PPF - Comparative Advantage and Absolute Advantage - Online Tutor, Practice Problems & Exam Prep

Understanding productivity differences among individuals or firms leads to the concepts of absolute and comparative advantage. Absolute advantage refers to producing more of a good with the same resources, while comparative advantage focuses on producing at a lower opportunity cost. To calculate opportunity cost, divide the maximum output of one good by the maximum output of another. This analysis helps determine who should specialize in which product, enhancing overall efficiency and potential gains from trade.

Two PPFs, Specialization, and Absolute Advantage

So now let's extend our discussion to include the idea that different people, and that could be firms or even countries, have different levels of productivity, which leads them to have different outcomes. A quick note I want to make is that we are going to be using linear models in this module, as you can see on the graphs, because it makes the math easier, and that's just how the textbooks do it. Other than that, the assumptions remain the same: we still have 2 goods, fixed technology, and fixed resources.

So, let's move on to the graphs. Imagine you are the president of the Economics Club at your university and you're organizing a big Economics Bash. Your friend, who just joined a fraternity, is also throwing a big bash. What do we have on our curve? We've got the 2 key essentials. Let's look at the graphs and see what your production possibilities are. As an economics major, if you only produced hunch punch, you could get 20 gallons. However, if you decided to produce only pizza rolls and neglect the hunch punch, which I think is a bad idea, you would get a total of 10 batches of pizza rolls—understanding that 10 pizza rolls wouldn't feed many people.

Now, let's look at your friend's graph for hunch punch. If they were to focus on producing only hunch punch, they would get 30 gallons. Similarly, with the pizza rolls, they could produce 30 batches. It looks like your friend is going to have a much better bash than you, right? They've got the resources and know-how to make both hunch punch and pizza rolls, making their bash more successful.

But what if I told you that you could be even better off than your current situation if you both specialized and traded? That is exactly what I'm going to show you now. Each of you could have a better bash than you could achieve just by yourselves. So let's go ahead and define specialization. Specialization means producing the goods you are best at producing. We need to define how we can determine what you're best at producing. You can produce 20 gallons of hunch punch but only 10 pizza rolls. Are you best at hunch punch or at pizza rolls? What can we say? Yes, you can make more hunch punch, but exactly how valuable is it?

First, let's talk about absolute advantage. Absolute advantage means producing more of a good with the same amount of resources. For instance, both of you have the same amount of time to prepare for this party; who can make more of each good? Regarding the pizza rolls, your friend can make 30 while you can only make 10. The same goes for hunch punch; you make 20 gallons, while your friend can make 30. So, it seems your friend has the absolute advantage in both. You might wonder how can we even trade? How can your weaker production match her production levels? Well, instead of looking for an absolute advantage, we are going to look for a comparative advantage.

Comparative advantage is defined as producing a good at a lower opportunity cost. There's always a comparative advantage when dealing with two separate goods. Someone is always going to have a comparative advantage in one good, and the other person in the other good. We are going to define how we calculate the opportunity cost in the next video. So let's go ahead and follow along.

Opportunity Costs and Comparative Advantage

Alright, so here we just have the graphs from the previous page, and let's go ahead and continue the discussion of comparative advantage. So, comparative advantage, we said, is producing a good at a lower opportunity cost, right? The lower opportunity cost. Remember, whenever you have two different options like this, one person is always going to have the comparative advantage in one product, and the other person in the other. So, it's just a matter of finding out who has which comparative advantage. Alright? Let's go ahead and start figuring out opportunity cost. So, we've got the steps to do it here.

The first thing you're going to do is choose an individual. So first, we're going to calculate either your opportunity cost or your friend's opportunity costs. Right? Then, we are going to identify the maximum for each good. So, we're only going to look at one graph at a time here, that's what I'm trying to portray. First, we're going to look only at your graph and then we'll look only at your friend's graph. Alright, we want to identify the maximum, so the maximum Pizza rolls if you didn't make hunch punch, right? What is the maximum amount of Pizza rolls you can make, and the maximum amount of hunch punch if you made no Pizza rolls?

And then, we're going to use this formula. Very simple. We're just going to do a division. You just have to be careful which one's on the top and the bottom. When you're finding the opportunity cost of say pizza rolls, then pizza rolls is on the bottom. Right? So you're going to divide max hunch punch by max pizza rolls, which is going to give us the opportunity cost of 1 pizza roll, and you can imagine it's vice versa for hunch punch. So let's start with your opportunity cost of 1 pizza roll. Alright, so let's go to our graph and let's find the maximum pizza rolls and maximum hunch punch that you can make.

So on our graph, before we had shown this as well, you could make 20 gallons of hunch punch or 10 batches of pizza rolls. Right? So your max hunch punch, hunch punch for you, the max hunch punch is going to be 20, and the max pizza rolls, I'll put PR for pizza rolls, is going to be 10. Okay? So let's take that information down here to the graph. Alright, so your max hunch punch was 20, your max pizza rolls was 10. Alright?

