Comparative and Absolute Advantage.pdf, Study notes of Law

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Law of Comparative Advantage

Specialization leads to

increased output

WHY?

What do we mean by “division

of labor?”

Comparative and Absolute Advantage Absolute Advantage

• Implies that a product can be produced more efficiently (i.e. with fewer inputs) Comparative Advantage
• Means that a person/firm/nation can produce the good with a lower opportunity cost

A Hypothetical Example

Labor Hours Needed to

Produce a Unit of:

Country Wheat Cloth

Portugal 10 20

England 20 60

Portugal has an ABSOLUTE ADVANTAGE in both products.

Calculations of Opportunity Cost Portugal Opportunity Cost of wheat = 10/20 = ½ cloth Opportunity Cost of cloth = 20/10 = 2 wheat England Opportunity Cost of wheat = 20/60 = 1/3 cloth Opportunity Cost of cloth = 60/20 = 3 wheat Which country has the comparative advantage in cloth? Portugal Which country has the comparative advantage in wheat? England

Output vs. Input

 The previous example used the “input

method” to determine comparative

advantage

 The “input method” measures the amount

of resources needed to produce one unit of

output

 However, the “output method” measures

the amount of output that can be

produced with a given amount of an input

Output Method

Radios produced per hour Wheat produced per hour Ted 3 radios (60 mins./20 mins.) 12 bushels (60 mins./5 mins.) Nancy 2 radios (60 mins./30 mins.) 4 bushels (60 mins./15 mins) Who has the comparative advantage in producing radios? Ted (1 radio = 4 bushels of wheat) Nancy (1 radio = 2 bushels of wheat) Who has the comparative advantage in producing bushels of wheat? Ted (1 bushel of wheat = ¼ radio) Nancy (1 bushel of wheat = ½ radio)

Cross-Multiplication Method

 A “life-hack” to this is the cross-multiplication method  Take the numbers in the matrix and cross multiply them  For outputs – you want the combination of numbers that gives you the greatest/biggest product  For inputs – you want the combination of numbers that gives you the smallest product

Output Method

Radios produced per hour Wheat produced per hour Ted 3 radios (60 mins./20 mins.) 12 bushels (60 mins./5 mins.) Nancy 2 radios (60 mins./30 mins.) 4 bushels (60 mins./15 mins) With Ted producing radios and Nancy producing wheat, the total production is 12 units of production. With Ted producing wheat and Nancy producing radios, the total production is 24 units of production. So Ted should produce wheat and Nancy should produce radios.