Economics Unit 1 Review You Are Better Off Consuming or Producing an Additional Good or Serves if

Learning Objectives

• Calculate absolute and comparative reward

Production Possibilities and Comparative Advantage

Consider the example of trade in two goods, shoes and refrigerators, between the United States and United mexican states. These goods are homogeneous, meaning that consumers and producers cannot differentiate between shoes from United mexican states and shoes from the U.S.; nor tin can they differentiate betwixt Mexican or American refrigerators.

From Table 1, we tin can see that it takes 4 U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to exercise so. It takes one U.S. worker to produce 1,000 refrigerators, just it takes four Mexican workers to do so. The United States has an absolute reward in producing both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.

Tabular array 1. Resources Needed to Produce Shoes and Refrigerators

Land	Number of Workers needed to produce 1,000 units — Shoes	Number of Workers needed to produce one,000 units — Refrigerators
United States	4 workers	1 worker
United mexican states	five workers	four workers

Absolute advantage just compares theproductivity of a worker between countries. It answers the question, "How many inputs do I need to produce shoes in Mexico?" Comparative advantage asks this aforementioned question slightly differently. Instead of comparing how many workers it takes to produce a good, information technology asks, "How much am I giving up to produce this good in this country?" Another mode of looking at this is that comparative advantage identifies the good for which the producer'due south accented reward is relatively larger, or where the producer's accented productivity disadvantage is relatively smaller. The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus 5), only it tin produce 1,000 refrigerators with only one-quarter as many workers (one versus 4). So, the comparative advantage of the Usa, where its accented productivity advantage is relatively greatest, lies with refrigerators, and Mexico's comparative reward, where its absolute productivity disadvantage is least, is in the product of shoes.

Mutually Beneficial Trade with Comparative Advantage

When nations increment production in their area of comparative advantage and trade with each other, both countries can benefit. The product possibilities frontier is a useful tool to visualize this benefit. Recall from earlier readings that the production possibilities frontier shows the maximum amount that each state tin can produce given its express resources, in this case workers.

Consider a situation where the United States and Mexico each take twoscore workers. For instance, as Tabular array 2 shows, if the United States divides its labor so that 40 workers are making shoes, so, since it takes four workers in the United States to make ane,000 shoes, a total of 10,000 shoes will be produced. (If four workers can make 1,000 shoes, and so 40 workers will make 10,000 shoes). If the 40 workers in the United States are making refrigerators, and each worker can produce i,000 refrigerators, then a total of 40,000 refrigerators volition be produced.

Table ii. Production Possibilities before Trade

Country	Shoe Production — using xl workers		Refrigerator Production — using 40 workers
Usa	10,000 shoes	or	xl,000 refrigerators
Mexico	eight,000 shoes	or	x,000 refrigerators

Equally always, the slope of the production possibility frontier for each country is the opportunity price of i refrigerator in terms of foregone shoe production–when labor is transferred from producing the latter to producing the old (run into Figure i).

Figure 1. Production Possibility Frontiers. (a) With 40 workers, the Us can produce either x,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. All other points on the production possibility line are possible combinations of the two goods that tin can be produced given current resources. Point A on both graphs is where the countries outset producing and consuming before trade. Indicate B is where they end up later merchandise.

Let's say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Table 3 shows the output of each skilful for each country and the total output for the two countries.

Table 3. Production at Signal A before Trade

Country	Current Shoe Production	Current Refrigerator Production
United States	five,000	20,000
Mexico	4,000	five,000
Total	9,000	25,000

Continuing with this scenario, each country transfers some amount of labor toward its expanse of comparative advantage. For example, the United states of america transfers half dozen workers away from shoes and toward producing refrigerators. Every bit a consequence, U.South. production of shoes decreases by 1,500 units (6/iv × 1,000), while its product of refrigerators increases past 6,000 (that is, 6/one × 1,000). United mexican states also moves production toward its surface area of comparative advantage, transferring 10 workers away from refrigerators and toward product of shoes. As a result, production of refrigerators in Mexico falls by 2,500 (x/4 × i,000), but production of shoes increases by 2,000 pairs (10/five × 1,000). Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table four. The reduction of shoe production by 1,500 pairs in the United States is more than commencement by the proceeds of two,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in United mexican states is more than than offset past the additional 6,000 refrigerators produced in the United States.

Table 4. Shifting Production Toward Comparative Advantage Raises Total Output

Country	Shoe Product	Refrigerator Production
United States	3,500	26,000
United mexican states	half dozen,000	two,500
Full	9,500	28,500

This numerical example illustrates the remarkable insight of comparative advantage: fifty-fifty when one state has an absolute advantage in all goods and another country has an absolute disadvantage in all appurtenances, both countries tin still benefit from trade. Fifty-fifty though the United States has an accented advantage in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which information technology has a comparative advantage. The United States will export refrigerators and in render import shoes.

Can a production possibility borderland be straight?

When you lot offset met the product possibility frontier (PPF) in an earlier module, information technology was drawn with an outward-bending shape. This shape illustrated that as inputs were transferred from producing one good to another—like from pedagogy to health services—at that place were increasing opportunity costs. In the examples in this module, the PPFs are fatigued as straight lines, which means that opportunity costs are constant. When a marginal unit of labor is transferred away from growing corn and toward producing oil, the refuse in the quantity of corn and the increment in the quantity of oil is always the aforementioned. In reality this is possible merely if the contribution of additional workers to output did not change as the scale of production changed. The linear production possibilities borderland is a less realistic model, but a straight line simplifies calculations. Information technology also illustrates economical themes similar accented and comparative reward just every bit conspicuously.

