Comparative Advantage

Figs and Peaches

Two fruits which until today I have rarely regarded important to my life, and more so important to understanding economics. But today I was humbled by the simplicity of fruit and trade. No I didn’t walk to a supermarket and compare the prices of what is ultimately the same fig or peach at varying price levels. I sat down in a classroom and considered the opportunity cost in the production of peaches or figs, within the scenario of being on an island which exclusively produces figs or peaches (i.e. a nation capable of trade).

The premise of what seemed like an amiable task, turned out to reveal the essence of trade and the benefit gained from engaging in trade. The simple definition of trade is the exchange of goods between two parties, but the real question to ask is what motivates us to trade?

Now as I am meandering my way into the topic of trade, and its benefits I must bring forward what has become an economic cliché of mentioning Adam Smith’s thoughts on the matter. Obviously, he was not the first to consider aspects of trade but it was his critique of Mercantilism alongside his development of what was to become the explanation for the need to trade. This extract summarises the basis of what was going to become the critique of mercantilism and the purpose of trade:

If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital which employs it, will not thereby be diminished, no more than that of the above-mentioned artificers; but only left to find out the way in which it can be employed with the greatest advantage.”

Adam Smith, The Wealth of Nations Book IV, Chapter II

Here, Smith notes the existence of a trade-off that benefits both parties involved. As the terms of trade are established in order to allow two nations who have specialised in the production of a given good to gain an advantage. The critique of mercantilism is clearer in David Hume’s use of the bullion example, which was in essence a supply of money issue. But Smith highlights the mercantilist’s inability to recognise absolute and comparative advantage. The final remark suggests that Smith was thinking in terms of what we would now consider a Production Possibility Frontier (PPF) in which trade will allow us to operate at a point outside of our original output.

Significantly, Smith had developed what was to become classical economics based on a Laissez-Fair approach, which encouraged free trade (removal of tariffs, and protectionism). However, it was not until the early 19th century when David Ricardo had begun to build up the theory of comparative advantage which facilitated the need for free trade and the benefits of trade even when a country has an absolute advantage in the products being traded.

Comparative Advantage:
“A country can produce a good at a lower opportunity cost than its direct competitor”

Absolute Advantage:
“A country is able to produce more of a good or service with the same amount of resources”

Now back to the figs and peaches, firstly it is important to establish why a country would be able to produce a product “better” than its competitor. This is where the factor of endowment comes into place; in accordance with this example it can take the form of an investment into human capital in order to educate the workforce so they know the correct growing conditions for peaches or figs.

Let’s assume that the islands are producing the following goods in the amounts stated, where they will specialise in the production of one good as they cannot maximise the production of both at the same time.

Picture1

Opportunity Cost:

If country A produces 300 peaches it gives up 600 figs, and if it produces 600 figs it gives up 300 peaches. Providing the ratios:

1 Fig – ½ Peach
1 Peach – 2 Figs

If country B produces 100 peaches it gives up 300 figs, and if it produces 300 figs it gives up 100 peaches. Providing the ratios:

1 Fig – ⅓ Peach
1 Peach – 3 Figs

So should there be trade?

Well, first who should export figs or peaches and who should import figs or peaches.

Country A has a lower opportunity cost in the production of peaches in comparison to country B, therefore, Country A should produces peaches as the only lose 2 figs per peach. So A has a comparative advantage in the production of peaches.

Country B has a lower opportunity cost in the production of figs in comparison to Country A, therefore Country B should produce figs as they only lose a 1/3 of a peach per fig. So B has a comparative advantage in the production of figs.

Terms of Trade:

Country A should trade 1 peach for between 2 figs & 3 figs. Below 2 figs they can produce it more effectively themselves, but above 3 country B can produce peaches themselves.

Country B should trade 1 fig for between ⅓ peach & ½ peach. Below ⅓ peach they can produce it more effectively themselves, but above ½ country A can produce figs themselves.

So the (approximate) terms will be:

1P: 2.5F for Country A
&
1F: 0.4P for Country B

This identifies the direct benefit of trade as the ability to go beyond the country’s original PPF, as now Country A can have approximately 150 more figs than before, and Country B can have approximately 20 more peaches. Even though Country A has an absolute advantage in the production of both peaches and figs, the differing comparative advantage means there is still a benefit to trade.

