Module 4: Trade & Comparative Advantage Economies always produce more and obtain a higher standard of living when each economy specializes in a specific task and then trades with another. The process of globalization.

Gains from Trade The key to a much better standard of living for everyone is trade. The reason we have an economy is that there are gains from trade. (Rather than operating individually) Gains from trade arise from specialization. (Focusing on one task) Normally a nation’s economy cannot produce or consume beyond its PPC, BUT with trade based on comparative advantage, two nations can consume beyond their own PPC. 2 of 16

Comparative Advantage And Gains from Trade KEY CONCEPT Anytime two nations or people have different opportunity costs then there is the opportunity to gain from trade

Production Possibilities for Two Castaways: Tom and Hank Figure 4.1 (a) Tom’s Production Possibilities by himself Quantity of coconuts 30 Tom’s consumption without trade Figure Caption: Figure 4.1 - Production Possibilities for Two Castaways Here, each of the two castaways has a constant opportunity cost of fish and a straight-line production possibility frontier. In Tom’s case, each fish always has an opportunity cost of 3⁄4 of a coconut. 9 Tom’s PPF 28 40 Quantity of fish 4 of 16 4

(b) Hank’s Production Possibilities by himself Figure 4.1 (b) Hank’s Production Possibilities by himself Quantity of coconuts 20 Hank’s consumption without trade Figure Caption: Figure 4.1 - Production Possibilities for Two Castaways Here, each of the two castaways has a constant opportunity cost of fish and a straight-line production possibility frontier. In Hank’s case, each fish always has an opportunity cost of 2 coconuts. 8 Hank’s PPF 6 10 Quantity of fish 5 of 16 5

Tom and Hank’s Individual Opportunity Costs Tom’s Opportunity Cost Hank’s Opportunity Cost One fish ¾ coconut 30C/40F 2 coconuts 20C/10F One coconut 4/3 fish 40F/30C ½ fish 10F/20C 6 of 16

Tom should specialize in catching fish. Both castaways are better off when they each specialize in what they are good at and trade. Tom should specialize in catching fish. Hank should specialize in gathering coconuts. 7 of 16

(a) Tom’s Production and Consumption (b) Hank’s Production and Consumption Quantity of coconuts Quantity of coconuts 30 Tom’s consumption without trade Hank’s production with trade Tom’s consumption with trade 20 Hank’s consumption with trade By specializing and trading, the two castaways can produce and consume more of both goods. Tom specializes in catching fish, his comparative advantage, and Hank— who has an absolute disadvantage in both goods but a comparative advantage in coconuts—specializes in gathering coconuts. The result is that each castaway can consume more of both goods than either could without trade. Tom’s production with trade 10 10 Hank’s consumption without trade 9 8 T o m 's Hank's PPF PPF 28 30 40 Quantity of fish 6 10 Quantity of fish 8 of 16 8

KEYS TO KNOW An individual has a Comparative Advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people. * Tom’s OC for a Fish is ¾ of a Coconut * Hank’s OC for a Fish is 2 Coconuts-Tom’s OC for 1 Fish to a Coconut is less than Hank’s, So Tom should focus on Fish! * Tom’s OC for a Coconut is 4/3 of a Fish * Hank’s OC for a Coconut is ½ of a Fish-Hank’s OC for 1 Coconut to a Fish is less than Tom’s, So Hank should focus on Coconuts! An individual has an Absolute Advantage in an activity if he or she can do it better than other people. Having an absolute advantage is not the same thing as having a comparative advantage. * Tom has a Absolute Advantage over Hank in both Catching Fish and Gathering Coconuts! 9 of 16 9

By agreeing to specialize and trade, both traders can be better off. Comparative advantage is the basis for trade. Trade can be beneficial to both even if one has an absolute advantage in the production of both goods. By agreeing to specialize and trade, both traders can be better off. Everyone has a comparative advantage in something. 10 of 16

Rich Nation, Poor Nation Most clothing is made overseas in countries that are much poorer than the U.S. The immediate reason for their poverty is that their economies are much less productive. Even though these economies are much less productive, these countries hold a comparative advantage in clothing production. Why? 11 of 16

International trade results from comparative advantage. If the U.S. concentrates on producing pork and ships some to Canada, & Canada concentrates on aircraft and ships some to the U.S., both countries can consume more than if they insisted on being self-sufficient. 12 of 16

(a) The U.S. Production Possibilities Frontier (b) Canadian Production Possibilities Frontier Quantity of aircraft Quantity of aircraft Canadian production with trade 3,000 U.S. consumption without trade U.S. consumption with trade Canadian consumption without trade 2,000 1,500 1,500 U.S. production with trade Canadian consumption with trade Figure Caption: Figure 2.6: Comparative Advantage and International Trade In this hypothetical example, Canada and the United States produce only two goods: pork and aircraft. Aircraft are measured on the vertical axis and pork on the horizontal axis. Panel (a) shows the U.S. production possibility frontier. It is relatively flat, implying that the United States has a comparative advantage in pork production. Panel (b) shows the Canadian production possibility frontier. It is relatively steep, implying that Canada has a comparative advantage in aircraft production. Just like two individuals, both countries gain from specialization and trade. 1,000 U .S. Canadian PPF PPF 1 2 3 0.5 1 1.5 Quantity of pork (millions of tons) Quantity of pork (millions of tons) 13 of 16 13

United States Canada Pork (Mill of Tons) Aircraft 1500 1500/3 2000 3000/1.5 Aircraft .002 3/1500 .0005 1.5/3000

Everyone has a comparative advantage in something. A higher standard of living comes from specialization and trade and thus globalization is ultimately a benefit for all nations economically. Comparative advantage explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something. Absolute advantage is the ability to produce a particular good or service better than anyone else. 15 of 16