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Chapter 3: Why Everybody Trades: Comparative Advantage

Chapter 3: Why Everybody Trades: Comparative Advantage. Contents. Mercantilism Absolute Advantage Comparative Advantage Production Possibility Curve. Adam Smith’s theory of the absolute advantage. Assumptions: Two countries – the US and the rest of the world

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Chapter 3: Why Everybody Trades: Comparative Advantage

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  1. Chapter 3: Why Everybody Trades: Comparative Advantage

  2. Contents • Mercantilism • Absolute Advantage • Comparative Advantage • Production Possibility Curve

  3. Adam Smith’s theory of the absolute advantage Assumptions: Two countries – the US and the rest of the world Two products – wheat and cloth Each product uses one resource – labour Two ways to show each country’s ability to produce Quantity of output per labour hour Labour hours needed to produce a unit of output

  4. Adam Smith’s ExampleAbsolute Advantage

  5. The US has higher productivity on wheat and hence an absolute advantage in wheat What about the rest of the world? What are the changes in world production if 1 hr of labour is shifted from cloth to wheat in the US? From wheat to cloth in the rest of the world? US: -0.25 cloth; +0.5 wheat ROW: +1 cloth; -0.4 wheat World: +.75 cloth; +0.1 wheat Global production efficiency is increased due to trade

  6. Ricardo’s Example:Comparative Advantage

  7. Ricardo’s theory of comparative advantage What if a country has absolute advantage in both products? Will this country benefit from trade? The principle of the comparative advantage A country will EXPORT the goods that it can produce at a LOWER OPPORTUNITY COST and IMPORT the goods that it would otherwise produce at a HIGHER OPPORTUNITY COST

  8. Ricardo focused on labor productivity (or resource productivity more generally) for different products in different countries Basis for trade: Relative differences in labor (resource) productivity.

  9. Which country has an absolute advantage in wheat? In cloth? The opportunity cost (price) of cloth in the US is the amount of wheat that we have to give up in order to produce a unit of cloth The opportunity cost of cloth is 2 W/C [0.5/0.25] or [4/2]

  10. The opportunity cost (price) of 1 unit of cloth in ROW is the amount of wheat that they have to give up, The opportunity cost of cloth in ROW is 0.67W/C [0.67/1]or [1/1.5] What about the prices of wheat? Wheat in US 0.5 C/W [.25/.5] or [2/4] Wheat in ROW 1.5 C/W [1/.67] or [1.5/1] Which product is cheaper in the US? In ROW?

  11. Ricardo’s Example:No-Trade Relative Prices

  12. Arbitrage (trade) is possible – buy cloth in ROW for 0.67W/C and sell in the US for 2W/C Eventually, the world price for cloth will be established between 0.67 and 2W/C. Suppose it is 1W/C And the world price of wheat between 0.5 and 1.5 C/W

  13. Gains from trade: US give up ½ unit of cloth to produce 1 unit of wheat for export (domestic substitution and specialization) import 1 unit of cloth in exchange for exporting 1 unit of wheat US is better-off by ½ unit of cloth after trade ROW give up 2/3 unit of wheat to produce a unit of cloth for export import 1 unit of wheat in exchange for exporting 1 unit of cloth ROW is better-off by 1/3 unit of wheat after trade

  14. Figure 3.1 – The Gains from Trade, Shown for Ricardo’s Constant-Cost Case

  15. The PPC with constant costs If the US has 100 billion labour hours and it produces only wheat, how much wheat will it produce? 50 billion units of wheat How much cloth will the US produce with 100 billion labour hours (if only producing cloth)? 25 billion units of cloth

  16. The PPC with constant costs If the ROW has 100 billion labour hours and it only produces cloth, how much cloth will it produce? 100 billion units of cloth How much wheat (assuming only wheat is produced)? 67 billion units of wheat

  17. The US PPC has a constant slope of 50/25=2W/C The ROW PPC has a constant slope of 67/100=0.67W/C Suppose that without trade each country produces in p.So on its PPC The trade line has a slope of 1W/C Thus each country can consume at point C on its trade line The PPC with constant costs

  18. US Now produces 30 units of wheat and exports 10 After producing 30 units of wheat (60 labour hours), the US can produce 10 units of cloth domestically (40 labour hours) Import 10 units of cloth from ROW at a price of 1

  19. The PPC with constant costs US Now produces 30 units of wheat After producing 30 units of wheat (60 labour hours), the US can produce 10 units of cloth domestically (40 labour hours) ROW ROW now produces 80 units of cloth using 80 labour hours The remaining 20 labour hours are used to produce wheat

  20. Ricardo’s Theory of Trade • Comparative advantage • A country will export products that it can produce at a low opportunity cost (in terms of other goods that could be produced within the country). • A country will import products that it would otherwise produce at a high opportunity cost. • Ricardo focused on labor productivity (or resource productivity more generally) for different products in different countries. • Basis for trade: Relative differences in labor (resource) productivity.

  21. Summary • Mercantilism • Absolute Advantage • Comparative Advantage • The Ricardian Model

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