Is this the best model?

Well, not really. It is clear there are some major flaws in this ultimately very simply model of how trade occurs. Firstly, it can be noticed that once a third country is involved a different formulation is necessary, and the existence of a large range of goods makes it difficult to have a clear trade-off. Secondly, the model is based on the immobility of capital, of which we are living in a world where capital is increasingly mobile. Finally, the model would suggest that agrarian nations would remain agrarian thereby not developing but specialising in natural resource production, this would create a larger technological gap and also led to an increasing inequality gap between nations. One alternative is the competitive advantage model, but it fails to provide an outlook on the trade-off and opportunity cost, and has a greater dependence upon the assumption that labour and natural resources are abundant and don’t necessarily effect the economy.

Types of Unemployment

Structural:

Changes in labour skills demanded, leaving different groups unrequired e.g. 1980s manufacturing in the UK, Welsh miners, and Detroit in 1990

Cyclical:

People lose jobs in a recession (two consecutive quarters of negative growth) this has strong links with the business cycle. This can lead to structural unemployment as the market becomes more concentrated on different business sectors.

Frictional:

People are in between jobs looking for work, for example those recently fired or quit. This is linked with the bureaucracy and procedure of finding work, as it takes times for checks, assessments, and interviews. This is also created through labour laws, labour unions, and the time taken for wage negotiation.

Seasonal:

This is unemployment during a specific season. An example of this is a ski instructor during the summer or ice cream salesman during the winter. There are certain jobs which have an aspect of this such as agricultural workers as there Is a wait time between sowing and planting, and the time of harvest.

Geographical:

Those with the required skill to work, but the jobs are not located where they can work. For example hypothetically a teacher is trained in Scunthorpe but there are no teaching jobs there; they are all in London, and the teacher is unable to commute to London.

The most dominant types of unemployment are structural and frictional; currently there has been a rise in cyclical unemployment as a result of the financial crisis. When an economy struggles to grow or experiences negative growth there is usually a high rate of unemployment as there are parts of the economy that are underutilised.

Unemployment can be shown through a variety of graphical methods all with their own merits. The most common is a simply supply of labour and demand of labour graph. Unemployment can be simply displayed through an inward shift of aggregate demand, and also operation in a PPF that is not on the curve. There is also the Marginal Revenue Product of Labour which can be graphed and this is used to argue that minimum wage can be beneficial.

South Africa: Sink or Swim

South Africa is currently suffering from a high rate of unemployment making it difficult for the economy to grow. Forecasted growth rates have already been downscaled as the largest economy in Africa is struggling to meet targets. The countries main contributor to GDP can be identified as consumer spending and this is why the persistent unemployment is having a considerable effect on growth forecasts.

Key Terms:

Unemployment – “Those out of work, actively seeking work at the current wage rate”

GDP/Growth – Measured by the output of an economy (gross domestic product)

Consumer Spending – Spending on retail goods, energy consumption, transportation, housing costs, and other areas where disposable income is spent.

Due to the high levels of unemployment it can be noted that there is a decline in aggregate demand within the economy. Colen Garrow states that the retail sector is weakening and there is going to be pressure overall as there is a lack of demand. It can be noted that to an extent the South African economy is contracting as there has been increased inflation as a result of a cost-push and fall in aggregate demand (shown below).

Picture1

The shift for aggregate demand from AD to AD1 is a result of the rise in unemployment, the people have less spending power and therefore there is an overall decrease in consumer demand. The shift of aggregate supply is a result of the tightening credit environment as firms struggle to meet their costs. The red rectangle represents the inflationary response in the economy as a result of the shift in aggregate supply. So as a whole the South African economy has retracted as output has significantly decreased (resulting in forecasts for future growth to decline) and there has been an inflationary response, as the price level has increased.

There is also the factor of unemployment which is 24.9% falling from the peak during Q4 of 2012 at 25.5%.This is shown simply below with a demand and supply relationship of labour in South Africa.

