Economics 2 Professor Christina Romer Spring 2020 Professor David - PDF document

Economics 2 Professor Christina Romer Spring 2020 Professor David Romer LECTURE 2 COMPARATIVE ADVANTAGE AND THE GAINS FROM SPECIALIZATION January 23, 2020 I. O VERVIEW II. T HE K EY R OLE OF D IFFERENCES IN R ELATIVE A BILITY A. Intuition B. Example: Specialization within a household C. Reciprocal absolute advantage D. Comparative advantage E. What do we learn from this example? III. O PPORTUNITY C OST AND C OMPARATIVE A DVANTAGE A. Comparative advantage means that a producer has a lower opportunity cost B. There are gains from specialization when opportunity cost differs C. Comparative advantage is a relative concept IV. S PECIALIZATION AND THE C URVATURE OF THE P RODUCTION P OSSIBILITIES C URVE A. Example: Specialization in a two-person economy B. PPC of two people combined without specialization C. PPC of two people combined with specialization D. Visualizing and understanding the gains from specialization E. Will both parties gain from specialization? V. R EAL -W ORLD E XAMPLE : S HOULD C ALIFORNIA G ROW R ICE ? A. Facts about California agriculture and water use B. Relative opportunity cost of growing rice in California and Arkansas C. Are we specializing along the lines of comparative advantage? D. If not, why not?

Economics 2 Christina Romer Spring 2020 David Romer L ECTURE 2 Comparative Advantage and the Gains from Specialization January 23, 2020

Announcements • Reminder: please put away all electronic devices. • It is essential that you attend section this week. • Some hints on taking notes and reading the textbook. • Please talk loudly so that the whole class can hear.

I. O VERVIEW

Two Fundamental Building Blocks • Scarcity, choice, and opportunity cost. • Comparative advantage and the gains from specialization.

II. T HE K EY R OLE OF D IFFERENCES IN R ELATIVE A BILITY

Example: Specialization within a Household • Two activities: dishwashing and painting. • There are 3 walls that need painting (and many dirty dishes).

Reciprocal Absolute Advantage Walls Dishes Abilities (per hour) C. 4 12 D. 2 20 No Specialization (Each paints ½ hr. and washes ½ hr.) C. 2 6 D. 1 10 3 16 Specialization (C. paints ¾ hr. and washes ¼ hr.; D. washes 1 hr.) C. 3 3 D. 0 20 3 23

Absolute Advantage • Someone or something can produce more with a given amount of resources.

Comparative Advantage Walls Dishes Abilities (per hour) C. 4 24 D. 2 20 No Specialization (Each paints ½ hr. and washes ½ hr.) C. 2 12 D. 1 10 3 22 Specialization (C. paints ¾ hr. and washes ¼ hr.; D. washes 1 hr.) C. 3 6 D. 0 20 3 26

Comparative Advantage • Someone or something is relatively more productive at one activity than at another.

Messages • Comparative advantage is necessary for there to be gains from specialization. • Reciprocal absolute advantage is just a special case of comparative advantage.

III. O PPORTUNITY C OST AND C OMPARATIVE A DVANTAGE

Opportunity Cost and Comparative Advantage Abilities (per hour) C. 4 walls or 24 dishes D. 2 walls or 20 dishes Opportunity Cost of 1 Wall C. 24/4 = 6 dishes D. 20/2 = 10 dishes Opportunity Cost of 1 Dish C. 4/24 = 1/6 wall D. 2/20 = 1/10 wall Lower opportunity cost implies comparative advantage.

Some Observations • There are gains from specialization when opportunity cost differs. • How much we want to specialize depends on how many of the two activities need to be done. • Comparative advantage is inherently a relative concept.

IV. S PECIALIZATION AND THE C URVATURE OF THE P RODUCTION P OSSIBILITIES C URVE

Example: Specialization in a Two-Person Economy • Two goods: fish and coconuts. • Abilities: • In an hour, Robinson can catch 1 fish or gather 1 coconut. • In an hour, Friday can catch 8 fish or gather 2 coconuts. • Each of them works 6 hours a day.

Production Possibilities Curve (PPC) • Diagram showing the combinations of two types of goods that could be produced in an economy just using all of the available inputs. • In this case, the two goods are fish and coconuts. • We will draw the PPC for a day. • Recall, the slope of the PPC is (minus) the opportunity cost of the good on the horizontal axis.

Opportunity Cost When Robinson and Friday Allocate Their Time the Same Way (No Specialization) • In an hour, they could catch 9 fish (1 from Robinson and 8 from Friday). • Or they could gather 3 coconuts (1 from Robinson and 2 from Friday). • So, they trade off 9 fish for 3 coconuts. • The opportunity cost of 1 coconut is 3 fish.

Island PPC without Specialization Fish 54 Slope is −3, because the opportunity cost of gathering 1 coconut for the two combined without specialization is 3 fish. PPC 00 Coconuts 18

Individual Abilities and Opportunity Costs • In an hour, Robinson could catch 1 fish or gather 1 coconut. • So, the opportunity cost of having Robinson gather 1 coconut is 1 fish. • In an hour, Friday could catch 8 fish or gather 2 coconut. • So, the opportunity cost of having Friday gather 1 coconut is 4 fish. • Robinson is the low opportunity cost provider of coconuts.

Island PPC with Specialization Fish Slope = −1 54 48 PPC Slope = −4 00 Coconuts 6 18

Gains from Specialization Fish 54 48 PPC with Specialization PPC without Specialization Gains from Specialization 00 Coconuts 6 18

What do we learn from this example? • There are gains from specialization when opportunity cost differs across producers and production is organized according to comparative advantage. • This explains why the PPC for a country is likely to be bowed out. • One determinant of the size of the gains from specialization is the difference in opportunity cost.

Will Robinson and Friday both benefit from specialization? • Simple Answer: As long as there is no coercion, if two parties choose to specialize and trade, both must be benefitting. • More complicated answer: In a market system, prices will tend to adjust to ensure that both parties gain from specialization and trade.

Implications of the Gains from Specialization • It explains why we see trade at all levels. • To have trade, we need markets.

V. R EAL -W ORLD E XAMPLE : S HOULD C ALIFORNIA G ROW R ICE ?

Source: Congressional Research Service, “California Agricultural Production and Irrigated Water Use,” 2015.

Source, Congressional Research Service, “California Agricultural Production and Irrigated Water Use,” 2015.

U.S. Rice Production by State In Thousand CWT | 2015-2017 Source: USA Rice Federation, https://www.usarice.com/resources/market-information.

Is California the low-opportunity-cost rice producer in the U.S.? • What does California give up to grow rice? • Or, to put it another way, what are the likely alternative uses of the resources (particularly the scarce water) used to grow rice? • What do other rice-compatible states (such as Arkansas) give up to grow rice?

Source, Congressional Research Service, “California Agricultural Production and Irrigated Water Use,” 2015.

Given that California almost surely isn’t the low-opportunity-cost rice producer: • Does it make sense that California has specialized (to some degree) in rice production? • What might explain why this has happened?