Comparative advantage and the terms of trade
Comparative advantage, specialization, and gains from trade
Let's now move away from the world of the hunter-gatherer and into the dinnerware market. So let's say we're going to talk about two products -- two types of dinnerware. We'll have cups on this axis, and we will have plates on this axis. And let's say we have a producer, Charlie, and if he were to focus all of his time on cups, he could produce - let me put these [labels]10, 20, 30. So if he were to focus all of his time on cups, he could produce 30 cups, and if he were to focus all of his time on plates, he could produce 10 plates. And we're going to assume he has a linear Production Possibilities Frontier. So, this is what his PPF is going to look like. We draw a little bit, actually connect the 2 dots, so that's.. I want to make it more looking like a line, so that's about as good as I can do. So that right over there is the PPF for Charlie. Now let's think about his opportunity cost. And because this is a linear PPF his opportunity cost does not change. The slope of this line is not changing. It's not that bow-shaped curve that we saw for the hunter gatherer. So it's going to be a fixed opportunity cost for one product relative to the other, at any point along this production possibilities frontier. So let's say we're sitting over here, this will just make things simple to just think about the end points, and he's producing 30 cups, what is his opportunity cost of producing 10 plates? Well to produce 10 plates, he's going to have to give up those 30 cups. So his opportunity cost of producing 10 plates, is equal to 30 cups. Or if you want the opportunity cost for one plate, you just divide both sides by 10, and so you get the opportunity cost of 1 plate, is equal to 3 cups. That's fair enough. Now let's think about the same scenario or let's think about another producer, in this market for dinner ware. Let's call her Patty. If Patty focused all of her time on cups she could produce 10 cups in a day and if she focused all of her time on plates, she could produce 30 plates in a day. So that is.. and she also has a linear production possibilities frontier, so that right over there is the PPF for Patty. And let's think about her opportunity cost for producing a plate. So the opportunity cost, if she's sitting right over here, and she was focused all on cups, and if she wanted to produce 30 plates, and I'm intentionally using the end points to make the math more obvious. If she wanted to produce 30 plates then she would have to give up 10 cups. So her opportunity costs to produce 30 plates is equal to 10 cups. Or if you divide both sides by 30, the opportunity cost of her producing 1 plate, in terms of cups, is 10 divided by 30, is 1/3, 1/3 of a cup. Now this is interesting, we can now compare their relative opportunity costs. The opportunity cost for Charlie to produce a plate is 3 cups, the opportunity cost for Patty to produce a plate is 1/3 of a cup. So for Patty, especially when you measure it in terms of cups, it is cheaper for her to produce a plate. She has a lower opportunity cost than Charlie does in producing plates. So relative to Charlie, we say, because her opportunity cost is lower in producing plates, 1/3 relative to 3, we say that Patty has the comparative advantage in plates, relative to Charlie. And it's not just because she can produce - We'll see situations in maybe the next video where we'll actually show this. It doesn't even have to be the case that she can produce more plates in a given day. This is not why she has a comparative advantage. This is called an absolute advantage, and we'll talk about that more. She has a comparative advantage because her opportunity cost is lower. Her opportunity cost for producing a plate is lower than it is for Charlie. Now let's think about it the other way around. Who has a comparative advantage in cups? Well, if we divide both sides of this right over here by 3, well let's swap both sides, so the opportunity costs for Charlie of producing 3 cups, is equal to 1 plate. Or if you divide both sides by 3, opportunity cost of 1 cup is 1/3 of a plate. If we go to the situation for Patty, let's swap these 2 around, the opportunity cost for 10 cups is 30 plates. If you divide both sides by 10, the opportunity cost of 1 cup is equal to 3 plates. And obviously, and we've talked about this before, the opportunity cost of 1 incremental unit is the same thing as the marginal cost of a cup. But anyway, who has the lower opportunity cost for producing cups? Well, let's see, Charlie can produce a cup, or Charlie's opportunity cost for producing an extra cup is 1/3 of a plate, and Patty's is 3 plates. So Charlie has the lower opportunity cost for producing a cup. So, it's only 1/3 plate relative to 3 plates. So this is where Charlie has the comparative advantage. What we're going to see is if both of these parties specialize in their comparative advantage and then trade, they can get outcomes that are beyond each of their individual production possibility frontiers. So what we can see is, for example, they can get an outcome where they are each able to get 15 cups and 15 plates, which would have been impossible left to their own devices. So let's see how they can actually do it. So we've said that Charlie has a comparative advantage in cups. His opportunity cost of producing a cup is lower than it is for Patty. It's only 1/3 of a plate relative to 3 plates. So let's make him specialize in cups. So cup specialties. So he's going to specialize in cups, and Patty, for the same reason, is going to specialize in plates. So Charlie specializing in cups means he's going to focus only on cups. So he's going to produce 30 cups every day. And Patty specializing in plates means that she's going to produce 30 plates every day. (Let me do this in a different color: magenta). She's going to produce 30 plates every day. Now imagine, I'm going to make an assumption here, but imagine that they both do that but they don't each only want to have what they're producing they want to have some combination of them, so they decide to trade. And I'm going to fix the price here. We're going to talk more about markets in the future. But I assume that they agree to trade at 1 cup for 1 plate. And this makes sense for either of them because this trading price, or this market price, is lower than their opportunity cost. So here's Charlie, he's got all of these cups, left to his own devices, if he wanted an extra plate he would have to spend 3 cups but now in the market, with this price over here, he only has to spend 1 cup for an extra plate. So, this makes sense for him because the market price is lower than his opportunity cost. So he would definitely rather get a plate in the market than have to do it by producing it himself. It‘s cheaper this way. And the same thing for Patty. She has all of these plates, but if she wants a cup, left by herself, she would have to spend 3 plates to do it. She would have to give up 3 plates. But now in the market, she would only have to give up 1 plate. So this is a good deal, this is lower than her opportunity cost. So she'll want to transact. And so they can do, each of them, so for example, Charlie could keep trading cups for plates and he could end up anywhere on this line over there. And Patty could actually do the same thing: she could trade the cups for plates and end up someplace over there. But obviously where they end up is dependent on how much the other one is willing to trade. But let's say that they both want to get to that 15-15 scenario so they can both trade 15 cups to the other person. So Charlie could trade 15 cups for 15 plates and obviously Patty would be trading 15 plates for 15 cups. And they would both be able to get right over there. Which is a situation that was unattainable left to their own production possibilities. So hopefully you found that interesting. By specializing they could get these gains of trade. They specialize in their comparative advantage.