Course: AP®︎/College Macroeconomics > Unit 1Lesson 3: Comparative advantage and the gains from trade
- Comparative advantage, specialization, and gains from trade
- Comparative advantage and absolute advantage
- Opportunity cost and comparative advantage using an output table
- Terms of trade and the gains from trade
- Input approach to determining comparative advantage
- When there aren't gains from trade
- Comparative advantage worked example
- Lesson summary: Comparative advantage and gains from trade
- Comparative advantage and the gains from trade
Comparative advantage worked example
In this video we work through an example of a question like you might see on an AP microeconomics or AP Macroeconomics exam determining who has comparative advantage in producing a good using data from a table. Topics include how to calculate opportunity costs and determine who has comparative advantage based on opportunity cost.
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- Is anyone going to comment on how this example is based on Pokémon :D. Kalos and Johto...shiny charms and berries :P(35 votes)
- what would be an example of when trade would not be beneficial between 2 countries?(5 votes)
- Trade would not be beneficial if two countries have identical opportunity costs. The source of the gains from trade is differences in comparative advantage, and comparative advantage is lower opportunity cost. So, no difference in opportunity cost implies no comparative advantage.(13 votes)
- why do less efficient countries also have comparative advantage? Intuitively this should not happen.(4 votes)
- It would seem ideal for all of the extremely wealthy and efficient countries to make all the goods and services they need to purchase, but because of specialization and trade, it is more efficient to have other, less efficient countries produce goods. This is why outsourcing to countries in South America and Asia happens. Less efficient countries would have a comparative advantage in this case.(9 votes)
- Question about finding a trading price for charms: I think that the way the question is posed in the video might be misleading; it suggests that both countries are trading charms, but I imagine that Kalos would be trading charms for berries while Johto would be trading berries for charms. If that's correct, then wouldn't Kalos pay no more than 1/2 charm per berry (their opportunity cost for berries) since they can produce berries more efficiently themselves? Similarly, wouldn't Johto pay no more than 3 berries per charm (their opportunity cost for charms) since they can produce charms more efficiently themselves?(4 votes)
- A general principle of the terms of trade is that the trading price lies between the two opportunity cost. So, the trading price of a charm will be between 2 berries and 3 berries, and the trading price of a berry will be between 1/3 of a charm and 1/2 of a charm.
You're right that Johto won't pay more than 3 berries per charm, but you've kind of got some of the rest mixed up there... the opportunity cost of berries for Kalos is 1/2 charm per berry, so 1/2 a charm that's the most they'd be willing to pay for berries. Notice that at that price, they'd both want to buy... nobody is willing to sell! Kalos' opportunity cost for charms is 2 berries, so that's the minimum they'd be willing to sell charms for. Kalos will be selling charms, so selling charms at 1/2 a charm per berry is the same as 2 berries per charm. Kalos would be indifferent to trade at that point because they can "sell" themselves a charm for the same benefit (if they give up producing one of their charms they get 2 berries). So, if someone comes along and offers them 2.5 berries per charm, that's a better deal than they can give themselves.
Johto is going to want to buy charms for less than they can produce them itself, so they'd never want to pay more than 3 berries per charm.(4 votes)
- Lmaoo the pokemon reference!!(4 votes)
- If Kalos trades 1 charm for 2.5 berries,it would have to sell at least 9 charms to get 22.5 berries which is more than the 20 it would have produced on its own to move beyond its PPC. Similarly Jhoto would sell 22.5 berries and presently have 57.5 berries but would only get 9 charms which is within its PPC. If two countries trade to go beyond the PPC why would Kalos and Jhoto trade?(3 votes)
- If Johto produced 75 berries, and traded 22.5 of them to Kalos in exchange for nine charms, Johto has:
75 - 22.5 = 52.5 berries, and
Johto's opportunity cost for producing a charm is 3 berries, so after the trade Johto has:
52.5 + 3(9) = 52.5 + 27 = 79.5 berries of value.
Before the trade, Johto only had 75 berries worth of value. Both countries still benefit from trading, but Johto benefits a lot less than Kalos.(2 votes)
- I feel, for the lectures on Microeconomics, the term 'countries' shouldn't be used, or can they?(2 votes)
- Even though Sal uses 'countries' for his example, the principle of comparative advantage is still the same whether he uses 'countries' or 'firms.'(3 votes)
- If the opportunity cost of Kalos for charms is 2 berries / charm, and the opportunity cost of Johto for charms is 3 berries / charm, won't the countries have different amounts of benefit? For instance, if the price was 2.3 berries / charm, then supposedly Kalos will earn 0.3 berries / charm while Johto saves 0.7 berries / charm.(3 votes)
- Hey, I've figured out a quick way to determine the comparative advantage (C.A.).
Comparing the opportunity costs of different countries/parties is EQUIVALENT to comparing the slopes visually. So, next time just visualize the slopes and know the which country has C.A. in which good/service.(2 votes)
- Is it true that the output table is based on the constant opportunity cost of charms and berries?
