Comparative Advantage and Gains from Specialization and Trade Tale of Two Builders

1. Comparative Advantage and Gains from Specialization and TradeTale of Two Builders

2. Consider two people, Carl and Sam. Both are in the construction business. Carl can build 2brick houses in a month. But if he makes frame houses instead, he can build 4frame houses in that month. Sam has ‘two left thumbs’, so he can build only 1 brick house in a month. If he makes frame houses instead, he can build only 1 frame house in that month.

3. Carl has an absolute advantage over Sam in the production both types of house, because he can produce more houses with the same resources. While it would appear that there would be no opportunity to trade – as Carl has the absolute advantage in both – we need to consider the opportunity costs for each builder.

4. Recall: Carl can build 2brick or 4frame houses Sam can build either 1 brick or 1 frame house. Complete the following table of opportunity costs

5. Opportunity Costs for Builders Who has the lowest opportunity costs for each type of house?

6. Person A has a comparative advantage over person B in the production of a good if person A has a lower opportunity cost of producing the good.personcomparative advantage Sam brick Carl frame

7. Law of Comparative Advantage: The total output of a group, an economy, or a group of nations will be greatest when the output of each good is produced by the person (or firm or nation) with the lowest opportunity cost.Let’s see how this law applies to Carl and Sam.

8. 12 Months Production without specializationLet’s say that the costs/prices of houses are identical for brick and frame houses, and – just for the variety – they each produce equal numbers of frame and brick houses over a period of 12 months:

9. Sam has an idea  • Sam is tired of working for 12 months of the year; he wants to work for only 11 months, and have a month’s holiday. He has a brainwave and approaches Carl to see if he will trade houses. • If Carl produces some extra frame houses, Sam figures he can make up the shortfall in brick houses. Will this work? Recall: Carl can build 4frame houses/month; hence it takes 5 ½ months to make 22. for another 5 ½ months he can make 11 brick houses (at 2 per month). Sam takes all 11 months to make 11 brick houses.

10. 11 Months Production with Specialization frame brick Carl Sam 0 11 Total

11. 11 Months Production with Specialization frame brick Carl 22 11 Sam 0 11 Total

12. 11 Months Production with Specialization frame brick Carl 22 11 Sam 0 11 Total 22 22

13. Terms of trade The terms of trade is the ratio of brick-to-frame that will be advantageous to both Sam and Carl. The terms of trade will be between 1 and 2 frame houses per brick house. It has to be over 1 for Sam, and under 2 for Carl.

14. After construction, Carl and Sam have the following:build Sam brick 11 frame 0 Carl brick 11 frame 22

15. Suppose that Carl and Sam agree to trade 6 frame houses for 5 brick houses. So we havebuildtrade Sam brick 11 - 5 frame 0 + 6 Carl brick 11 + 5 frame 22 - 6

16. The result is:buildtraderesultSam brick 11 - 5 6 frame 0 + 6 6Carl brick 11 + 5 16 frame 22 - 6 16

17. Now Carl and Sam each have the same number of houses as before specialization and trade. However, they are better off now because they get a month of vacation. Alternatively, if they worked a 12-month year, they could produce more houses than before.

18. Comment:It is comparative advantage, not absolute advantage, that makes gains from trade possible.By each party specialising in the area(s) they have the comparative advantage, total production is increased. This Gain in production will be shared out according to the prices resulting from the trade.