How Opportunity Cost Sets the Boundaries of Trade

This instance shows that both parties can benefit from specializing in their comparative advantages and trading. Past using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country.

Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and five,000 refrigerators. Then, in the numerical instance given, United mexican states shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. Thus, if Mexico tinexport no more than two,000 pairs of shoes (giving upward 2,000 pairs of shoes) in substitution for imports of at least 2,500 refrigerators (a gain of two,500 refrigerators), it will be able to consume more of both goods than before trade. Mexico volition be unambiguously better off. Conversely, the United States started off, earlier specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. In the example, information technology then shifted production toward its comparative advantage, producing merely 3,500 shoes but 26,000 refrigerators. If the United States can consign no more than half dozen,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, information technology volition exist able to swallow more of both appurtenances and will be unambiguously better off.

The range of trades that tin benefit both nations is shown in Table 5. For case, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would be able to consume more of both goods than in a world without merchandise.

Table 5. The Range of Trades That Benefit Both the United states of america and Mexico

The U.S. economy, after specialization, will benefit if it:	The Mexican economic system, after specialization, volition benefit if it:
Exports fewer than vi,000 refrigerators	Imports at least ii,500 refrigerators
Imports at least ane,500 pairs of shoes	Exports no more than two,000 pairs of shoes

Trade allows each country to take advantage of lower opportunity costs in the other country. If Mexico wants to produce more refrigerators without merchandise, information technology must face its domestic opportunity costs and reduce shoe production. If Mexico, instead, produces more shoes then trades for refrigerators fabricated in the United States, where theopportunity price of producing refrigerators is lower, Mexico tin can in effect have reward of the lower opportunity cost of refrigerators in the The states. Conversely, when the United States specializes in its comparative reward of refrigerator production and trades for shoes produced in United mexican states, international trade allows the Usa to accept reward of the lower opportunity cost of shoe production in United mexican states.

The theory of comparative advantage explains why countries trade: they have unlike comparative advantages. Information technology shows that the gains from international trade consequence from pursuing comparative advantage and producing at a lower opportunity price. The following feature shows how to calculate absolute and comparative advantage and the style to apply them to a country's product.

Calculating Accented and Comparative Advantage

In Canada a worker can produce xx barrels of oil or 40 tons of lumber. In Venezuela, a worker can produce lx barrels of oil or xxx tons of lumber.

Tabular array 6. Oil and Lumber Production in Canada and Venezuela
Country	Oil (barrels)		Lumber (tons)
Canada	20	or	40
Venezuela	sixty	or	thirty

1. Who has the absolute advantage in the production of oil or lumber? How can you tell?
2. Which country has a comparative advantage in the product of oil?
3. Which country has a comparative advantage in producing lumber?
4. In this example, is accented advantage the same as comparative advantage, or not?
5. In what production should Canada specialize? In what production should Venezuela specialize?

Step 1. Make a table similar Table 6.

Stride 2. To calculate absolute reward, look at the larger of the numbers for each production. One worker in Canada tin produce more than lumber (40 tons versus xxx tons), so Canada has the absolute advantage in lumber. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who tin can produce only 20.

Step three. To calculate comparative advantage, find the opportunity toll of producing ane butt of oil in both countries. The state with the lowest opportunity toll has the comparative reward.

With the same labor time, Canada can produce either 20 barrels of oil or twoscore tons of lumber. Then in result, 20 barrels of oil is equivalent to forty tons of lumber: 20 oil = twoscore lumber. Separate both sides of the equation by twenty to calculate the opportunity cost of one barrel of oil in Canada. 20/20 oil = 40/20 lumber. ane oil = two lumber. To produce one additional barrel of oil in Canada has an opportunity cost of ii lumber.

Calculate the same way for Venezuela: sixty oil = 30 lumber. Split both sides of the equation by 60. Ane oil in Venezuela has an opportunity cost of 1/2 lumber. Because 1/two lumber < ii lumber, Venezuela has the comparative advantage in producing oil.

Step 4. Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Canada, forty lumber is equivalent in labor fourth dimension to xx barrels of oil: 40 lumber = 20 oil. Dissever each side of the equation past forty. The opportunity cost of one lumber is 1/2 oil.

In Venezuela, the equivalent labor fourth dimension will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Divide each side by xxx. One lumber has an opportunity cost of two oil. Canada has the lower opportunity price in producing lumber.

Step 5. In this example, accented advantage is the same every bit comparative advantage. Canada has the absolute and comparative reward in lumber; Venezuela has the absolute and comparative reward in oil.

Pace 6. Canada should specialize in what information technology has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber.

Try It

Merchandise and Incomes

Incomes depend on labor productivity. A country with an accented advantage in some product has college labor productivity than another land does in the production of that product.If a country has an absolute advantage in producing both goods, it has higher labor productivity in both and its workers volition earn college incomes than those in the other land. Thus, the boilerplate income in a country depends on its average labor productivity. Now consider comparative advantage. If a country specializes production in the production in which it has a comparative reward, it raises its average labor productivity and raises its average income. Thus, comparative advantage is more important than absolute reward in understanding which land should trade which product in order to maximize the standard of living in both countries.

Sentinel It

Watch this video to review the ways that comparative advantage benefits all the parties involved.

For additional practice and review using numbers, sentinel this video from ACDC economics.

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Source: https://courses.lumenlearning.com/wm-microeconomics/chapter/comparative-advantage-and-the-gains-from-trade/

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