AP Macroeconomics

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AP Macroeconomics

• Comparative Advantage

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Ricky Ricardo

• Lucys Cuban-American husband drumming on the
  bongo.

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David Ricardo

• English economist responsible for promoting
  comparative advantage as the basis of trade. No
  relation to Ricky Ricardo.

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Absolute Advantage v. Comparative Advantage

• Absolute Advantage
• Individual exists when a person can produce
  more of a certain good/service than someone else
  in the same amount of time.
• National- exists when a country can produce more
  of a good/service than another country can in the
  same time period.
• Comparative Advantage
• Individual/National- exists when an individual or
  nation can produce a good/service at a lower
  opportunity cost than can another individual or
  nation

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Specialization

• Individuals and Countries can be made better off
  if they will produce in what they have a
  comparative advantage and then trade with others
  for whatever else they want/need.

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Example

• Assume David Ricardo and Ricky Ricardo are going
  to throw a party in exactly one hour. They decide
  on serving homemade pizzas and cakes. Assume they
  have like 15 ovens in their apartment and lots of
  pots and pans. Use the information in the next
  slide to determine who should produce what.

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Example
Bake Cakes Make Pizza
David Ricardo 2 cakes/hr. 4 pizzas/hr.
Ricky Ricardo 6 cakes/hr. 8 pizzas/hr.
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Example
Bake Cakes Make Pizza
David Ricardo 2 cakes/hr. 4 pizzas/hr.
Ricky Ricardo 6 cakes/hr. 8 pizzas/hr.
Who has the absolute advantage in baking
cakes? Who has the absolute advantage in making
pizza?
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Example
David Ricardo Ricky Ricardo
Bake Cakes 2 cakes/hr. 6 cakes/hr.
Make Pizza 4 pizzas/hr. 8 pizzas/hr.
Why? Well, because 6 cakesgt2 cakes 8 pizzasgt4
pizzas.
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Example
David Ricardo Ricky Ricardo
Bake Cakes 2 cakes/hr. 4 cakes/hr.
Make Pizza 6 pizzas/hr. 8 pizzas/hr.
Who has the comparative advantage in baking
cakes? Who has the comparative advantage in
making pizza?
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Example
Who has the comparative advantage in baking
cakes? Who has the comparative advantage in
making pizza?
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Example
Why? Ricky only gives up 2 pizzas in order to
bake a cake, whereas David gives up 3 pizzas in
order to bake a cake.
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Example
It only cost David 1/3 of a cake to make a pizza,
whereas it costs Ricky ½ of a cake to make a
pizza.
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U.S.
Brazil
Absolute Advantage? Should the U.S. and Brazil
specialize and trade?
Even though the U.S. has an absolute advantage in
both goods it should specialize and trade.
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Determine Comparative Advantage
Step 1 Set up the problem Step 2 Identify
Production Maximums
Coffee
Wheat U.S. Brazil
30
30
1
1
(1W)
(1C)
20
10
2
1
(1/2 W)
(2C)
Step 2 Reduce Ratios Step 3 Identify
Opportunity Cost Step 4 Compare Costs --- lowest
has CA
Coffee Wheat
U.S.
Brazil
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Gains From Trade
Coffee Wheat U.S.
Brazil
18
12
8
4
20
22
Before After Gain
20
30
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Step 1 Set up the problem Step 2 Identify
production prior to specialization Step 3 Total
production in each product prior to
specialization Step 4 Identify maximum possible
production of each product with specialization
according to comparative advantage Step 5
Compare output before/after specialization and
trade
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Terms of Trade (Trading Possibilities)
U.S. 1 C 1
W Brazil 2C 1/2 W
Possible Term of Trade
1.5C 1W
Step 1 Identify original reduced ratios for
each country Step 2 Terms of trade fall between
the limits set by the ratios Step 3 Trading
possibilities are the maximums set by the ratios
Terms are mutually beneficial
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Terms of Trade (Trading Possibilities)
U.S. 1 C 1
W Brazil 2C 1 W
Possible Term of Trade
1.5C 1W
1C lt 1W lt 2C
Trading Possibilities
Both nations benefit from 1.5C traded for 1W.
Prior to trade, the U.S. gave up 1W for each
coffee. With trade, the U.S. can receive 1.5C
for each unit of wheat. Before trade, Brazil
gave up 2C for each unit of wheat. With trade,
Brazil gives up only 1.5C for each wheat.
Terms are mutually beneficial
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Should the U.S. and Brazil specialize and trade?
Yes!!!!!!!!