Picture2

Currently in the market labour is only being demanded at the point of LD but the supply is at LS. This surplus of labour is the current unemployment. With so many out of work and seeking work it is clear that economy is not working to full capacity. If a production possibility frontier for the economy was shown it would be operating within the curve. This further explains the economies inability to have substantial growth.

Consumer spending has radically decreased, making it difficult for the economy to grow and therefore attempt to combat the unemployment. This is realised by the fact that private sector demand for credit dropped from 10.09% to 8.64%. This is why the retail sector is struggling, as the unemployment and inflation has led to the decline of demand.

The unemployment in South Africa can be seen as a combination of structural and cyclical unemployment. Mining has been one of the major consumers of labour in the region, and recent closing of mines and movement by companies to other African regions for mining has meant a structural change in labour demand. The cyclical unemployment is a result of the struggling economy, as different firms reduce the amount of people they employ to meet the higher costs of production.

In the short run the economy is not likely to recover, growth is a must if the government aims to combat the high rate of unemployment. It is essential to restore consumer confidence in the economy, and also enable people to obtain credit more easily as to restore the aggregate demand of the economy.

In the long run for the economy to attempt to maintain growth, eliminating unemployment is essential to attempt to get the economy working back at a point of the PPF. However this could lead to an inflationary response in the form of a demand pull, and the government will need to begin considering how to reduce already increasing inflation as a result of increasing production costs.

Currently in the South African economy the rate of unemployment is pulling it down, in this situation there are no winners within the country. Exports may become more favourable as the inflation will weaken the South African Rand, but make investing in South Africa unlikely. To solve the unemployment in South Africa is difficult as a result of its cyclical and structural qualities; the first step would be to create more job opportunities. However, it is also essential that a greater majority of people achieve education and training whether it is academic or vocational to help improve employability prospects.

Expected growth by 2014 is forecasted at around 3.4% which is still considerable in comparison to some countries in the EU. There is still risk though investing within the country and the government must do more to encourage foreign investment and begin a round of serious structural investment such as roads to create jobs and spur on growth.

There is the potential for South Africa to climb out of the current situation, and unemployment stands at the centre of it. The country is still Africa’s biggest economy and will continue to be so if it can achieve consistency with its currency and sustained growth.

Growth & Structural Reform

Production Possibility Frontier & Aggregate Supply:

There are many determinants for a shift in aggregate supply; this would mean an increase in real output without an increase in the price level.

Picture2

Some examples of the determinants are:

  • Education: Increased productivity, capabilities, and efficiency of the labour force
  • Innovation/R&D: The product may become more useful or easier to manufacture
  • Government Regulation or Subsidy: Encourages production, or deregulates an immobile market.
  • Transport/Infrastructure: If there was better transport then people could work more often rather than waste time in traffic,  development of infrastructure develops efficiency.

p2


Analysis from Article:

Using Evidence from the Article Explain the Impact of Investment on the UK’s PPF?

Increasing the quality of university education and teachers may mean that the workforce becomes more efficient and productive. The article highlights the need to invest in human capital. This would lead to an outward shit for the PPF because there is a greater potential for production. If this potential were to be realised there would be a shift to the right for the aggregate supply curve.

The article mentions that the government should target investment towards equipment rather than property, increasing government investment into R&D and general innovation. The lack of innovation is identified through the lack of patents submitted. The issue surrounding R&D and capital investments are the long pay-off periods, whereas financial products pay-off in the short term. If more money were to be invested in long term research and development projects there is an outward shift for the PPF as there is a higher possibility of products being manufactured with greater efficiency.

Finally, the article recognises that British infrastructure is considered “mediocre” being ranked 24th in the world. It relates this to government failure, and the amount of time it takes to get energy bills through and the time it takes for projects to come to fruition. If there were to a boost in infrastructure spending, then there is the potential for an increase in productivity leading to an outward shift in the PPF.

Evaluate the Argument That Structural Investments Alone Are Not Enough to Stimulate Growth?

There are many theories and manners of approaching how best to stimulate growth, the article heavily leans toward the Salter Cycle. This can be summarised as an increase in productivity and efficiency, resulting in reduced inputs of land, labour, and capital while achieving a great output. This what the article highlights as structural investment, i.e. improving education, improving transport, and stimulating research and development. This does work to stimulate growth however it must be realised that humans can only ever be so efficient or productive, and that factors such as capital and land become scarcer in developed countries.

