Asymmetric information, bargaining, and comparative advantage in trade relationships: an interactive game.

1. Introduction

The concept of comparative advantage, that individuals or countries can gain from specializing in the activity in which their opportunity cost is lower, is a fundamental tool taught in economics. And although comparative advantage is used most extensively in classes relating to international trade, it is a concept introduced in virtually all principles of economics textbooks, and hence, presumably most principles classes. Yet, on first introduction of comparative advantage, the concept is often not fully grasped by the typical student. One reason for this is that the definition of comparative advantage itself does not lend to easy application in the real world. Telling students to specialize in activities with lower opportunity cost is often a foreign concept without proceeding further into the ideas of gains from specialization and terms of trade. In this paper, I present the layout of an interactive classroom game that highlights each of the essential elements of comparative advantage in a way that students can better grasp the underlying intuition and importance of this concept.

Classroom experiments emphasizing comparative advantage are not uncommon. Various authors have developed innovative classroom experiments to help students understand the notion of comparative advantage and the value of specialization and trade. For example, Stodder (1994) pairs students to represent either the United States or Mexico to show that gains from trade can exist despite one country having an absolute advantage in the production of all goods. In Haupert's (1996) experiment, students possessing one of four production functions attempt to achieve their respective consumption goals by interacting with other students. More recent papers have incorporated utility functions into their games. For example, Bergstrom and Miller (2000) developed a game that uses a simple utility function defined by the minimum quantity of two goods produced, whereas Anderson et al. (2005) introduced a Cobb-Douglas utility function to more realistically incorporate the role of preferences in trade. Last, a web-based game entitled the Ricardian Explorer offers an alternative approach to the traditional classroom game that is useful in classes where computers are readily available (Isgut, Ravishanker, and Rosenblat 2005).

In the game presented in this paper, I emphasize the role of asymmetric information and negotiation in trade relationships. Unlike prior games, there are no predetermined trade partners; instead, each student represents a distinct firm that can benefit from trade with nearly all other firms. The contribution of the game is that the extent of the gains from specialization depends on estimating the privately known production functions of other firms and negotiating the terms of trade on the basis of available information.

The procedure of the game is simple: Students representing firms with an endowed production function openly negotiate to form partnerships to increase their own profit. This game has wide application: it can be effective in a class with as few as four students and in a class with over 100 students, it can be played by principles of economics students as well as graduate students, and it can be played and discussed within a 50-minute class period.

2. Essential Elements of Comparative Advantage

The elements of comparative advantage can be described by the following: (i) individuals can have a comparative advantage in an activity (and benefit from specialization) despite not having an absolute advantage in that activity, (ii) the gains from specialization are greatest when individuals have the most heterogeneous skill sets, and (iii) the extent of each individual's share of the gains from specialization is often left to negotiation, with asymmetric information playing an influential role. Whereas most textbooks use a two-country, two-good Ricardian trade model to illustrate these elements, presenting comparative advantage in this manner in principles classes often does not lead to an easy understanding of how the gains from specialization are generated and shared. The following example presents an alternative approach to illustrate these features.

Assume that two brothers, Alex and Will, open a car wash service in their neighborhood, where a car will be washed and waxed by hand for a price of $10. Assume that there are 24 cars interested in the service, resulting in total revenues of $240. Further, assume the following productivity rates: Alex can wash a car in 15 minutes and wax a car in 30 minutes, while Will can wash a car in 20 minutes and wax a car in 1 hour. Table 1 presents these productivity rates in a simple matrix.

On the basis of Table 1, Alex has an absolute advantage in both activities and a comparative advantage in waxing, whereas Will has a comparative advantage in washing. Comparative advantage is determined by calculating the opportunity cost for an activity; for example, Will's opportunity cost of washing one car is the capacity to wax 1/3 of a car, which is lower than Alex's opportunity cost of washing one car, the capacity to wax 1/2 of a car. Next, we determine each brother's hourly wage rate if they divide the job in half, so that each has 12 cars to wash and wax and each earns $120. Using the productivity rates above, it would take Alex nine hours and Will 16 hours to complete the job, resulting in an hourly wage rate of $13.33 and $7.50, respectively. These wages represent the "autarky" equilibrium. When each brother specializes in the activity in which he has a comparative advantage, Will would wash all 24 cars in eight hours and Alex would wax all 24 cars in 12 hours. Using the hourly wage rates from autarky, Alex earns $160 and Will earns $60. Compared with the total wage of $240 under autarky, the brothers are able to complete the task at a cost savings of $20, which translates directly to the gains from specialization.

The final issue is how the $20 is to be shared. One consideration is that, compared with autarky, Alex is able to work more hours than Will. In this case, Will may demand more of the gains from specialization (resulting in a higher hourly wage) before he agrees to the partnership. Another thought, based on John Stuart Mill's "Theory of Reciprocal Demand," which states that a country with greater preference for trade will acquire less of the gains (Mill 2004), would suggest that the brother who most desires the partnership would gain less. Another possibility addresses the fact that constant returns to scale in production is assumed; if we assume that diminishing marginal returns occur with specialization, then more gains would accrue to the brother who is more able to maintain productivity. Last, if the brothers' parents supervise the project, the parents could arbitrarily distribute the gains or simply keep the gains (i.e., as company profits).

In sum, specializing in the activity in which each brother has a comparative advantage led to reduced production costs (as evidenced by lower total wages paid on the basis of autarky wage rates) and increased efficiency (as evidenced by fewer total hours worked). Resources (the brothers' labor) are allocated to their highest productivity, which allowed cars to be processed more quickly and potentially benefiting both brothers by sharing the gains from specialization that result in higher wage rates.

3. The Classroom Game

The classroom game is based on the example presented in section 2. Ideally, the concept of comparative advantage is first taught using the example in section 2 and then the setup of the classroom game is described, followed by each student receiving a preparation sheet to prepare for the game, which is most effective if played at the start of the following class period. Instructor preparation is minimal: completion of the student preparation sheets on the basis of the estimated number of participating students.

The game is based on a market of many small, perfectly competitive firms that help students format and proofread term papers for their classes. Each student in the class represents a firm (for larger classes, a group of students can represent one firm). Further, each firm provides services of equal quality with all other firms, and there is a standard pricing of $100 per 24 pages of manuscript (includes both formatting and proofreading), with no quantity discounts. The university, which regulates the firms to ensure consistent quality, also controls the price (which is identical for all firms). The difference between firms lies in the rate at which firms can format and proofread papers to the quality standard.

Assume that a standardized shipment of papers (a.k.a. project) consists of 240 pages of manuscript (in some combination of term papers) and is worth $1000 to the firm. Although there are an unlimited number of projects available, each firm is limited by time constraints. For the sake of simplicity, we assume constant returns to scale in each activity (which is consistent with the basic Ricardian model).

Before the game (preferably the class period prior), each student receives a preparation sheet (Appendix A) detailing the game as well as that student's confidential productivity rates. In real life, this confidential information is based on one's innate abilities. Both in this game and in real life, keeping information private can lead to greater gains when negotiating with other firms. The importance of private information must be emphasized to students.