Lecture 3 Econ 1101 Radek Stefanski

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Lecture 3 Econ 1101 Radek Stefanski

• International Trade and Comparative Advantage
• No nation was ever ruined by trade.
• BENJAMIN FRANKLIN

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Why Trade?

• Reasons countries benefit from foreign trade
• They can import resources they lack at home.
• They can import goods for which they are a
  relatively inefficient producer.
• Each countrys climate, labor force and other
  endowments make it a relatively efficient
  producer of some goods and an inefficient one of
  others
• Specialization sometimes permits economies of
  large-scale production.

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Why Trade?

• Mutual Gains from Trade
• When trade is voluntary
• Both sides must expect to gain from it
• Otherwise, they would not trade

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International versus Intranational Trade

• International and intranational trade are similar
  in many respects.

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International versus Intranational Trade

• Why international trade is studied separately
• Countries are governed by separate governments
  (political factors)
• International trade involves the exchange of
  national currencies (volatility!)
• Labor and capital are less mobile internationally
  than they typically are within a country
  (geography, culture, language, law etc)

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Absolute Advantage

• One country is said to have an absolute advantage
  over another in the production of a particular
  good if it can produce that good using smaller
  quantities of resources than can the other
  country.

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Example of Abs. Adv.

• Paula has the Absolute advantage in both baking a
  cake and cooking a chicken

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Comparative Advantage

• One country is said to have a comparative
  advantage over another in the production of a
  particular good if it produces that good less
  inefficiently than the other country.
• This is known as The Law of Comparative
  Advantage

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The Law of Comparative Advantage

• The law of comparative advantage applies even if
  one country is at an absolute disadvantage
  relative to another country in the production of
  every good.

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Example
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The Law of Comparative Advantage

• Both countries gain from trade even if one of
  them is more efficient than the other in
  producing everything.

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The Law of Comparative Advantage

• The Arithmetic of Comparative Advantage
• When countries differ in the relative efficiency
  with which they produce different goods
• Both world output and the welfare of each country
  can be increased if
• Each country specializes in producing the goods
  for which it has a relative advantage
• And then trades with the other.

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Example

• Paula has absolute and comparative advantage in Y
  and Simon has absolute and comparative advantage
  in X.

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• If each of them reallocates his/her time towards
  the good in which he/she has comparative
  advantage, then more goods can be produced.

• These extra quantities can be split between them,
  for example, each can have ¼ cake and ¼ chicken
  more that before.

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• Why do have more goods without working more?
• Each time we produce something we have to give up
  something (scarcity principle).
• But each time Paula produces chicken we give up
  only half a cake while each time Simon produces a
  chicken we give up 2 cakes.
• Similarly, it is cheaper for Simon to produce
  cakes. So by trading, they can agree that Paula
  will produce chicken for Simon and Simon will
  produce cakes for Paula.

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Deriving the PPF

• Production Possibilities Frontier a graph that
  shows the combinations of outputs of X and Y,
  such that it is impossible to produce more of one
  good without decreasing the output of another
  good.

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• If Paula spends all time on X she produces at
  most 6 units.
• If Paula spends all time on Y she produces at
  most 12 units.
• So points on Paulas PPF(0,12) and (6,0)
• Notice increase of prod. of X by one unit
  decreases prod. of Y by 2 units always
• So, slope of PPF constant -2

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Autarky

• Suppose that Paula and Simon initially consume
  their own production and do not trade with each
  other. We call this autarky (no trade).
• Also assume that they like to consume equal
  amount of X and Y
• What is the consumption bundle of Paula and
  Simon?

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Autarky Cont.

• Solving both systems
• Paula (X 4, Y 4) Simon (X 4, Y 4).
• The total output in the economy (autarky)
• (X 8, Y 8).

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Aggregate PPF

• Observe
• maximal amount of Y that can be produced is18
• maximal amount of X that can be produced is 18
• Thus two points on aggregate PPF (0,18) and
  (18,0)
• Now starting with the point (0,18), that is both
  Paula and Simon produce only Y, we are asking who
  should produce X if the economy desires to
  consume some X?

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Aggregate PPF

• Paula unit of X costs 2 units of Y
• Simon unit if X costs ½ unit of Y
• Thus, initially allocate Simon to production of X
  
• After allocating all Simons time to X economy
  produces 12 units of X and 12 units of Y
• If the economy needs more units of X, we have no
  choice but to allocate Paulas time to the
  production of X

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Results

• If the economy wishes to produce (and consume)
  equal amounts of X and Y, it is possible to
  produce in total (X 12, Y 12) - 4 units more
  than before.
• The reason is specialization.
• Simon specializes in X (a good in which he has
  comparative advantage) and Paula specializes in Y
  (in which she has comparative advantage). Thus,
  each good is produce with minimum cost in terms
  of the other good.

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Results

• In autarky on the other hand, they both produce
  both goods, so some of the output is produced at
  relatively high cost.