It is true that the government needs to stimulate development within Britain; it is unacceptable to continue supporting financial institutions that don’t contribute to growth. Energy and energy efficiency are two factors which are integral to stimulating growth within an economy, simply because when there is a greater quantity of energy and at a cheaper price more is used. This is where the American government unlike the British government took a lead and has effectively introduced shale fracking to slash gas prices down and increase consumption. The British government has been slow to develop supporting infrastructure and R&D for the implementation of fracking, when a recent geology report displayed the abundance of shale formation across Britain. This highlights the need for structural investments, but into sectors that have optimistic prospects for the future.

The other methods of approaching growth stimulus can be equally as effective. There is the classical approach of increasing free trade between countries, and the development of trade agreements to stimulate production resulting in general economic growth. In the article there is a display of a real GDP per person graph, it shows that Britain had the highest real GDP in 1870. This was a time when Britain had abundant trade from its colonies (without restriction due to naval dominance and to an extent exploitation), and the expansion of trade into the “new world”.

Structural investment will assist Britain in re-modernising; however it can be argued that it is best suited to developing economies that still have a greater abundance of land, labour, and emerging capital. One possible route is the development of military infrastructure; this would mean creating more aircraft carriers and submarines. This has worked to an extent to help stimulate American growth as it announced that two new aircraft carriers are going to be developed, and the roll out of the successor to the F-22 Raptor.

Another possible approach to growth stimulation is to induce a state of semi-isolationism which had worked for East-Asian economies in the 90s. The crash for the East-Asian economies can be attributed to the liberalization of markets which had stifled growth due to speculation. Creating a state of semi-isolation reduces the inefficiency of market speculation, and makes a country more self-dependent, and this may be realised through structural investment. Overall, it can be recognised that structural investment are a necessity, but it must be coupled with a new economic approach to achieve not only growth but sustainable growth.

 

 

10 Terms to Know For Microeconomics

Production Possibility Frontier (PPF):

A production possibility frontier represents where resources can be allocated to produce certain amounts of a good in comparison to another good. It represents the choice the market has in production between two different goods, limited by the factor that certain resources are scarce.

Unemployment:

When there is surplus of labour which does not get utilised by the market. There are two manners in which to define unemployment. The first being the classic definition which states that if the price of employment increases above equilibrium there is more labour supplied but less demand. The second definition is “cyclical unemployment” where there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.

Infrastructure:

Infrastructure is the physical structures that are required for the operation of society and enterprise; it provides the means for an economy to function.

Supply:

Supply is the total amount of a good or service available for consumption at a given price at a certain moment in time.  The basis of the law of supply which states that as the price of good or service increases, the quantity supplied also increases.

Demand:

Demand is a consumer’s desire and willingness to purchase a good or service at a given price at a certain moment in time. The basis of the law of demand which states that as the price of a good or services decreases, the quantity demanded increases.

Market Failure:

Market Failure is when there is the inefficient allocation of resources, the existence of a negative externality on either the consumption or production of a good or service, and the existence of a monopoly power.

Externality:

An effect to a third party which was not accounted for in the price of the original transaction of the good, this can be either positive or negative.

Consumer & Producer Surplus:

Consumer surplus is where a consumer was willing to pay a price above equilibrium but only had to pay the equilibrium price, and producer surplus is where a producer was willing to produce at a price below equilibrium but was able to sell their good at equilibrium price.  Represented by the graph below:

P7 - Social Surplus

Public Good:

A public good is typically provided by the government, and it is meant to be non-rivalrous and non-excludable. Meaning that anyone can have access to it, you do not directly pay for it, and one person using it does not affect your usage of it. Some examples are street lighting, beaches, benches, and air.

Indirect Tax:

An indirect tax is paid through the consumption of good or services, whereas a direct tax is on your income. Examples of indirect taxes are Value Added Tax, Sales Tax, and Excise Tax. They provide a source of government income, and are a manner in which a negative externality can be resolved.