Can i use the output table if the OC of the two country doesn't remain constant?(1 vote)
- [Instructor] The countries of Kalos and Johto can produce two goods. Shiny charms and berries. Yep, you got to love these worlds created in these economics questions. The table below describe the production possibilities of each country in a day. So here it tells us that Kalos, if it puts all of its energy behind charms, it can produce 10 charms in a day. But if it put all of its energy behind berries, it can produce 20 berries in a day. And then Johto, all of its energy behind charms, 25, all of its energy behind berries, 75. Given these numbers are based on both countries having the same labor and capital inputs, who has the absolute advantage in charms? So pause the video and see if you can figure this out. All right, so let's just remind ourselves. Absolute advantage is just who is more efficient? Who, given the same inputs, can produce more? And they told us that these countries, they have the same labor and capital inputs, so this is really just a question of who can produce more charms in a day? And you can see very clearly that Johto can produce more charms in a day. And so I would say Johto, because they produce, let me write that a little bit neater, they produce more charms per day. Charms per day. With same inputs. Same inputs. So they are more efficient. More efficient. So they have the absolute advantage. Now this is an interesting thing, because our intuition might say well whoever has the absolute advantage, maybe they're the ones that should be producing charms. But this is what's interesting when we study comparative advantage. That is not always the case. And I suspect that this question will lead us there. All right, next question. They say calculate the opportunity cost in Kalos of charms. So the opportunity cost, in Kalos, of charms. So when Kalos decides to produce 10 charms, they're trading off 20 berries. Or another way of thinking about it, it costs them 20 berries to produce 10 charms. So we could say it costs 20 berries for 10 charms, which is equal to two berries, two berries per charm, in Kalos. So there you have it. The opportunity cost, they trade off two berries per charm. And actually, let me make it a little column here. The opportunity cost. So this is two berries per charm. And I have a feeling, and if you're taking an exam, say an AP exam, it's not a bad idea to just fill this thing out, so what is the opportunity cost, they haven't asked us that yet, but I'm just gonna do it really fast. What is the opportunity cost of charms in Johto? Well, they are trading off, to produce 25 charms, they trade off 75 berries. So this would be 75 divided by 25, this would be three berries per charm. 75 berries for 25 charms is three berries per charm. And if you want to know the opportunity cost of berries, well you can just take the reciprocal of each of these. So in Kalos, the opportunity cost is one half charms, charms per berry. And then in Johto, it is one third charms per berry. That if they wanted to produce 25 berries, if they wanted to produce 75 berries, they would trade off 25 charms. So it would cost them 25 charms to produce 75 berries, or one third of a charm per berry. So I'm just doing a little bit of extra. But then it's gonna be useful, because in the next question, they actually are asking us, who, we'll scroll up a little bit. They're saying who has the comparative advantage in berries, explain. So berries, whoever has the lower opportunity cost has the comparative advantage. So we see here that Johto has the lower opportunity cost in berries. One third is lower than one half. It's a lower opportunity cost of producing a berry. So Johto has one third charms per berry opportunity cost, opportunity cost. Which is lower than Kalos', Kalos' one half charms per berry opportunity cost. So Johto has comparative advantage. So Johto has comparative, comparative advantage in berries. And I apologize a little bit for my penmanship, I'm trying to save time by writing a little bit fast, but hopefully me saying it out loud at the same time is making it somewhat legible. All right. So the next question. If these countries were to specialize in trade, who would produce which good, explain. Well whoever have the comparative advantage of each will produce that one. So Kalos has comparative advantage, Kalos has lower opportunity cost in, in let's see, they have the lower opportunity cost when you compare them to, oh let me see, let me put it this way. For charms, let me write I this way, Kalos has a lower opportunity cost for charms. Kalos has advantage in charms. And then we already said Johto has advantage in berries. And so, Kalos, I keep saying it weird, Kalos produces charms, Johto produces berries, produces berries. And once again, this goes back to something we touched on at the beginning of the video. Even though Johto has the absolute advantage, in fact they have the absolute advantage in either, Johto is not, even though they can produce charms way more efficiently than Kalos, Johto is actually in this, if you buy all the arguments of comparative advantages, Johto should actually produce the berries, while Kalos should produce the charms, because they have a lower opportunity cost in terms of berries. Now let's answer this last question right over here. What would be a trading price that Johto and Kalos would agree on to trade charms for? Now you might be saying, well what's a price, I'm used to saying that in terms of just maybe dollars or some type of currency, how do I answer a price right over here? Well, the key is that we can give a price in terms of opportunity cost. So they want a price of charms. So it really could be in terms of berries. So let's see. Let's look at each of their cost of charms. So, Kalos' opportunity costs of a charm is two berries per charm, Johto's in three berries per charm. So let me rewrite that over here. So Kalos, Kalos opportunity cost of charms is two berries per charm. And then Johto opportunity cost of charms is three berries per charm. And here we're going to appreciate why comparative advantage works. We said that Kalos would be the one that would focus on the charms. And so notice. If they can sell the charms to Johto for something that is higher than their opportunity cost, and lower than Johto's opportunity cost, then they both benefit. And so a good price, let's say you could go halfway between the two, but it really could be anything in between the two, let's say 2.5 berries per charm. They both benefit. So they would trade at this, trade at 2.5 berries per charm. Why does this make sense for Johto, even though they have the absolute advantage? Well if they produce nothing but charms, it would cost them, or no matter what they do, it'll cost them three berries per charm. But now they figured out a way, through trade, to get charms at two and a half berries per charm. And so this will be a better deal for Johto. And so one thing to appreciate when we talk about comparative advantage, some people think that it's about one country benefiting more than the other. But if we assume all of the assumptions about comparative advantage in our models, then it's actually about both countries that are trading benefit. They will both be better off. They will both get gains from trade, and both will be better off.