1. © Pilot Publishing Company Ltd. 2005 Chapter 10 International Trade I --- The Law of Comparative Advantage

2. © Pilot Publishing Company Ltd. 2005 The law of comparative advantage Distribution of gains from trade Graphical illustration of international trade International trade – Reasons and hindrance Advanced Materials 10.1 : Graphical illustration of international trade – Increasing production costAdvanced Materials 10.1 : Graphical illustration of international trade – Increasing production cost Contents:

3. © Pilot Publishing Company Ltd. 2005 The Law of Comparative Advantage

4. © Pilot Publishing Company Ltd. 2005 Necessary conditions for international trade Factors of production cannot be moved across national boundaries but goods can. Why? Production costs of the trading parties are different. Why? Protectionist measures are not prohibitive. Why? The transportation and the transaction costs involved do not exhaust the gains from trade. Why?

5. © Pilot Publishing Company Ltd. 2005 A country is said to have an absolute advantage over another country in the production of a good if it can produce a larger amount of the good than the other country with the same amount of resources. Absolute advantage

6. © Pilot Publishing Company Ltd. 2005 Two countries are said to have a reciprocal absolute advantage over each other if each country has an absolute advantage over the other in producing one of the two goods. Reciprocal absolute advantage

7. © Pilot Publishing Company Ltd. 2005 The principle Given that two countries have a reciprocal absolute advantage over each other, if each specializes in producing the good in which it has an absolute advantage, then the world’s total output will increase.

8. © Pilot Publishing Company Ltd. 2005 Case I *1 unit of resources (a combination of labour, capital, and land) Which country has an absolute advantage in the production of food? Food Clothing Output of 1 unit of resources* Country A 108 Country B 310 Country A Which country has an absolute advantage in the production of clothing? Country B

9. © Pilot Publishing Company Ltd. 2005 Specialization leads to increase in world’s output If now country A shifts 1 unit of resources from the production of clothing to the production of food. And country B shifts 1 unit of resources from the production of food to the production of clothing. Country A 108 Country B 310 World’s total output FoodClothing +10  -8 -3  +10 +7 +2

10. © Pilot Publishing Company Ltd. 2005 Case II *1 unit of resources ( a combination of labour, capital, and land) Which country has an absolute advantage in the production of food? FoodClothing Country A Output of 1 unit of resources* Country A 10080 Country B 310 Which country has an absolute advantage in the production of clothing? Country A

11. © Pilot Publishing Company Ltd. 2005 Comparative advantage A country is said to have a comparative advantage over another country in the production of a good if it can produce the good at a lower opportunity cost than the other country.

12. © Pilot Publishing Company Ltd. 2005 The law of comparative advantage or the law of comparative cost states that if each country specializes in the production of the good in which it has a comparative adv. (or a lower production cost), the world’s total output will increase. The law of comparative advantage

13. © Pilot Publishing Company Ltd. 2005 Production cost of 1FProduction cost of 1C Country A Country B Output of 1 unit of resources Country A100F80C Country B3F10C

14. © Pilot Publishing Company Ltd. 2005 Country A +1.0F-0.8C Country B -0.3F+1.0C World’s total output +0.7F+0.2C Food Clothing If country A produces one more unit of food while country B produces one more unit of clothing Specialization leads to an increase in world’s output

15. © Pilot Publishing Company Ltd. 2005 Absolute advantage versus comparative advantage 1. Abs. adv. and comp. adv. are unrelated.  Abs. adv. compares productivity of the two countries (the amount of output obtained per unit of resources).  Comp. adv. compares production costs of the two countries (the amount of another good forgone per unit of output).  However, if two countries have a reciprocal absolute advantage over each other, each will have a comparative advantage in the production of the good that it has an absolute advantage.

16. © Pilot Publishing Company Ltd. 2005 2. It is possible for a country to have an absolute advantage in the production of all goods, but it is impossible for the country to have a comparative advantage in all production. 3. It is the comparative advantage (not the absolute advantage) that determines the allocation of resources and the direction of trade.  However, comparative advantage does not determine the volume of trade, the terms of trade or the balance of trade.

