ECONOMIC SECOND EDITION in MODULES S Paul Krugman Robin Wells with Margaret Ray and David Anderson MODULE 4 Comparative Advantage and Trade Krugman Wells How trade leads to gains for an individual or an economy The difference between absolute advantage and comparative advantage How comparative advantage leads to gains from trade in the global marketplace 3 of 16 Gains from Trade The key to a much better standard of living for everyone is trade The reason we have an economy is that there are gains from trade Gains from trade arise from specialization 4 of 16 Production Possibilities for Two Castaways a Tom s Production Possibilities Figure 4 1 Quantity of coconuts 30 Tom s consumption without trade 9 Tom s PPF 0 28 40 Quantity of fish 5 of 16 Production Possibilities for Two Castaways b Hank s Production Possibilities Figure 4 1 Quantity of coconuts 20 Hank s consumption without trade 8 Hank s PPF 0 6 10 Quantity of fish 6 of 16 Tom and Hank s Opportunity Costs One fish One coconut Tom s Opportunity Cost Hank s Opportunity Cost coconut 2 coconuts 4 3 fish fish 7 of 16 Comparative Advantage and Gains from Trade Both castaways are better off when they each specialize in what they are good at and trade Tom should specialize in catching fish Hank should specialize in gathering coconuts 8 of 16 Comparative Advantage and Gains from Trade a Tom s Production and Consumption Quantity of coconuts 30 b Hank s Production and Consumption Quantity of coconuts Tom s consumption without trade Hank s production with trade Tom s consumption with trade Tom s production with trade 10 9 20 Hank s consumption with trade Hank s consumption without trade 10 8 Hank s PPF Tom s PPF 0 2830 40 Quantity of fish 0 6 10 Quantity of fish 9 of 16 How the Castaways Gain from Trade Both Tom and Hank experience gains from trade 10 of 16 Comparative Advantage and Gains from Trade An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people An individual has an absolute advantage in an activity if he or she can do it better than other people Having an absolute advantage is not the same thing as having a comparative advantage 11 of 16 Comparative Advantage and Gains from Trade Comparative advantage is the basis for trade Trade can be beneficial to both even if one has an absolute advantage in the production of both goods The PPF teaches two important lessons By agreeing to specialize and trade both traders can be better off Every has a comparative advantage in something 12 of 16 Rich Nation Poor Nation Most clothing is made overseas in countries that are much poorer than the U S The immediate reason for their poverty is that their economies are much less productive Even though these economies are much less productive these countries hold a comparative advantage in clothing production 13 of 16 Comparative Advantage and International Trade a The U S Production Possibilities Frontier b Canadian Production Possibilities Frontier Quantity of aircraf Quantity of aircraf U S consumption without trade U S consumption with trade 3 000 Canadian production with trade Canadian consumption without trade 2 000 1 500 1 500 Canadian consumption with trade U S production with trade 1 000 U S PPF 0 1 2 3 Quantity of pork millions of tons 0 0 5 1 Canadian PPF 1 5 Quantity of pork millions of tons 14 of 16 Comparative Advantage and International Trade International trade results from comparative advantage If the U S concentrates on producing pork and ships some of its output to Canada while Canada concentrates on aircraft and ships some of its output to the U S both countries can consume more than if they insisted on being self sufficient 15 of 16 1 A higher standard of living comes from specialization and trade 2 Comparative advantage explains the source of gains from trade between individuals and countries 3 Everyone has a comparative advantage in something 4 Absolute advantage is the ability to produce a particular good or service better than anyone else 16 of 16