• Why Efficiency Argument and Output Argument
• More efficient use of scarce global resources
• The U.S. gives up 1 coffee for each wheat /
  Brazil gives up 2
• coffees for each wheat --- The U.S. gives up
  less to produce wheat.
• Brazil gives up ½ wheat for each coffee / U.S.
  gives up 1
• wheat for each coffee --- Brazil gives up less
  to produce coffee.
• Gains from trade --- more can be produced from
  the same resources
• 8 additional units of wheat can be produced
  through specialization and
• trade

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Distinguishing

• Input/Output Problems

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Distinguishing input from output problems.

• An OUTPUT problem presents the data as products
  produced given a set of resources. (ex. Number of
  pens produced)
• An INPUT problem presents the data as amount of
  resources needed to produce a fixed amount of
  output. (ex. Number of labor hours to produce 1
  bushel)
• When identifying absolute advantage, input
  problems change the scenario from who can produce
  the most to who can produce a given product with
  the least amount of resources.

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Which type of problem?

• Acres to produce one unit of each.
• Input problem

Apples Pears
Tom 10 5
Sam 6 2
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Absolute Advantage?

• Acres to produce one unit of each.
• Who has the absolute advantage in apples and
  pears?
• Sam

Apples Pears
Tom 10 5
Sam 6 2
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Explanation

• Acres to produce one unit of each.
• Sam has an absolute advantage in both pears and
  apples because he can produce 1 unit of each in
  fewer acres than Tom. Absolute advantage in INPUT
  problems is based on using the LEAST amount of
  resources to produce the given unit(s) of
  product.

Apples Pears
Tom 10 5
Sam 6 2
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Input or Output problem?

• Number caught per day.
• Output problem

Trout Bass
Tom 4 6
Sam 24 12
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Absolute Advantage?

• Number caught per day.
• Which guy has the absolute advantage in the
  production of each product?
• Sam

Trout Bass
Tom 4 6
Sam 24 12
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Explanation

• Number caught per day.
• Sam has an absolute advantage in catching both
  trout and bass as he can catch more of each than
  Tom in one days time.

Trout Bass
Tom 4 6
Sam 24 12
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Input or Output Problem?

• Days to produce one unit of each.
• Input problem

Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
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Explanation

• Days to produce one unit of each.
• This is an input problem as it refers to how many
  days (work days for labor) will be needed to
  produce 1 unit. The problem is phrased in terms
  of resources used rather than products produced.

Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
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Absolute Disadvantage?

• Days to produce one unit of each.
• Which corporation has an absolute disadvantage in
  the production of both products?
• QKFX

Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
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Explanation

• Days to produce one unit of each.
• XYZ has an absolute advantage in producing both
  cars and planes because it can produce 1 unit of
  each in less time (days) than QKFX. This means
  that QKFX has an absolute disadvantage in
  producing both products. QKFX uses more days to
  produce both products.

Cars Planes
XYZ Corp. 8 10
QKFX Corp. 15 12
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Input or Output Problem?

• To produce the following from one ton of olives.
• Output problem

Canned Olives Olive Oil
Zaire 60 10
Colombia 24 8
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Explanation?

• To produce the following from one ton of olives.
• This is an output problem because it is the
  number produced (output in canned olives and
  olive oil) from a given unit of resources (1 ton
  of olives)

Canned Olives Olive Oil
Zaire 60 10
Colombia 24 8
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Absolute Advantage?

• To produce the following from one ton of olives.
• Which nation has the absolute advantage in both
  products?
• Zaire

Canned Olives Olive Oil
Zaire 60 10
Colombia 24 8
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Explanation

• To produce the following from one ton of olives.
• Zaire has an absolute advantage in producing both
  products because it can produce more given the
  unit of resources available (1 ton of olives).

Canned Olives Olive Oil
Zaire 60 10
Colombia 24 8