Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Further assume that consumers in both countries desire both these goods. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. There is only one resource available in both countries, labor hours. Saudi Arabia can produce oil with fewer resources, while the United States can produce corn with fewer resources. Table 19.1 illustrates the advantages of the two countries, expressed in terms of how many hours it takes to produce one unit of each good.
|Country||Oil (hours per barrel)||Corn (hours per bushel)|
Table19.1 How Many Hours It Takes to Produce Oil and Corn
In Table 19.1, Saudi Arabia has an absolute advantage in the production of oil because it only takes an hour to produce a barrel of oil compared to two hours in the United States. The United States has an absolute advantage in the production of corn.
To simplify, let's say that Saudi Arabia and the United States each have 100 worker hours (see Table 19.2). We illustrate what each country is capable of producing on its own using a production possibility frontier (PPF) graph, shown in Figure 19.2. Recall from Choice in a World of Scarcity that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers, and its level of technology.
|Country||Oil Production using 100 worker hours (barrels)||Corn Production using 100 worker hours (bushels)|
Table19.2 Production Possibilities before Trade
Figure 19.2 Production Possibilities Frontiers (a) Saudi Arabia can produce 100 barrels of oil at maximum and zero corn (point A), or 25 bushels of corn and zero oil (point B). It can also produce other combinations of oil and corn if it wants to consume both goods, such as at point C. Here it chooses to produce/consume 60 barrels of oil, leaving 40 work hours that can be allocated to producing 10 bushels of corn, using the data in Table 19.1. (b) If the United States produces only oil, it can produce, at maximum, 50 barrels and zero corn (point A'), or at the other extreme, it can produce a maximum of 100 bushels of corn and no oil (point B'). Other combinations of both oil and corn are possible, such as point C'. All points above the frontiers are impossible to produce given the current level of resources and technology.
Arguably Saudi and U.S. consumers desire both oil and corn to live. Let's say that before trade occurs, both countries produce and consume at point C or C'. Thus, before trade, the Saudi Arabian economy will devote 60 worker hours to produce oil, as shown in Table 19.3. Given the information in Table 19.1, this choice implies that it produces/consumes 60 barrels of oil. With the remaining 40 worker hours, since it needs four hours to produce a bushel of corn, it can produce only 10 bushels. To be at point C', the U.S. economy devotes 40 worker hours to produce 20 barrels of oil and the remaining worker hours can be allocated to produce 60 bushels of corn.
|Country||Oil Production (barrels)||Corn Production (bushels)|
|Saudi Arabia (C)||60||10|
|United States (C')||20||60|
|Total World Production||80||70|
Table19.3 Production before Trade
The slope of the production possibility frontier illustrates the opportunity cost of producing oil in terms of corn. Using all its resources, the United States can produce 50 barrels of oil or 100 bushels of corn. So the opportunity cost of one barrel of oil is two bushels of corn – or the slope is 1/2. Thus, in the U.S. production possibility frontier graph, every increase in oil production of one barrel implies a decrease of two bushels of corn. Saudi Arabia can produce 100 barrels of oil or 25 bushels of corn. The opportunity cost of producing one barrel of oil is the loss of 1/4 of a bushel of corn that Saudi workers could otherwise have produced. In terms of corn, notice that Saudi Arabia gives up the least to produce a barrel of oil. These calculations are summarized in Table 19.4.
|Country||Opportunity cost of one unit – Oil (in terms of corn)||Opportunity cost of one unit – Corn (in terms of oil)|
Table19.4 Opportunity Cost and Comparative Advantage
Again recall that comparative advantage was defined as the opportunity cost of producing goods. Since Saudi Arabia gives up the least to produce a barrel of oil, ( in Table 19.4) it has a comparative advantage in oil production. The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production.<
In this example, there is symmetry between absolute and comparative advantage. Saudi Arabia needs fewer worker hours to produce oil (absolute advantage, see Table 19.1), and also gives up the least in terms of other goods to produce oil (comparative
advantage, see Table 19.4). Such symmetry is not always the case, as we will show after we have discussed gains from trade fully. But first, read the following Clear It Up feature to make sure you understand why the PPF line in the graphs is
When you first met the production possibility frontier (PPF) in the chapter on Choice in a World of Scarcity it was drawn with an outward-bending shape. This shape illustrated that as inputs were transferred from producing one good to another – like from education to health services – there were increasing opportunity costs. In the examples in this chapter, the PPFs are drawn as straight lines, which means that opportunity costs are constant. When a marginal unit of labor is transferred away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. It also illustrates economic themes like absolute and comparative advantage just as clearly.