Confused about comparative advantage, specialisation and trade.
November 3, 2008 9:22 PM Subscribe
EconomicsNewbieFilter: I'm confused about absolute advantage, comparative advantage and specialisation. Particular example inside.
I'm doing a Master of Management, which means I have to cram for microeconomics. Hah, I thought - I remember all of this from high school - scarcity, supply, demand, elasticity, PPCs. Then I hit Chapter 2 of Frank and Bernanke's Principles of Microeconomics and groan - frickin' advantage and specialisation.
So I learn about the difference between absolute and comparative advantage. I see that just because somebody has an absolute advantage for producing two goods doesn't mean they can't benefit from specialisation and trade. Specialisation good. Trade good. Everybody wins. So far, all OK.
At the end of the chapter there's an exercise:
Ted can wax a car in 20 minutes or wash a car in 60 minutes. Dan can wax a car in 15 minutes or wash a car in 45 minutes. Who has an absolute advantage in washing cars? What is each man's opportunity cost of washing a car? Who has a comparative advantage in washing cars? Can Ted and Dan benefit from specialisation and trade? Explain.
I figure that Dan has an absolute advantage in washing cars (and waxing, too). Each man has the same opportunity cost for washing a car - three wax jobs. This would seem to mean that neither has a comparative advantage in washing cars, and this in turn would seem to imply that there's no benefit for Ted and Dan to specialise and trade.
Up until now, though, the text has given a pretty consistent message that specialisation and trade are always a good thing, so I think I've missed something. I've compared their PPCs (Ted's lies entirely within the 'inefficient' zone of Dan's - but doesn't this just mean Dan has an absolute advantage for waxing and washing?) and checked what would happen if each specialised in waxing or washing over a 6-hour day then traded (they get more washes but less waxes, or vice versa).
Where have I gone wrong?
I'm doing a Master of Management, which means I have to cram for microeconomics. Hah, I thought - I remember all of this from high school - scarcity, supply, demand, elasticity, PPCs. Then I hit Chapter 2 of Frank and Bernanke's Principles of Microeconomics and groan - frickin' advantage and specialisation.
So I learn about the difference between absolute and comparative advantage. I see that just because somebody has an absolute advantage for producing two goods doesn't mean they can't benefit from specialisation and trade. Specialisation good. Trade good. Everybody wins. So far, all OK.
At the end of the chapter there's an exercise:
Ted can wax a car in 20 minutes or wash a car in 60 minutes. Dan can wax a car in 15 minutes or wash a car in 45 minutes. Who has an absolute advantage in washing cars? What is each man's opportunity cost of washing a car? Who has a comparative advantage in washing cars? Can Ted and Dan benefit from specialisation and trade? Explain.
I figure that Dan has an absolute advantage in washing cars (and waxing, too). Each man has the same opportunity cost for washing a car - three wax jobs. This would seem to mean that neither has a comparative advantage in washing cars, and this in turn would seem to imply that there's no benefit for Ted and Dan to specialise and trade.
Up until now, though, the text has given a pretty consistent message that specialisation and trade are always a good thing, so I think I've missed something. I've compared their PPCs (Ted's lies entirely within the 'inefficient' zone of Dan's - but doesn't this just mean Dan has an absolute advantage for waxing and washing?) and checked what would happen if each specialised in waxing or washing over a 6-hour day then traded (they get more washes but less waxes, or vice versa).
Where have I gone wrong?
They can't get a benefit from trading because the opportunity costs of their actions are identical. Neither Dan nor Ted has a comparative advantage over the other. This is an exercise to illustrate that trading occurs only in situations where one party has a comparative advantage rather than an absolute advantage.
posted by I Foody at 9:59 PM on November 3, 2008
posted by I Foody at 9:59 PM on November 3, 2008
Best answer: Trade is good because it exploits differences. You let people do what they are good at and everybody benefits. In this case however, there are no (relative) differences to exploit and so trade would leave both parties equally well (but not better) off.
Note that equality of relative productivity is the only case in which the gains from trade are zero; in all other cases they are positive. For instance, if Dan's waxing gets a little faster, gains are positive again: Dan should wax and Ted should wash. But if instead he gets slower at waxing, the couple can again gain by letting Ted wax and Dan wash.
Equality of relative productivity is a pretty rare and special case, which is why the theory says that in general, trade is good.
posted by thijsk at 1:06 AM on November 4, 2008
Note that equality of relative productivity is the only case in which the gains from trade are zero; in all other cases they are positive. For instance, if Dan's waxing gets a little faster, gains are positive again: Dan should wax and Ted should wash. But if instead he gets slower at waxing, the couple can again gain by letting Ted wax and Dan wash.
Equality of relative productivity is a pretty rare and special case, which is why the theory says that in general, trade is good.
posted by thijsk at 1:06 AM on November 4, 2008
I think your intuition is correct here; or at least I'd answer it in the same way.
The question is a 'trick' only insofar as it's designed to demonstrate the exceptional case to what is otherwise a general rule (namely, "trade is good").
posted by Kadin2048 at 8:15 AM on November 4, 2008
The question is a 'trick' only insofar as it's designed to demonstrate the exceptional case to what is otherwise a general rule (namely, "trade is good").
posted by Kadin2048 at 8:15 AM on November 4, 2008
This thread is closed to new comments.
posted by MadamM at 9:40 PM on November 3, 2008