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31.14: Comparative Advantage

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    47677
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    Comparative advantage explains why individuals and countries trade with each other. Trade is at the heart of modern economies: individuals specialize in production and generalize in consumption. To consume many goods while producing relatively few, individuals must sell what they produce in exchange for the output of others. Countries likewise specialize in certain goods and services and import others. By so doing, they obtain gains from trade.

    Table 31.2.4 "Hours of Labor Required" shows the productivity of two different countries in the production of two different goods. It shows the number of labor hours required to produce two goods—tomatoes and beer—in two countries: Guatemala and Mexico. From these data, Mexico has an absolute advantage in the production of both goods. Workers in Mexico are more productive at producing both tomatoes and beer in comparison to workers in Guatemala.
    Tomatoes (1 Kilogram) Beer (1 Liter)
    Guatemala 6 3
    Mexico 2 2

    Table \(\PageIndex{4}\): Hours of Labor Required

    In Guatemala, the opportunity cost of 1 kilogram of tomatoes is 2 liters of beer. To produce an extra kilogram of tomatoes in Guatemala, 6 hours of labor time must be taken away from beer production; 6 hours of labor time is the equivalent of 2 liters of beer. In Mexico, the opportunity cost of 1 kilogram of tomatoes is 1 liter of beer. Thus the opportunity cost of producing tomatoes is lower in Mexico than in Guatemala. This means that Mexico has a comparative advantage in the production of tomatoes. By a similar logic, Guatemala has a comparative advantage in the production of beer.

    Guatemala and Mexico can have higher levels of consumption of both beer and tomatoes if they trade rather than produce in isolation; each country should specialize (either partially or completely) in the good in which it has a comparative advantage. It is never efficient to have both countries produce both goods.

    Key Insights

    • Comparative advantage helps predict the patterns of trade between individuals and/or countries.
    • A country has a comparative advantage in the production of a good if the opportunity cost of producing that good is lower in that country.
    • Even if one country has an absolute advantage in all goods, it will still gain from trading with another country.
    • Although this example is cast in terms of countries, the same logic is also used to explain production patterns between two individuals.

    The Main Use of This Tool

    31.14 Costs of Production

    The costs of production for a firm are split into two categories. One type of cost, fixed costs, is independent of a firm’s output level. A second type of cost, variable costs, depends on a firm’s level of output. Total costs are the sum of the fixed costs and the variable costs.

    The change in costs as output changes by a small amount is called marginal cost. It is calculated as follows:

    Because fixed costs do not depend on the quantity, if we produce one more unit, then the change in total cost and the change in the variable cost are the same. Marginal cost is positive because variable costs increase with output. Marginal cost is usually increasing in the level of output, reflecting the diminishing marginal product of factors of production.

    For example, suppose that total costs are given by

    \[total\ costs = 50 + 10 \times quantity.\]

    Here the fixed cost is 50, and the variable cost is 10 times the level of output. In this example, marginal cost equals 10. These costs are shown in Table 31.2.5.

    Output Fixed Cost Variable Cost Total Cost
    0 50 0 50
    10 50 100 150
    20 50 200 250
    50 50 500 550

    Table \(\PageIndex{5}\)

    We sometimes divide fixed costs into two components: entry costs, which are the one-time fixed costs required to open a new business or set up a new plant, and fixed operating costs, which are the fixed costs incurred regularly during the normal operation of a business.

    Some costs are sunk costs; once incurred, these costs cannot be recovered. Such costs should be ignored in forward-looking business decisions. Other costs are partially or fully recoverable costs. For example, if a firm purchases an asset that can be resold, then the cost of that asset is recoverable.

    3c1318c8634f79e7df03e1d16f325776.jpg
    Figure \(\PageIndex{11}\): Cost Measures

    Figure 31.2.11 "Cost Measures" shows these various measures of costs. It is drawn assuming a fixed cost of 50 and variable costs given by

    \[variable\ costs = 10 \times quantity + 0.1 \times quantity^{2}.\]

    For this example, marginal cost is positive and increasing.

    Key Insights

    • Fixed costs are independent of the level of output, whereas variable costs depend on the output level of a firm.
    • Pricing decisions depend on marginal costs.
    • Decisions to enter and/or exit an industry depend on both fixed and variable costs.

    31.14: Comparative Advantage is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

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