An Introduction to International Economics Chapter 2: Comparative Advantage Dominick Salvatore John Wiley & Sons, Inc. Dale R. DeBoer University of Colorado, Colorado Springs

The basic questions of international trade What is the basis of trade? Two answers to this question will be discussed in this chapter: Absolute Advantage and Comparative Advantage

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.

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?

The Mercantilists What is wealth? The Mercantilist answer was the stock of precious metals possessed by a country.

The Mercantilists What is wealth? How can precious metals be obtained? Extraction from naturally occurring stocks This option is available to few countries

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

The Mercantilists What is wealth? How can precious metals be obtained? The natural conclusion – exports must exceed imports for a country to become wealthy!

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.

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

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 A further look at the Mercantilists Federal Reserve Bank of San Francisco’s “Major Schools of Economic Theory” FRBSF WWW link

Is “wealth” precious metals? To the Mercantilists, yes.

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 a definition of wealth the differs significantly from modern notions of wealth. This distinction leads to very different conclusions about how to become a wealthy nation.

Absolute advantage Built on the ideas of Adam Smith The Library of Economic Liberty Biography of Adam Smith WWW Link

Absolute advantage Built on the ideas 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.

An example of absolute advantage Countries Scotland Mexico Goods Coffee beans Wool

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

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

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

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

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.

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.

Comparative advantage Built on the ideas of David Ricardo The New School History of Economic Thought Biography of David Ricardo WWW Link

Comparative advantage Built on the ideas of David Ricardo The law of comparative advantage shows how mutually beneficial specialization and trade may be driven by relative advantages in production rather than absolute advantages in production. Given the somewhat counter-intuitive nature of the law of comparative advantage its implications are best seen through example.

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.

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

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

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

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

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

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 4£ ÷ 1 unit = 4£ per unit 4£ x 10P/£ = 40P per unit

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 4£ ÷ 4 units = 1£ per unit 1£ x 10P/£ = 10P per unit

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 100P ÷ 10 units = 10P per unit

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 100P ÷ 5 units = 20P per unit

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.

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.

Does the source of the productive difference matter? No The original idea of comparative advantage was based on the labor theory of value. 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.

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 180 150 20 120 40 90 60 80 30 100

Constructing the PPF United States Wheat Cloth 180 150 20 120 40 90 60 150 20 120 40 90 60 80 30 100

Constructing the PPF United States Wheat Cloth 180 150 20 120 40 90 60 150 20 120 40 90 60 80 30 100

Constructing the PPF United States Wheat Cloth 180 150 20 120 40 90 60 150 20 120 40 90 60 80 30 100

Regions of the PPF Productive maximum Underutilized resources Unattainable with existing resources and technology

Trade with the PPF model Suppose the US and the UK have the PPFs given to the right

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 (90W, 60C) (40W, 40C)

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. (90W, 60C) (40W, 40C)

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. (110W, 70C) Production Production (70W, 50C)