Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 3 Comparative Advantage and the Gains from Trade

Introduction: The Gains from Trade The improvement in national welfare is known as the gains from trade Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-2

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-3 Adam Smith 1776, Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations –Attacked mercantilism—it dominated economic thought in the 1700s –Proved wrong that trade was a zero sum game that the gain of one nation from trade was the loss of another –Voluntary exchange (trade) is a positive sum game —both nations gain

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-4 Implications of Adam Smith’s Theory Specialization is important Key to wealth creation is access to international markets –Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs

Adam Smith and Trade Barriers Highly critical of trade barriers Trade barriers decrease - Specialization - Technological progress - Wealth creation Widely accepted by modern economists Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-5

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-6 A Simple Model of Production and Trade Referred to as the Ricardian model, named after economist David Ricardo Assumptions –Markets are competitive: Firms are price takers –Static world: Technology is constant and there are no learning effects –Labor is perfectly mobile: It can easily move back and forth between industries

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-7 Absolute Productivity Advantage and the Gains from Trade –Productivity: The amount of output obtained from a unit of input –Labor productivity: (units of output) / (hours worked) –Absolute productivity advantage: Country that produces more of a certain good per hour worked

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-8 TABLE 3.1 Output per Hour Worked

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-9 Absolute and Comparative Productivity Advantage Contrasted Benefits from trade have nothing to do with country’s absolute advantage. Comparative productivity advantage (or comparative advantage): Country has lower opportunity costs of producing a good than its trading partners Comparative advantage allows a country that lacks absolute advantage to sell its products abroad

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Production Possibilities Curve (PPC) A production possibilities curve (PPC) shows the tradeoffs a country faces when choosing between two goods

Copyright © 2011 Pearson Addison-Wesley. All rights reserved The Price Line or Trade Line Autarky: The complete absence of trade; all nations can only consume the goods they produce at home

Case Study – Comparative Advantage in Single Natural Resource Copyright © 2011 Pearson Addison-Wesley. All rights reserved –Comparative advantage in crude largely depends on endowment –Oil is valuable resource, so develop oil industry –Becomes difficult to develop other economic activities –Only Saudi Arabia, Kuwait and United Arab Emirates (UAE) are high income

Case Study – Comparative Advantage in Single Natural Resource Copyright © 2011 Pearson Addison-Wesley. All rights reserved –Resource Curse: negative economic effects when country has single, valuable resource –Difficult to develop diversified, educated work force –National income greatly impacted when price of dominant commodity changes –Can lead to political strife

Table 3.2 Ten Largest Oil Reserves Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-14

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Domestic Prices and the Trade Price If trade price is 4 loaves/ton: –Nothing changes for US –Canada will also specialize in steel and trade for bread –Nobody is producing bread –Shortage of bread, surplus of steel: bread price increases and steel price falls –World price falls to less than 3.

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 3.3 Output per Hour Worked

Table 3.4 Indicators of the Korean Economy Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-17

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Changing Comparative Advantage Since 1960, real per capita income in Republic of Korea grew 5.6% After Korean War, grew economy by limiting imports and concentrate on import substitutes. In 1960, removed import barriers and promoted export oriented industries Evolved from simple goods and few skills to capital goods with more skills and capital Now high income country capable of exporting technologically advanced goods

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Changing Comparative Advantage Comparative advantage can change and can increase incomes and product development, but need: –Development of education and research –Organizational changes –To raise financial capital

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Comparative Advantage and “Competitiveness” Comparative advantage = competitive advantage when the prices of both inputs and outputs are an accurate indication of their relative scarcity Comparative advantage ≠ competitive advantage when the markets fail to correctly value the price of inputs and outputs - Imbalances result from government policies, such as subsidies or protection

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Economic Restructuring Economic restructuring: Changes in the economy that may require some industries to grow and others to shrink or disappear –Often due to increased foreign competition –If there’s a net gain from trade, economic gains from winners exceed losses of losers –Increased foreign competition can create new problems

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Economic Restructuring Government can pass policies to make adjustment less painful –Increases support for free trade –Trade adjustment assistance (TAA) Provides extended unemployment benefits, and worker retraining

Table 3.5 Low-Cost and High-Cost Cotton Producers Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-23

Table 3.5 (continued) Low-Cost and High-Cost Cotton Producers Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 3-24