17. © Pilot Publishing Company Ltd. 2005 Q10.4: For each of the following typical cases, determine (a) which country has an absolute advantage in the production of (i) food(ii) clothing (b) which country has a comparative advantage in the production of (i) food (ii) clothing

18. © Pilot Publishing Company Ltd. 2005 Case 1: Output of 1 unit of resources Country A Country B Food 810 Clothing 26 Case 2: Output of 1 unit of resources Food Clothing Country A 810 Country B 26

19. © Pilot Publishing Company Ltd. 2005 Case 3: Amount of resources for producing 1 unit of output Food Clothing Country A 810 Country B 26 Case 4: Production cost of 1 unit of output Food Clothing Country A $8$10 Country B £2£2£6£6

20. © Pilot Publishing Company Ltd. 2005 Calculation of production costs 1.Given the amount of good X and good Y produced per unit of resources (marginal products), i.e., MP X and MP Y : Production cost of 1X is Production cost of 1Y is

21. © Pilot Publishing Company Ltd. 2005 Calculation of production costs 2. Given the amount of resources required to produce one unit of good X and good Y (real marginal costs in terms of resources), i.e., MC X and MC Y : Production cost of 1X is Production cost of 1Y is

22. © Pilot Publishing Company Ltd. 2005 Calculation of production costs 3. Given the amount of money required to produce one unit of good X and good Y (nominal marginal costs in terms of money), i.e., MC X and MC Y : Production cost of 1X is Production cost of 1Y is

23. © Pilot Publishing Company Ltd. 2005 Distribution of Gains from Trade

24. © Pilot Publishing Company Ltd. 2005 Principle Specialization raises the world’s total output, while trade distributes the output among trading parties. The world price (or exchange ratio or terms of trade) of a good is determined by its D & S in the world market. From the trading of a good, a country gains the difference between its production cost of the good and the good’s world price.

25. © Pilot Publishing Company Ltd. 2005 Country A8 lab10 lab Country B10 lab3 lab FoodClothing Amount of labour required to produce a unit of food and clothing in country A and country B Illustration

26. © Pilot Publishing Company Ltd. 2005 Production cost of 1FProduction cost of 1C Country A Country B Calculation of gains from trade Given exchange ratio: 1F=1C World price of 1F (=1C) > Country A’s production cost of 1F (=0.8C) Country A exports food From each unit of food exported, country A gains 0.2C (=1C-0.8C).

27. © Pilot Publishing Company Ltd. 2005 Production cost of 1FProduction cost of 1C Country A Country B Calculation of gains from trade Given exchange ratio: 1F=1C World price of 1F (=1C) < Country B’s production cost of 1F (=3.33C) Country B imports food From each unit of food imported, country B gains 2.33C (=3.33C-1C).

28. © Pilot Publishing Company Ltd. 2005 Terms of trade Terms of trade ( TOT ) is the ratio of a country’s export price (P X ) to its import price (P M ). TOT=

29. © Pilot Publishing Company Ltd. 2005 Implications of the terms of trade  An improvement (or deterioration) in the terms of trade reflects an increase (decrease) in the gain from trade per unit of export.  A change in the terms of trade has no implication on the amount of trade, the total gain from trade or the balance of trade. Why? TOT  It measures the amount of import that a country can exchange with a unit of its export

30. © Pilot Publishing Company Ltd. 2005 Terms of trade index The terms of trade index = the unit value index for total exports the unit value index for imports measured in the same base period The unit value index for total exports (or imports)  is the weighted average of the export prices (or the import prices).  where the weight of a good is equal to the proportion of its value in the total value of exports (or the total value of imports).

31. © Pilot Publishing Company Ltd. 2005 Q10.6 How will the terms of trade of Hong Kong be affected under the following situations? (a) A rise in the price of foodstuff imported from the mainland. (b) An improvement in the labour productivity in Hong Kong. (c) A rise in the exchange value of Japanese yen.

32. © Pilot Publishing Company Ltd. 2005 Graphical Illustration of International Trade

33. © Pilot Publishing Company Ltd. 2005 A. Illustration with two separate diagrams – constant production cost Given information: - Production possibility curves of countries A & B - Indifference maps of countries A & B - A price line with its slope representing the world price (or the exchange ratio or the terms of trade) of good X in terms of good Y

34. © Pilot Publishing Company Ltd. 2005 1. The situation without trade (the autarkic situation) - Without trade, a country is self-sufficient. It can consume what it can produce only, i.e., its production possibility curve (PPC) = its consumption possibility curve (CPC). - To maximize social welfare, the country’s consumption optimum (CO) is the tangency point of its PPC and the highest indifference curve achievable, which is also its production optimum (PO) under self-sufficiency.

