Unit Five: International Trade Topic: Absolute and Comparative Advantage

Learning Goals 1.I will be able to determine absolute and comparative advantage in order to establish terms of trade.

Definitions Absolute advantage – producing more with the same amount of resources or producing one output with fewer inputs. Comparative advantage – producing at a lower opportunity cost (giving up less of another good).

David Ricardo David Ricardo based his concept of comparative advantage on an extension of Adam Smith’s ideas regarding specialization. According to Ricardo’s theory of comparative advantage, all trading partners will benefit from specializing and trading, even if one of the partners is better at all economic activities.

Comparative Advantage Rule Specialization and trade are beneficial if there is a difference in opportunity costs.

Comparative Advantage Process 1.Is there a difference in opportunity costs? If yes, then are they increasing, decreasing or constant? If no, STOP! Trade is not advantageous. 2.Is it an input or output problem? Input – are you looking at the number of resources required to produce one unit? Output – are you looking at how many goods you are producing? 3.What are the ratios? Fill in the chart – remember OOO or IOU. 4.Who has the lowest opportunity cost? 5.What are the terms of trade?

Output Problem For output problems, opportunity cost goes over when determining ratios (OOO). Computers Opp. Cost of one computer Tomatoes Opp. Cost of one tomato U.S Mex Which country has the absolute advantage in computers? In tomatoes? 2. Which country has the lowest opportunity cost (comparative advantage) in computers? In tomatoes? 3. What are the terms of trade?

Output Problem - Answer Computers Opp. Cost of one computer Tomatoes Opp. Cost of one tomato U.S Mex Which country has the absolute advantage in computers? In tomatoes? Both – U.S. 2. Which country has the lowest opportunity cost (comparative advantage) in computers? U.S. In tomatoes? Mexico 3. What are the terms of trade? Between 100 and 400 tomatoes for one computer or between.0025 and.01 computers for one tomato. 5000/50 => 1C = 100T 4000/10 => 1C = 400T 50/5000 => 1T =.01C 10/4000 => 1T =.0025C

Input Problem For input problems, opportunity cost goes under when determining ratios (IOU). Labor hrs. per Computer Opp. Cost of one computer Labor hrs. per MP3 player Opp. Cost of one MP3 player U.S.32 Japan31 1. Which country has the absolute advantage in computers? In MP3 players? 2. Which country has the lowest opportunity cost (comparative advantage) in computers? In MP3 players? 3. What are the terms of trade?

Input Problem - Answer 1. Which country has the absolute advantage in computers? Neither In MP3 players? Japan 2. Which country has the lowest opportunity cost (comparative advantage) in computers? U.S. In MP3 players? Japan 3. What are the terms of trade? Between 1.5 and 3 MP3 players for one computer or between.33 and.67 computers for one MP3 player. Labor hrs. per Computer Opp. Cost of one computer Labor hrs. per MP3 player Opp. Cost of one MP3 player U.S.32 Japan31 3/2 => 1C = 1.5M 3/1 => 1C = 3M 2/3 => 1M =.67C 1/3 => 1M =.33C