2 Learning ObjectivesExplain comparative advantage as the basis of trade.Identify the difference between absolute and comparative advantage.Calculate gains from trade in a 2x2 model.Illustrate comparative advantage using production possibility frontiers.
3 Assumptions of the Ricardian Model A 2-country, 2-commodity worldPerfect competitionNo transportation costsFactors mobile internally, immobile internationallyConstant costs of productionFixed technology for each countryAll resources are fully employedThe “labor theory of value” holds
4 Notation Let: ax = labor time to produce 1 X in country A ay = labor time to produce 1 Y in country Abx = labor time to produce 1 X in country Bby = labor time to produce 1 Y in country B
5 Comparative Advantage Defined Country A has a comparative advantage in good X if:(Px/Py)A < (Px/Py)B OR ifax/ay < bx/by OR ifax/bx < ay/byIf country A has a comparative advantage in good X, country B must have a comparative advantage in good Y.
7 Comparative Advantage Since the U.S.’s APR for corn is lower than Mexico’s (1/5 < 1/2), the U.S. must have a comparative advantage in corn.Since Mexico’s APR for blankets is lower than the U.S.’s (2 < 5), Mexico must have a comparative advantage in blankets.
8 Comparative Advantage and the Total Gains from Trade Ricardo’s argument is that trade will be mutually advantageous as long as the two countries’ autarky price ratios are different.How do we know that this is true?
9 Comparative Advantage and the Total Gains from Trade The Production Possibilities Frontier (PPF) is the set of all combinationsTable 3ClothWinePrice Ratio in AutarkyCountry A1 hr / yd3 hr / bottle1W: 3CCountry B2 hr / yd4 hr / bottle1W: 2C
10 Comparative Advantage and the Total Gains from Trade Lets assume that Country A has 9,000 labor hours available and Country B has 16,000 labor hours available.Then, using Table 3,Country A can produce a maximum of 9,000 yards of cloth (9,000 / 1 hr per yard) with no wine production and it can produce a maximum of 3,000 bottles of wine (9,000 / 3 hr per bottle) with no cloth production.Similarly, Country B can produce a maximum of 8,000 yards of cloth (16,000 / 2 hr per yard) with no wine and a maximum of 4,000 bottles (16,000 / 4 hr per bottle) with no cloth production.If we assume that these two countries exchange at the terms of trade 1 W:2.5 C.We also assume that country A exchanges 2,500 yards of cloth for 1,000 bottles of wine.
11 Comparative Advantage and the Total Gains from Trade What are the gains from trade for these two countries if any?Country ABefore TradeAfter TradeCloth Production6,000 CCloth Consumption6,000 – 2,500(exported cloth) = 3,500 CWine Production1,000 W1,000 WWine Consumption(1,000 before trade+ 1,000 imported wine) = 2,000 WREQUIRED LABOR HOURS OF PRODUCTION[ (6,000 *1 ) + (1,000 * 3) ] = 9,000[ (3,500 * 1) + (2,000*3) ] = 9,500
12 Comparative Advantage and the Total Gains from Trade What are the gains from trade for these two countries if any?Country BBefore TradeAfter TradeCloth Production3,000 CCloth Consumption3, ,500(imported cloth) = 5,500 CWine Production2,500 WWine Consumption(2,500 before trade - 1,000 exported wine) = 1,500 WREQUIRED LABOR HOURS OF PRODUCTION[ (3,000 *2 ) + (2,500 * 4) ] = 16,000[ (5,500 * 2) + (1,500* 4) ] = 17,000
13 Comparative Advantage and the Total Gains from Trade What are the gains from trade for these two countries if any?Gains from Trade (in terms of labor hours)Country A:After trade, residents of country A could consume 3,500 C and 2,000 W which would require 9,500 hours of labor so gains from trade is 500 hours (9,500-9,000)Country B:After trade, consumption of residents by country B would require 17,000 hours of labor so gains from trade is 1,000 hours (17,000-16,000)
14 Comparative Advantage and the Total Gains from Trade The Production Possibilities Frontier (PPF) is the set of all combinations of goods that a country is capable of producing, given available technology and resources.Suppose in our example the U.S. has 1000 hours of labor available and Mexico has 1800.
16 U.S. Production Possibilities Corn1000Slope: rise/run = -1000/200 = -5A500100200Blankets
17 Slope of the PPF for this example, -5 Notice: the slope (in absolute value) is the APR of the good on the horizontal axis.Therefore, the slope is the opportunity cost of the good on the horizontal axis.The slope is also the marginal rate of transformation.
18 Mexico’s Production Possibilities Corn600Slope = -2,or the opportunity cost of blanketsB300Blankets150300
19 Classical Model: The Gains from Trade Suppose that in autarky, the U.S. is at point A, producing and consuming 500 corn and 100 blankets.Suppose that in autarky, Mexico is at point B, producing and consuming 300 corn and 150 blankets.
20 U.S. Production Possibilities Corn1000A500100200Blankets
21 Mexico’s Production Possibilities Corn600B300150Blankets300
22 Classical Model: The Gains from Trade Suppose now that the U.S. and Mexico agree to trade at an “exchange rate” of 1B = 3.33C (or, 1C = .3B).If the U.S. specializes in corn, how many units of corn could it produce?If Mexico specializes in blanket manufacture, how many blankets could be made? 300.
23 The Gains from Trade: U.S. If the U.S. wants to continue to consume 500C, they will now have 500C to trade for blankets.If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how many blankets can the U.S. get in exchange for 500C?150Therefore, the U.S. can consume outside its PPF (to point C) by trading!
24 U.S. Production Possibilities Corn1000AC500100150200Blankets
25 The Gains from Trade: Mexico If Mexico wants to continue to consume 150B, they will now have 150B to trade for corn.If the “exchange rate” is 1B = 3.33C (or, 1C = .3B), how much corn can Mexico get in exchange for 150B?500Therefore, Mexico can also move outside its PPF (to point D) by trading!
26 Mexico’s Production Possibilities Corn600D500B300150Blankets300
27 The Gains from TradeNote: In general, the Ricardian model results in complete specialization.However, in trade between a small and a large country the small country may not be able to produce enough to satisfy the large country; the large country might then partially specialize.
28 The Consumption Possibilities Frontier (CPF) The CPF is a collection of points that represent combinations of corn and blankets that a country can consume if it trades.
29 U.S. Consumption Possibilities Corn1000AC500CPF100150200300Blankets
30 The Consumption Possibilities Frontier (CPF) The CPF’s slope is the same as the terms of trade.The CPF pivots around the production point.If trade is to the benefit of a country, the CPF lies outside the PPF.
32 The Limits to Mutually Advantageous Trade “Exchange rate” must be at least as great as Mexico’s APR.“Exchange rate” must be no greater than the U.S.’s APR.Bottom line: we still don’t know how the terms of trade will be determined, but they must be between the countries’ APRs if trade is to be mutually beneficial.Mexico’s APR: 1B = 2C; why trade if U.S. isn’t paying more than that? Also, Mexico can buy corn for ½ a blanket; why import if U.S. sells at a higher price than that?
33 The CPF and “Small” Countries The nearer are the terms of trade to a country’s APR, the less that country will gain from trade.The farther away the terms of trade are from a country’s APR, the more that country will gain from trade.Moral: to Ricardo, small countries stand to gain a lot from trade, large countries gain less.