35. © Pilot Publishing Company Ltd. 2005 Clothing Food PPC A0 Slope = Cost of 1F = 1 600C/2 000 = 0.8C 1F 1 600 2 000 0 Country A: The situation without trade CO A0 PO A0 = CPC A0

36. © Pilot Publishing Company Ltd. 2005 Clothing Food0 Country B 450 1 500 PPC B0 Slope = Cost of 1F = 1 500C/450 = 3.33C 1F CO B0 PO B0 = CPC B0

37. © Pilot Publishing Company Ltd. 2005 2. The situation with trade  The slope of a PPC shows the marginal production cost of good X in terms of good Y. On the other hand, its inverse shows the marginal production cost of good Y in terms of good X.  From the PPCs, the amount of output of the two countries can be compared. However, without information on their amount of resources endowed, absolute advantage cannot be determined.  As PPC A has a gentler slope than PPC B, country A has a lower cost in producing good X (food) while country B has a comparative advantage in producing good Y (clothing).

38. © Pilot Publishing Company Ltd. 2005  The world price is determined by demand & supply at which Q d of the importing country equals Q s of the exporting country.  With the existence of international market, a country can sell what it produces to buy what it wants to consume. This can be represented by a movement along the price line passing through the PO.  To maximize wealth, the new PO is the point through which the outermost price line passes.  The outermost price line is the new CPC.  To maximize social welfare, the CO is the point at which the new CPC touches the highest indifference curve achievable.

39. © Pilot Publishing Company Ltd. 2005 Clothing Food PPC A 1 600 2 000 0 2 000 Country A ---- Possible consumption possibility curves PO A Complete specialization ---- Outermost consumption possibility curve

40. © Pilot Publishing Company Ltd. 2005 Clothing Food0 450 1 500 PPC B Country B ---- Possible consumption possibility curves PO B Complete specialization ---- Outermost consumption possibility curve

41. © Pilot Publishing Company Ltd. 2005 Amount of trade  If PO > CO, the excess amount of the good is exported. On the other hand, if PO < CO, the insufficient amount is imported.  Country A’s export is country B’s import and vice versa.

42. © Pilot Publishing Company Ltd. 2005 Clothing Food PPC A 1 600 2 000 0 Country A 2 000 1 000 CPC A Graphical illustration CO A PO A Export Import

43. © Pilot Publishing Company Ltd. 2005 Clothing Food0 Country B 450 1 500 PPC B 500 1 000 Export Import CPC B PO B CO B Graphical illustration

44. © Pilot Publishing Company Ltd. 2005 Clothing Food PPC A 1 600 2 000 0 1 000 C F 0 PPC B CO A =CO B PO A = PO B Illustration with a composite diagram – Constant production cost C: Export of country B = Import of country A = 1 000 units of clothing F: Export of country A = Import of country B = 1 000 units of food Countries A & B

45. © Pilot Publishing Company Ltd. 2005 Advanced Material 10.1 Graphical Illustration of International Trade – Increasing Production Cost

46. © Pilot Publishing Company Ltd. 2005 MC A0 MC B0 By production possibility curve and indifference curve Without trade (the autarkic situation) Country ACountry B CO A0 PO A0 CO B0 PO B0 Clothing

47. © Pilot Publishing Company Ltd. 2005 With trade PO A1 Export of country A Import of country A CO A1 Country A IC A1 > IC A0 Clothing

48. © Pilot Publishing Company Ltd. 2005 Country B Export of country B Import of country B PO B1 CO B1 IC B1 > IC B0 Clothing

49. © Pilot Publishing Company Ltd. 2005 International Trade --- Reasons and Hindrance

50. © Pilot Publishing Company Ltd. 2005 Reasons for international trade 1. Incapable of being self-sufficient 2. Difference in production costs 3. Economies of scale and learning by doing 4. A wider range of goods and services 5. Improvement in technology and productivity 6. Suppression of domestic monopoly 7. Price stability 8. Intangible benefits

51. © Pilot Publishing Company Ltd. 2005 Hindrance to international trade 1. Transportation cost 2. Protectionism 3. Lack of a mutually acceptable exchange ratio 4. International tension 5. Internal instability 6. Fluctuations in exchange rate

52. © Pilot Publishing Company Ltd. 2005 Correcting Misconceptions: 1. If a country has an absolute advantage in the production of good X, it will also have a comparative advantage in its production. 2. It is possible for a developed country to have an absolute advantage as well as a comparative advantage over a developing country in the production of all goods.

53. © Pilot Publishing Company Ltd. 2005 3. Comparative advantage determines the direction of trade, the terms of trade, the amount of trade as well as the balance of trade. 4. The terms of trade is the ratio of a country’s amount of import to its amount of export. 5. The terms of trade determines the gain from trade, the amount of trade as well as the balance of trade. Correcting Misconceptions:

54. © Pilot Publishing Company Ltd. 2005 6. If the terms of trade of a country becomes more favourable, the country will be better off. 7. Trade enables a country to produce and consume beyond its production possibility curve. 8. Difference in opportunity cost is both the necessary and sufficient conditions for international trade. Correcting Misconceptions: