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. Comparative advantage determines which country will specialize in which good.
The gains from trade are only based on comparative advantage, not on absolute advantage. A country or person can have an absolute advantage in both goods or activities, and yet still gain from trade by specializing in the good or activity in which it has a comparative advantage. We will go over an example very carefully, step by step, to highlight all the important concepts associated with the topic of “gains from trade and comparative advantage.” Calculating Absolute and Comparative Advantage Martha and Sheldon wallpaper and paint rooms. In one week, Martha can paint 20 rooms or wallpaper 5 rooms. In the same amount of time, Sheldon can paint 10 rooms or wallpaper 4 rooms. The information is usually summarized in a table like this one: Table 1: Production Possibilities for 1 Week Rooms Finished in 1 Week
If they want, Martha and Sheldon can also split their time between activities. For example, Martha could spend 50% of her week on painting and 50% of her week on wallpapering, to produce 10 painted rooms and 2.5 wallpapered rooms. Using the information here, we can determine absolute advantage. Since Martha can produce more painted rooms than Sheldon in the same amount of time (20 > 10), she has the absolute advantage in painting. Since she can produce more wallpapered rooms than Sheldon in the same amount of time (5 > 4), she also has the absolute advantage in wallpapering. The goal of this exercise is to show you that Martha and Sheldon are better off if they specialize in the good in which they have a comparative advantage and then trade, rather than trying to produce everything for themselves and not trading. This is true even though Martha has the absolute advantage in both activities. Let’s start with the case of no trade, and assume that each person spends half a week on each activity. The resulting output is given in Table 2. Table 2: Production without Specialization Rooms Painted Martha Rooms Wallpapered Rooms Painted Sheldon Rooms Wallpapered
For future reference, notice that the total production is 15 (10 + 5) rooms painted and 4.5 (2.5 + 2) rooms wallpapered. Remember that the person who has the smaller opportunity cost is said to have a comparative advantage. Therefore, we need to calculate the opportunity cost of each activity for each person. This is a...
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