Comparative Advantage

MBA 525 ~ Practice with comparative advantage and gains from trade.

The principle of comparative advantage states that if nations (or individuals) specialize in the production of goods and services that they can produce at lower opportunity cost relative to other nations, then there can be mutual gains from trade. As a result, there will be more efficient production and consumption. Applying the efficiency principle, this means that mutually beneficial trade allows each nation to consume a mix of goods that is beyond what they could produce alone – the whole pie is bigger, so everyone can have a larger slice.

Example to see gains from trade:

Assume that Jay and Leah can spend the day either washing cars or mowing lawns. The table below shows how much of each task they could accomplish in one day if they spent the whole day doing just that task. For example, Jay could wash 20 cars or mow 5 lawns in one day.
______________________________________________
Jay Leah
______________________________________________
Cars washed 20 15
Lawns mowed 5 3
______________________________________________

Note: Jay has the absolute advantage in both goods. This does not mean that he has comparative advantage. Even though he is “better” at producing both goods than Leah, he can still benefit from trading with her.

Question: Use the principle of comparative advantage to illustrate how specialization can make them more productive than they can be alone.

Steps:

1. Calculate the opportunity cost of each activity for each person.

Jay
The opportunity cost of mowing 5 lawns is washing 20 cars.
 the opportunity cost of mowing 1 lawn is washing 4 cars.
 the opportunity cost of washing 1 car is mowing ¼ of a lawn.

Leah
The opportunity cost of mowing 3 lawns is washing 15 cars.
 the opportunity cost of mowing 1 lawn is washing 5 cars.
 the opportunity cost of washing 1 car is mowing 1/5 of a lawn.

2. Use the opportunity costs to see who has comparative advantage (lower opportunity cost) in each good, and therefore who should specialize in each good.

Jay has a lower opportunity cost for mowing lawns so he has the comparative advantage in lawns (he gives up only 4 cars per lawn while Leah gives up 5 cars).

Leah has a lower opportunity cost for washing cars so she has the comparative advantage in cars (she gives up only 1/5 of a lawn per car while Jay gives up ¼ of a lawn).

 Jay should specialize in mowing lawns and Leah should specialize in washing cars.
3. Use the opportunity costs of each good to figure out how much they would be willing to pay or accept in a trade.

Since Jay is doing all the lawn mowing and Leah is doing all the car washing, we can see that Jay will trade some lawns for Leah’s car washing.

Questions: a) how many lawns would Jay be willing to mow for Leah if Leah washes one car for Jay? b) how many lawns would Leah accept as a trade for each car she washes for Jay?

Answers: a) Jay would mow up to ¼ of a lawn, but not more, for each car that Leah washes for him (because this is his opportunity cost or what he would have to give up if he washed a car himself).
b) Leah would accept anything above 1/5 of a lawn, but not less, for each car that she washes for Jay.

Notice that there is a “window” of opportunity for trade. Any amount of lawns between ¼ and 1/5 will be acceptable to both Jay and Leah and make them both better off.

Example of a mutually beneficial trade:

Suppose Jay mows 6 lawns for Leah.

What is the most that Leah would pay Jay (in car washes) for these 6 lawns?
 Leah will pay up to 30 cars for this because for her the opportunity cost of 1 lawn is 5 cars, so the opportunity cost of 6 lawns is 30 cars.

What is the least that Jay will accept for these 6 lawns?
 Jay will accept anything greater than 24 cars for this because for her the opportunity cost of 1 lawn is 4 cars, so the opportunity cost of 6 lawns is 24 cars.

If Leah gives Jay 27 cars for the 6 lawns (or any other number between 24 and 30) then they will both be better off.

Jay gets 27 cars washed at a “price” of only 6 lawns – if he were to wash 27 cars himself he would have to give up 6.75 lawns (27 x 0.25) – he is therefore better off by ¾ of a Lawn.

Leah gets 6 lawns mowed at a “price” of only 27 cars – if she were to mow 6 lawns herself she would have to give up 30 cars (6 x 5) – she is therefore better off by 3 cars.