So if we're looking for the opportunity cost of 1 pizza roll for you, we're going to take our max hunch punch of 20 divided by our max pizza rolls 10. 20 divided by 10 gives us 2. So the opportunity cost of 1 pizza roll for you is 2 hunch punch that you're going to have to give up. You're going to give up 2 gallons of hunch punch for every pizza roll that you want to create. Alright, let's do the same thing with hunch punch. What's your opportunity cost of hunch punch? Right. So we have the same numbers right. We're still dealing with your graph so your max hunch punch is 20, your max pizza rolls is 10, so we're going to do the same thing. Remember it's the opposite now. Since hunch punch is what we're looking for, hunch punch is what's on the bottom of the fraction. So we're going to have the opposite here. I'm going to draw that line a little straight here. We've got 20 on the bottom because we're doing hunch punch, so hunch punch is on the bottom. Pizza rolls on top, 10, and we are going to get 10 divided by 20 is half, which is equal to 0.5. You are giving up 0.5 pizza rolls, so half a pizza roll for every gallon of hunch punch. So, every time you want one more gallon of hunch punch, you're going to have half of a pizza roll.

Let's do the same thing for your friend's graph. So let's find your friend's maximum pizza rolls and your friend's hunch punch. So if we look on the graph, the maximum amount of hunch punch up here was 30, right? 5, 10, 15, 20, 25, 30. Same over here, pizza rolls 30, so she actually has both max of 30. So, try to think of what that's going to do to the fraction, right. Let's go back down here and put this information in. We've got, let me go to the top here so I'm not in the way. Alright. So we've got HP. Her maximum hunch punch was 30, right? Her maximum pizza rolls were also 30. So in this case, it's hard to mess up the fraction but let's do it in the correct order anyway. When we're doing the opportunity cost of pizza rolls, max pizza rolls is on the bottom. So the max pizza rolls was 30, max hunch punch was 30, we're going to get 1, right? So for each additional pizza roll, she's going to have to give up 1 gallon of hunch punch. Okay. And for hunch punch, we're going to have those same numbers, right? But now hunch punch is on the bottom, so the hunch punch 30 is on the bottom. The pizza rolls 30 is on the top, and we are going to get 1 pizza roll. So for every gallon of hunch punch, your friend wants to produce, he has to give up 1 pizza roll.

So now we can figure out who has the comparative advantage in each product. Over here, we'll put the comparative advantage in pizza rolls, and over here the comparative advantage in hunch punch. Alright, so to see who has the comparative advantage, we have to see who has the lower opportunity cost. So, we're talking about pizza rolls, every time you want 1 more pizza roll, you give up 2 hunch punches. Your friend, when she wants 1 more pizza roll, she gives up 1 hunch punch. Your friend has comparative advantage in pizza roll production. Right? She has a lower opportunity costs.

Hunch punch, your opportunity cost of hunch punch is half a pizza roll, 0.5 pizza rolls while your friend's opportunity cost of hunch punch is 1 pizza roll. For each additional gallon, you only have to give up half a pizza roll, while your friend has to give up an entire pizza roll. So, hallelujah! You have a comparative advantage in hunch punch creation because your opportunity cost is lower. Cool. Alright, guys. Let's move on and see how this affects the trade.

Who has the absolute advantage in making scrambled eggs?

• A. Joe
• B. Carla
• C. No one

Who has the absolute advantage in making fresh squeezed orange juice?

• A. Joe
• B. Carla
• C. No One

Who has the comparative advantage in making scrambled eggs? 

• A. Joe
• B. Carla
• C. No one

Who has the comparative advantage in making fresh squeezed orange juice? 

• A. Joe
• B. Carla
• C. No one

Here’s what students ask on this topic:

What is the difference between absolute advantage and comparative advantage?

Absolute advantage refers to the ability of an individual, firm, or country to produce more of a good or service with the same amount of resources compared to others. In contrast, comparative advantage focuses on producing goods or services at a lower opportunity cost. This means that even if one party has an absolute advantage in producing all goods, they can still benefit from trade by specializing in the goods for which they have a comparative advantage. This specialization and trade can lead to more efficient resource allocation and increased overall production.

How do you calculate opportunity cost in the context of comparative advantage?

To calculate opportunity cost, you need to determine the maximum output of two goods. For example, if you can produce either 20 gallons of hunch punch or 10 batches of pizza rolls, the opportunity cost of producing one batch of pizza rolls is the amount of hunch punch you give up. The formula is:

$\frac{\mathrm{Max} \mathrm{Hunch} \mathrm{Punch}}{\mathrm{Max} \mathrm{Pizza} \mathrm{Rolls}}$

So, the opportunity cost of one pizza roll is 20/10 = 2 gallons of hunch punch. Conversely, the opportunity cost of one gallon of hunch punch is 10/20 = 0.5 pizza rolls.

Why is comparative advantage important in trade?

Comparative advantage is crucial in trade because it allows for specialization, which leads to more efficient resource allocation and increased overall production. When individuals, firms, or countries specialize in producing goods for which they have a lower opportunity cost, they can trade to obtain other goods at a lower cost than if they produced everything themselves. This specialization and trade result in mutual benefits, higher productivity, and improved economic welfare for all parties involved.

Can a country have a comparative advantage in producing all goods?

No, a country cannot have a comparative advantage in producing all goods. Comparative advantage is based on the concept of opportunity cost. Even if a country has an absolute advantage in producing all goods, it will still have a lower opportunity cost for some goods compared to others. This means that it will have a comparative advantage in producing certain goods while other countries will have a comparative advantage in producing different goods. This difference in opportunity costs is what makes trade beneficial.

How does specialization relate to comparative advantage?

Specialization is the process of focusing on the production of a particular good or service in which an individual, firm, or country has a comparative advantage. By specializing, they can produce more efficiently and at a lower opportunity cost. This specialization allows for increased overall production and efficiency. When specialized producers trade with each other, they can obtain other goods at a lower cost than if they tried to produce everything themselves, leading to mutual benefits and higher economic welfare.