Micro CHAPTER 1.4:

CHAPTER SUMMARY

Not all countries or communities produce things with the same efficiency. To get the best outcome, we need to analyze which countries are more efficient at producing things.

If a worker in Malaysia can produce 16 kilograms of rubber per day, but a worker in India can only produce 8 kilograms of rubber in the same amount of time, we would say that Malaysia has an absolute advantage - they are better at producing that thing. Now imagine a worker in Malaysia can also produce 4 kilograms of coffee beans per day, while a worker in India can only produce 1 kilogram per day. This means the Malaysian worker also has an absolute advantage in producing coffee.

The worker in Malaysia has a choice - work on a rubber plantation and produce 16 kg each day, work on a coffee farm and produce 4 kg each day, or produce some mix of the two (like 8 kg of rubber and 2 kg of coffee, if they split their time equally). The worker in India has to decide whether to work on the rubber plantation and produce 8 kg each day, work on a coffee farm and produce 1 kg each day, or do a bit of both (like 4 kg of rubber and 0.5 kg of coffee, if they split their time equally). Their Production Possibilities Curves would look like this:

If they don't interact with each other, their output would land somewhere on their PPC and they would get to use whatever they produce. However, there is a trick that would allow each person to get more than they can produce themselves. The Malaysian worker knows that for every 1 kg of coffee he produces, he has to give up 4 kg of rubber. This is his opportunity cost of producing coffee. Meanwhile, for each 1 kg of coffee that the Indian worker produces, he has to give up 8 kg of rubber. This means that the Malaysian worker has a lower opportunity cost to produce coffee (4:1 vs. 8:1). Having a lower opportunity cost to produce something is called a comparative advantage. The Malaysian has a comparative advantage in producing coffee.

On the flipside, for every 1 kg of rubber that the Malaysian worker produces, he has to give up 1/4 kg of coffee. However, the Indian worker only has to give up 1/8 kg of coffee to produce the same 1 kg of rubber. That means that the Indian worker has a lower opportunity cost to produce rubber, giving him a comparative advantage in growing rubber.

Under the economics of trade, each worker should focus on producing the thing in which they have a comparative advantage, and then trade with each other. Because the Malaysian worker has a comparative advantage in producing coffee, he should focus on that, making 4 kg of coffee. Because the Indian worker has a comparative advantage in producing rubber, he should focus on that, making 8 kg of rubber. They can then trade some of what they produced with each other. The Malaysian worker can give 1 kg of coffee to the Indian worker in exchange for 5 kg of rubber. After doing this, the Malaysian worker would now have 5 kg of rubber and 3 kg of coffee, and the Indian worker would now have 3 kg of rubber and 1 kg of coffee. As you can see on the PPCs below, these are more than either of them could have produced for themselves without trade - beyond their individual PPCs! They are both now better off than they were before.

To make sure both people are better off, they have to find the right terms of trade - the ratio at which they will trade with each other. To do this, they simply need to make sure that the trade agreement is better than their own opportunity cost to produce something. If the Malaysian worker had to give up 1/4 kg of coffee for each 1 kg of rubber and the Indian worker had to give up 1/8 kg of coffee for each 1 kg of rubber, the actual terms of trade should be somewhere in between these two numbers. I used 1/5 in my example, but anything in between 1/4 and 1/8 would benefit both countries.

It is important to remember that one country can have an absolute advantage in all things, but it cannot have a comparative advantage in all things because comparative advantage only considers opportunity costs.

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