#Economics 101 ~ Absolute Advantage, Comparative Advantage, and the PPF

1 Oct

*As always, this is not intended to be professional advice. This was written with ESL students in mind, designed for a basic #Economics class. We simply hope that it may be helpful to other students trying to understand the concept.

UNDERSTANDING THE PPF

PPF.jpg

The two lines you see up above are called Product Possibility Frontiers or the PPF.

Situation: Vietnam (越南) and Thailand (泰国) both are given $500 to make Swords (剑) or Bows & Arrows (弓箭). Because their money is limited (有限) (there is an end to the money), both countries need to decide how many they should make. Problem: if they spend money on swords, that means less money for bows and arrows. And if they spend money on bows and arrows, that means less money available for swords. It’s a CHOICE (or in economics — a TRADE-OFF).

They have three choices: 1) Make only Swords. 2) Make only Bows and Arrows. 3) Make some of both.

The green line (Vietnam) shows all the possible combinations (组合) that Vietnam can make if it uses ALL the money ($500).

PPF T 1.jpg

Notice that the RED circle (4S + 10 B&A) is possible, but not very good (we call it inefficient (低效) because Vietnam COULD do better (4S + 30 B&A).

The PURPLE circle (10S + 40 B&A) is impossible because the best Vietnam can do with 10 S is make 15 B&A. They do not have enough money to make the Purple Circle. Tis a Pity!

The same is true for Thailand and the blue line.

This graph can be very helpful to Vietnam and Thailand because it shows them:

  1. What it is possible for them to do
  2. What is possible, but not efficient for them to do.

********************

ABSOLUTE ADVANTAGE AND THE PPF

PPF 2.jpg

Notice up above that the lines for Thailand and Vietnam are DIFFERENT.

For example, if Thailand uses all $500 on swords, they can only make 10 swords. But if Vietnam makes only swords, they can make up to 16 swords. That means Vietnam can make 6 more swords for the same amount of money.

The reason for this difference is that Vietnam and Thailand are paying different costs (成本) to make the sword.

  • Vietnam’s cost is $500/16swords = $31.25 per sword.
  • Thailand’s cost = $50.00 per sword.

Since Vietnam pays a lower cost for each sword, we say they have an absolute advantage (绝对优势). Absolute Advantage means that this country can create the product (产品) for a lower cost.

Practice Problem:

Question: Using the graph up above, which country has the absolute advantage in Bows & Arrows?

Solution: Look at the place on the graph where they both make ONLY bows and arrows (0 swords). Thailand can make 50 Bows and Arrows where Vietnam can only make 40.

Thailand has the absolute advantage in bows and arrows.

********************

OPPORTUNITY COST

Normally, when we think about the ‘cost’ of a product, we think about it like absolute advantage –> how much money do you lose to make a sword?

But there is also another cost: the opportunity cost ( ).

The opportunity cost is the lost SWORDS when a country makes BOWS & ARROWS. Or the lost BOWS & ARROWS when the country makes SWORDS.

Practical Example:

PPF T 2.jpg

Question: Let’s say that China has $100 and they decide they should make a new product. Which should they make? Wheat (小麦) or Flour (面粉)?

One Wheat has a profit (利润) of $12. One Flour has a profit of $11. Wheat is good!

Not so fast. . . . Remember, this is another PPF (because the money is limited  (有限)). If China makes Wheat, that means less money for Flour. 如果中国生产小麦,他们生产面粉的钱就会减少。 If China makes one Wheat, how much Flour did it sacrifice?

Answer: Look at the COST. It takes $8 to make 1 Wheat and $4 to make 1 Flour. So if China makes 1 Wheat, it spends $8 (2 Flours) to do that.

1 Wheat ($8 cost) = 2 Flour ($8 cost)

or 1 Wheat ($12 Profit) = 2 Flour ($22 Profit).

0_0 Making one wheat means you LOSE the opportunity to make an extra $10 profit! That’s not good! 不好!

We call the two flours the opportunity cost of wheat.

1 Wheat = 2 Flour

Practice Problem (2):

PPF 2

Question: Can you find the Opportunity Cost of 1 Sword for Thailand?

Solution: Remember that Thailand has $500.

  • If they make $500 cost of Swords, they make 10S
  • If they make $500 cost of Bows and Arrows, they make 50 B&A

10S ($500 cost) = 50 B&A ($500 cost)

  • 1S = 50/10 B&A = 5B&A
  • 1B&A = 10/50 S = 0.2S

ANSWER:

  • Opportunity Cost of 1 Sword is 5 Bows & Arrows
  • Opportunity Cost of 1 Bow and Arrow is 0.2 Swords.

********************

COMPARATIVE ADVANTAGE AND THE PPF

Absolute Advantage says that the country can make the product at a lower money cost.

Comparative Advantage says that a country can make the product at a lower opportunity cost.

Think about this PPF:

PPF 3.jpg

Question 1:

Who has the Absolute Advantage in Swords and Bows & Arrows?

Answer: This is easy! Vietnam can make more swords AND bows & arrows. So they have the absolute advantage in BOTH.

Question 2:

What has the Comparative Advantage in Swords and Bows & Arrows?

PPF T2

Answer:

Find the opportunity costs of each (remember Comparative Advantage is who has the lower opportunity cost).

Based on the table above,

Swords:

  • Vietnam loses 2.5 B&A for each sword
  • Thailand loses 2 B&A for each sword

THAILAND HAS THE COMPARATIVE ADVANTAGE IN SWORDS

Bows & Arrows:

  • Vietnam loses 0.4 S for each bow and arrow
  • Thailand loses 0.5 S for each bow and arrow

VIETNAM HAS THE COMPARATIVE ADVANTAGE IN SWORDS

YOUR TURN! Go back to your class and try to use these strategies on the examples from your textbook. Can you find the Absolute Advantage and Comparative Advantage? 

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: