Post on 17-Jan-2016
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An Introduction to International Economics
Second Edition
Comparative Advantage
Dominick SalvatoreJohn Wiley & Sons, Inc.
CHAPTER T W O
2
The basic questions of international trade What is the basis of trade?
Absolute Advantage Comparative Advantage
3
The basic questions of international trade
What is the basis of trade? What are the gains from trade?
The models of Absolute and Comparative Advantage show that the gains from trade are increased consumption gained through specialization in production and trade.
4
The basic questions of international trade
What is the basis of trade? What are the gains from trade? What is the pattern of trade?
What determines the pattern of specialization that drives international trade?
5
The Mercantilists
What is wealth? The Mercantilist answer was the stock
of precious metals possessed by a country.
6
The Mercantilists
What is wealth? How can precious metals be
obtained? Extraction from naturally occurring
stocks This option is available to few countries
7
The Mercantilists
What is wealth? How can precious metals be
obtained? Extraction from naturally occurring
stocks Earn precious metals through exports of
goods and services Since payment for exports is made with
precious metals, exporting causes precious metals to flow into a country
Similarly, since payment for imports is also made with precious metals, importing causes precious metals to flow out of country
8
The Mercantilists
What is wealth? How can precious metals be
obtained? The natural conclusion – exports
must exceed imports for a country to become wealthy!
9
The Mercantilists
What is wealth? How can precious metals be
obtained? The natural conclusion – exports
must exceed imports for a country to become wealthy!
Can this condition hold for all countries? No! Therefore, the wealth of one country must
come at the expense of another country.
10
The Mercantilists
What is wealth? How can precious metals be
obtained? The natural conclusion – exports
must exceed imports for a country to become wealthy!
Can this condition hold for all countries?
Mercantilist policy Strict government control over economic
activity to ensure a positive trade balance
11
Are precious metals “wealth”? To the Mercantilists, yes. Modern measures of wealth are
based on a country’s ability to produce the goods and services that improve quality of life. Hence, the Mercantilist conclusion is
based on a definition of wealth that differs significantly from modern notions of wealth.
This distinction leads to very different conclusions about how to become a wealthy nation.
12
Absolute advantage
Built on the ideas of Adam Smith The Library of Economic Liberty
Biography of Adam Smith Absolute advantage exists between
nations when they differ in their ability to produce goods. More specifically, absolute advantage
exists when one country is good at producing one item, while another country is good at producing another item.
13
An example of absolute advantage Countries
Scotland Mexico
Goods Coffee beans Wool
Units produced per hour
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
14
An example of absolute advantage
How does specialization and trade advantage Scotland? By reducing
coffee bean production, resources are freed for producing more wool
Each hour of production change costs 1 unit of coffee beans but gains 4 units of wool
Units produced per hour
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
15
An example of absolute advantage
How does specialization and trade advantage Scotland? Scotland can send
3 units of wool to Mexico and receive 7 units of coffee beans back
Thus, by specializing in production Scotland gains 1 unit of wool and 6 units of coffee per hour of production moved
Gains per hour of production moved
012
34567
89
10
Scotland Mexico
Coffeebeans
Wool
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An example of absolute advantage
Does specialization and trade also advantage Mexico? By reducing wool
production, resources are freed for producing more coffee beans
Each hour of production change costs 2 units of wool but gains 10 units of coffee beans
Units produced per hour
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
17
An example of absolute advantage
Does specialization and trade also advantage Mexico? Mexico can send 7
units of coffee beans to Scotland and receive 3 units of wool back
Thus, by specializing in production Mexico gains 1 unit of wool and 3 units of coffee beans per hour of production moved
Gains per hour of production moved
012
34567
89
10
Scotland Mexico
Coffeebeans
Wool
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Policy recommendations from absolute advantage Specialization and trade advantage
both countries Therefore, the best policy is to allow
producers and consumers in both countries unfettered access to goods from both countries to maximize the number of advantageous trades that can occur.
In other words, laissez-faire. The policy of minimum government
interference with economic activity.
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A fatal flaw?
Absolute advantage requires one country to be better at production of one product and another country to be better at production of another good for specialization and trade to be mutually advantageous.
What if one country is better at everything? The theory of comparative advantage
provides this answer.
20
Comparative advantage
Built on the ideas of David Ricardo The New School History of Economic Thought
Biography of David Ricardo WWW Link
The law of comparative advantage says a nation should specialize in and export the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage), and should import the other commodity. Implications of comparative advantage are best seen
through example.
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An example of comparative advantage
Countries Scotland Mexico
Goods Coffee beans Wool
The difference lies in the relative productivity of the countries In this case, Mexico is
more productive at generating both goods.
Units produced per hour
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
22
An example of comparative advantage
How does specialization and trade advantage Mexico? By reducing wool
production, resources are freed for producing more coffee beans
Each hour of production change costs 5 units of wool but gains 10 units of coffee beans
Units produced per hour
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
23
An example of comparative advantage
How does specialization and trade advantage Mexico? Mexico can send 9
units of coffee beans to Scotland and receive 7 units of wool back
Thus, by specializing in production Mexico gains 1 unit of coffee beans and 2 units of wool per hour of production moved
Gains per hour of production moved
012
34567
89
10
Scotland Mexico
Coffeebeans
Wool
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An example of comparative advantage
Does specialization and trade also advantage Scotland? It does. To see this
consider consider Scotland trading two hours of output.
Two hours of production change from coffee beans to wool costs 2 units of coffee beans but gains 8 units of wool
Units produced per hour
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
25
An example of comparative advantage
Does specialization and trade also advantage Scotland? Scotland can send
7 units of wool to Mexico, receiving 9 units of coffee beans in return
Thus, by specializing in production Scotland gains 1 unit of wool and 7 units of coffee beans
Gains per hour of production moved
012
34567
89
10
Scotland Mexico
Coffeebeans
Wool
26
Implications of comparative advantage Laissez-faire still holds
Gains need not be equal
Hours of work traded need not be equal but the advantage still exists
Trade is based on the existence of relative – not absolute – production advantages
27
Does money alter the story? No Suppose the costs of
production are as given below Mexico: 100
pesos/hour Scotland: 4
pounds/hour Suppose the
exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
4£ ÷ 1 unit = 4£ per unit
4£ x 10P/£ = 40P per unit
28
Does money alter the story? No Suppose the costs of
production are as given below Mexico: 100
pesos/hour Scotland: 4
pounds/hour Suppose the
exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool
4£ ÷ 4 units = 1£ per unit
1£ x 10P/£ = 10P per unit
29
Does money alter the story? No Suppose the costs of
production are as given below Mexico: 100
pesos/hour Scotland: 4
pounds/hour Suppose the
exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool
100P ÷ 10 units = 10P per unit
30
Does money alter the story? No Suppose the costs of
production are as given below Mexico: 100
pesos/hour Scotland: 4
pounds/hour Suppose the
exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool
100P ÷ 5 units = 20P per unit
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Does money alter the story? At these prices
goods will naturally flow from the cheaper market (Scotland for wool, Mexico for coffee beans) to the more expensive market.
Again, this demonstrates the law of comparative advantage but through prices not relative outputs.
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool
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Does the source of the productive difference matter? No The original idea of comparative
advantage was based on the labor theory of value. The labor theory of value holds that costs and prices
are solely determined by the labor content of an item.
The examples given above rely on opportunity cost. Opportunity cost holds that the cost of an item is the
amount of another item the must be given up to release sufficient resources to produce one more unit of the first item.
33
The production possibility frontier The production
possibility frontier (PPF) identifies the maximum combinations of two products that a nation can produce by fully utilizing all factors of production with the best technology available.
Consider the production possibilities schedule for an example:
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
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The production possibility frontier The production
possibility frontier (PPF) identifies the maximum combinations of two products that a nation can produce by fully utilizing all factors of production with the best technology available.
Consider the production possibilities schedule for an example:
United Kingdom
Wheat Cloth
60 0
50 20
40 40
30 60
20 80
10 100
0 120
35
Constructing the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
36
Constructing the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
37
Constructing the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
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Regions of the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
Productive maximum
Underutilized resources
Unattainable with existing resources and technology
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Trade with the PPF model
Suppose the US and the UK have the PPFs given to the right
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
40
Trade with the PPF model
Suppose the US and the UK have the PPFs given to the right
Further suppose that each country produces and consumes at the marked spot in the absence of international trade
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
(90W, 60C)
(40W, 40C)
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Trade with the PPF model
Can specialization and trade lead to more aggregate production and consumption?
If the US specialized in wheat production and the UK in cloth production, aggregate production would increase from 130W to 180W and from 100C to 120C.
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
(90W, 60C)
(40W, 40C)
42
Trade with the PPF model
This increased production would allow each country to consume at a point outside of its PPF as indicated by the blue lines in the graphs.
The increased consumption is the gains from trade.
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
(110W, 70C)
(70W, 50C)
Production
Production
43
Trade with the PPF model
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Cloth
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Cloth
(110W, 70C)
(70W, 50C)
Production