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Diane Enahoro Session 2 2013 1 Week 2 Comparative Advantage - the Basis for Trade Opportunity Cost and Specialisation The Principal of Comparative Advantage The Sources of Comparative Advantage The Production Possibility Curve/Frontier Shifts of the P.P.C. Barriers to Specialisation

ECON1101 Week 2 Comparative Advantage Trade 2013

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  • Diane Enahoro Session 2 2013*Week 2

    Comparative Advantage - the Basis for Trade

    Opportunity Cost and SpecialisationThe Principal of Comparative AdvantageThe Sources of Comparative AdvantageThe Production Possibility Curve/FrontierShifts of the P.P.C.Barriers to Specialisation

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Define and determine absolute advantage and comparative advantageExplain how specialisation and exchange give rise to gains from tradeIdentify sources of comparative advantage Define, construct and describe a production possibility curve (PPC)Explain the principle of increasing opportunity costsDescribe the factors shifting a PPC over timeIdentify the costs and benefits of specialisationLearning objectives

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013* Lecture Outline People living in a group (two or more) can either do everything for themselves (be self sufficient) or they can specialise. If a comparative advantage exists, specialisation will lead to higher a output for the group than self sufficiency will. A Production Possibilities model will show this. Specialisation has Costs and Benefits

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*

    Comparative Advantage, Absolute Advantage and the Production Possibility Curve(Frontier)

    Absolute advantage exists where one economic agent can produce more goods in a given time than another economic agent can produce; or takes less time to perform a given task.Comparative advantage, measured in terms of opportunity cost, exists where one economic agents opportunity cost is lower than another economic agents opportunity cost.

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*The Principle of Comparative Advantage illustrated.Diane is more efficient at cooking meals and at washing dishes. She has an absolute advantage in producing both goodsShould she cook the meals and wash dishes?Table 1 Time taken to perform each task

    Time to CookMealsTime to Wash DishesDiane20 mins10 minsLiz30 mins30 mins

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Table 2 same as Table 1 but showing the number of meals each can produce in a given time (1 hour)

    No of washes in one hourNo of meals cooked in one hour By Diane6 washes3 mealBy Liz2 wash2 meal

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*The Principle of Comparative Advantage states that Diane should produce that good in which she has a Comparative Advantage i.e. the good where she has the lowest opportunity cost. See lecture 1.Reminder: Opportunity Cost is the value of the next-best alternative to taking a particular action

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*To calculate the opportunity cost ask: How many washes could Diane perform in the time it takes her to cook a meal? How many meals could Diane have cooked in the time it takes to wash the dishes?Then ask the same questions for Liz.

    Opp. Cost of 1 MealOpp. Cost of 1 WashFor Diane2 washes mealFor Liz1 wash1 meal

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*

    To calculate comparative advantage

    Compare the opportunity costs for Meals for Diane and LizCompare the opportunity cost of Washes for Diane and Liz.Then ask:Whose opportunity cost is the lowest for washing? Whose opportunity cost is lowest for meals?

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*

    Answer: To calculate comparative advantage

    Compare the opportunity costs for Meals for Diane (2) and Liz (1)Compare the opportunity cost of Washes for Diane (1/2) and Liz (1).

    Whose opportunity cost is the lowest for washing? Diane Whose opportunity cost is lowest for meals?Liz

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Sources of Comparative Advantage

    For an IndividualInborn talentEducation & trainingExperience

    For a CountryNatural resourcesInfrastructureCultural institutions

    Comparative advantage can change over time.Read background briefing 2.2 page 39.

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Where comparative advantage exists a country can produce more of everything if its population engages in specialisation. To illustrate this using the Production Possibilities Curve

    State the assumptions

    Assumptions:1. Only two workers working full time (full employment)2. Only two goods3. Technology is fixed

    The model can be presented in:In wordsDiagramsEquations

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*

    Assumptions:Two workers working 6 hours a day.Sam (short), can produce 2kgs nuts /hour or4kgs coffee/hourTim (tall) working can produce 4kgs nuts/hour or 2kgs of coffee/hour

    2. Two goods-coffee grown on low bushes and nuts grown on tall trees.

    3. Technology is fixed

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Coffee kg/dayProduction Frontier = Production Possibilities Curve shows all possible combinations of coffee and nuts when using Sams and Tims labour fully. Nuts kg / DayCoffee kg/day Nuts kg / DaySams Production Frontier Tims Production Frontier24

    4 8 1216

    8128 4 8 16 24

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Coffee kg/day Nuts kg / Day Sams Production Frontier Tims Production FrontierSams Op C. nuts = loss in coffee gain in nutsTims Op C. nuts = loss in coffee gain in nutsSams Op C. coffee = loss in nuts gain in coffeeTims Op C. coffee = loss in nuts gain in coffee128 48 16 24 Nuts kg / DayCoffee kg/day24

    4 8 12 168

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Coffee kg/day Nuts kg / Day Sams Production FrontierTims Production FrontierSams Op C. nuts =Tims Op C. nuts =Sams Op C. coffee =Tims Op C. coffee = 128 48 16 24 Nuts kg / DayCoffee kg/day24

    4 8 12 16 8

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013* Nuts kg / DayCoffee kg / DayCombining Production PossibilitiesWho has the absolute advantage in coffee?Who has the absolute advantage in nuts?Who has the comparative advantage in coffee?Who has the comparative in nuts?

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013* Nuts kg/ Day 24

    12

    8 8 12 24 Coffee kg / DaySam does 4kg coffee/hour and 2kg nutsTim does 2kg coffee/hour and 4kg nuts

    Let them produce 8 k of coffee and 8 k nuts eachTimSam

    CoffeeNutsSam88Tim88Total1616

    CoffeeNutsSam-2+1Tim+1-2

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013* Nuts kg / DayThe Gains arising from Specialisation in a two Person Economy24

    12 8

    8 12 24 Coffee kg / DayCResult of specialisationResult of specialisation and trade

    CoffeeNutsSam240Tim024Total2424

    CoffeeNutsSam-1+1Tim+1-1

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Coffee 1000s kg/dayNuts1000s kg /day The Production Possibilities Curve for a Large Economy (many person economy)Principle of Increasing Opportunity Costs 36036

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Nuts 1000s kg /day The Production Possibilities Curve for a Large Economy (many person economy)Efficient and inefficient pointsAttainable and unattainable pointsProductive and allocative efficient points36036Coffee 1000s kg /day

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Coffee 1000s kg/dayNuts 1000s kg /dayGrowth and Production Possibilities03636

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Factors that Shift the PPF Outwards (Cause growth)

    Economic growth is caused by:1. Increasing productive resources Investment in new factories and equipment Population growth

    2. Improvements in knowledge and technology Investment in education, R&D and ICT

    Diane Enahoro Session 2 2013

  • Diane Enahoro Session 2 2013*Some Countries have been slow to specialiseBecause of:

    Population density and geographical isolation

    Laws and customs that limit the freedom to exchange goods and services

    Can we have too much specialisation?

    Is more specialisation always better than less?The extent to which we should specialise depends on costs and benefits of specialisation

    What are the costs of specialisation?

    Diane Enahoro Session 2 2013

    Microeconomics 1 Week 1*Microeconomics 1 Week 1