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Economics 2

Lecture 4: Gains from Trade

comparative advantage and trade
an example

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Comparative Advantage and Trade

Tiger Woods can probably mow his lawn faster than anyone else. But just because he can mow his lawn fast, does this mean he should?

Let's say Tiger can mow his lawn in 2 hours while a neighborhood kid can mow Tiger's lawn in 4 hours. Because he can mow the lawn in less time, Tiger Woods has an absolute advantage in mowing lawns. An individual has an absolute advantage in producing a good if they can produce it using fewer resources than can someone else.

However, is mowing his lawn the best use of Wood's time? Suppose that in the same 2 hours it takes him to mow his lawn, he could play golf with Microsoft executives and earn $50,000. Wood's opportunity cost (the value of his next best alternative) of mowing the lawn is $50,000.

In contrast, the neighborhood kid's next best alternative is to work at Burger King where he earns $8 an hour. So, in the 4 hours it would take him to mow Tiger's lawn, he could have earned $32. The neighborhood kid's opportunity cost of mowing Tiger's lawn is $32.

Tiger Woods has an absolute advantage in mowing lawns because he can do the work in less time. But, the neighborhood kid has a comparative advantage in mowing lawns because he has the lower opportunity cost. A person or a country has a comparative advantage when they can produce a good at a lower opportunity cost compared to someone else.

The gains from trade are enormous. Rather than mowing his lawn, Woods should play golf with the Microsoft executives and hire the neighborhood kid to mow the lawn. As long as Tiger pays him more than $32 and less than $50,000, both of them are better off.

Countries can benefit from specialization and trade with one another in the same way individuals can. The gains from trade do not disappear at national borders.

Without trade countries must consume at a point on their production possibilties curve. With trade, a country can consume at a point outside of its PPC.

An Example

Once again, in the absence of trade a country must consume the goods and services it produces. The production possibilities frontier shows combinations of goods a country can produce. Without trade countries must consume at a point on their PPC's. With trade, a country can consume at a point outside of its PPC.

Consider two countries (France and Germany) and two goods (wine and steel). The tables below provide the production possibilities for each country.

         France                 Germany

     wine     steel          wine     steel
   (barrels)  (tons)       (barrels)  (tons)

      12         0            6          0
       6         5            3          5
       0         8            0         10

Suppose both countries want 5 tons of steel. Then, in the absence of trade, each will produce and consume the quantity of wine and steel given by point A on their respective production possibilities curves.

The gains from trade come from specialization: concentrating resources in activities in which our opportunity costs are lowest and then trading for the other things we want.

To see how the countries should change their production we need to see which country has a comparative advantage in which product. Let's calculate the opportunity costs of producing 5 tons of steel. Assume that both countries go from producing all wine and no steel to producing 5 tons of steel. Wine production in France drops from 12 to 6 barrels, making its opporunity cost equal to 6 barrels of wine. The opportunity cost of producing 5 tons of steel in Germany is 3 barrels of wine. So, Germany has a comparative advantage in steel production while France must then have the comparative advantage in winemaking.

Germany should specialize in producing steel while France specializes in making wine. Each produces at point B on their PPC's.

Now, they trade. Suppose Germany trades 5 tons of steel to France in exchange for 4 barrels of wine.

France now consumes 8 barrels of wine (the 12 it produced minus the 4 traded to Germany) and 5 tons of steel (the 5 acquired from Germany). Germany consumes the 4 barrels of wine it acquired from France and 5 tons of steel (the 10 tons it produced minus the 5 traded to France). Both countries are consuming at their point C's, points that lie outside of their production possibilitiy curves.

Trade allows both countries to consume combinations of health care and food that lie in the impossible regions of their PPC's, combinations of output that lie beyond their own resource capabilities.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31