Chapter 1: The Market

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BBB4MBenefits of International Trade
Source http//www.ifpri.cgiar.org/training/materi
al/economicconcepts/training_econcon6.ppt
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Principle of Absolute Advantage

• A country has "absolute advantage" in the
  production of a good e.g. oranges, if its
  production costs are lower than other countries'
  (at prevailing prices and exchange rates).
• One country can produce goods with fewer
  resources than another country.
• Florida has an absolute advantage in orange
  production over Ontario
• Ontario can grow oranges, but it does not make
  sense, as the costs are more per orange to
  produce because of need for greenhouses, heaters
  etc. (more resources) to keep the orange trees
  warm during the winter.

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Absolute Advantage
Output per hour worked

• U.S. has absolute advantage in Medicine (produces
  more per hour)
• China has absolute advantage in clothing
  production.
• Each country can focus on what they are good at,
  and trade for the other product.

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• Conclusion
• The principle of absolute advantage appeals to
  common sense. i.e. focus on what you are good at
  based on your climate, resources, soils, skills,
  technology, etc.
• What if a nation has an absolute advantage in all
  its products because of size, very cheap labor,
  abundant resources, or highly sophisticated
  technology?
• - Is there still an advantage to trading?
• - What goods or services to import or export?
• - What amounts should they import or export?

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Principle of Comparative Advantage

• The logic of absolute advantage suggests that
  this nation would export products but import
  nothing.But....
• - Does the country have infinite resources? (No)
• - Can the country possibly produce everything?
  (No)
• - What would it do with its export earnings
  i.e. revenue from selling exports? (Buy other
  goods i.e. import them)
• These questions and others led economists to
  develop the alternative idea of "comparative
  advantage."

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Opportunity Cost

• Economic Scarcity Not enough resources to
  satisfy all our wants. Resources are limited,
  wants are unlimited.
• Decisions or tradeoffs are required more of
  one thing means less of another.
• E.g. If Canada produces more cars, then we have
  less workers and factories to produce computers.
• E.g. If you have two exams on the same day, one
  hour of math studying means less time to study
  history.
• What you lose or give up is the opportunity
  cost of your choice.

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The Principle of Comparative Advantage

• Resources (land, labour, capital) are finite
  (limited)
• A country must allocate (use) resources
  carefully!
• To maximize or optimize economic production,
  you must consider the cost of producing
  additional units of any one product in terms of
  the reduction needed in the output of other
  goods. We compare the relative costs of each
  product.
• E.g. 1 - To grow more units of wheat, Canada
  needs to change resource usage to give up the
  opportunity to produce some units of corn.
• Thus, the theory suggests that we compare these
  "opportunity costs" of producing a commodity
  between countries.

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Comparative Advantage

• On Valentines Day the U.S. demand for roses is
  about 10 million roses
• Growing roses in the U.S. in the winter is
  difficult.
• Heated greenhouses should be used.
• The costs for energy, capital, and labor are
  substantial.
• Resources for the production of roses could be
  used to produce other goods, e.g. computers.

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• Opportunity Cost
• The opportunity cost of roses in terms of
  computers is the number of computers that could
  be produced with the same resources as a given
  number of roses e.g. 10 million roses can be
  produced with the same resources as it takes to
  make 100,000 computers.
• Comparative Advantage
• A country has a comparative advantage in
  producing a good if the opportunity cost of
  producing that good in terms of other goods is
  lower in that country than it is in other
  countries.

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Comparative Advantage

• In the U.S. 10 million roses can be produced with
  the same resources as 100,000 computers.
• In Mexico 10 million roses can be produced with
  the same resources as 30,000 computers.

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Comparative Advantage

• If each country specializes in the production of
  the good with lower opportunity costs, trade can
  be beneficial for both countries.
• Roses have lower opportunity costs in Mexico.
• Computers have lower opportunity costs in the
  U.S.
• The benefits from trade can be seen by
  considering the changes in production of roses
  and computers in both countries.
• If each country exports the goods in which it has
  comparative advantage (lower opportunity costs),
  then all countries can in principle gain from
  trade.

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Comparative Advantage

• Comparative Advantage
• Where one country can produce goods at a lower
• opportunity cost it sacrifices less resources
  in production
• Example 1 Imagine two countries, A and B, where
  there are only two products grapes and
  pineapples. We will analyze the production for
  one unit of labour (i.e. one worker)
• Each country has a different climate, soil,
  technology
• The yield (harvest) of grapes is different for
  country A and country B
• Question based on the next slide, who should
  focus only on grape production? Why?

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In terms of the numbers of grapes, pineapples are
cheaper to produce in Country A than in Country B.
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The Principle of Comparative Advantage

• The theory of comparative advantage compares the
  "opportunity costs" of producing a product
  between countries.
• Canada should import goods when the international
  price is less than the opportunity cost of
  producing an additional unit in Canada.
• Canada should export products when the
  international price is higher than the
  opportunity cost of producing an additional unit
  in Canada.
• Through international trade, we can obtain a
  lower cost and a more abundant and wider
  selection of goods and services.

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The Principle of Comparative Advantage

• International trade depends on differences
  between countries in the rates at which
  production of one item can be replaced by another
  (the opportunity cost) through internal
  reallocation of resources.
• Note that the principle of comparative advantage
  is symmetrical.
• If a country has a comparative advantage in the
  production of one or more goods, then it must
  have a comparative disadvantage in the production
  of some other goods.

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In terms of the numbers of pineapples -- grapes
are cheaper to produce in Country B (one grape
¼ pineapple) than in Country A (one grape ½
pineapple).
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Comparative Advantage
One unit of labour in each country can produce
either oil OR whisky.
A unit of labour in Russia can produce either 10
barrels of oil per period OR 5 litres of whisky.
A unit of labour in Scotland can produce either
20 barrels of oil OR 40 litres of whisky.
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Comparative Advantage
Opportunity Cost (OC) sacrifice or giving up
something
Russia Moving 1 unit of labour from whisky to
oil means losing 5 litres of whisky but gaining
10 barrels of oil (OC 5/10 ½) Moving 1 unit
of labour from oil to whisky production means
losing 10 barrels of oil to gain 5 litres of
whisky (OC of whisky is 10/5 2)
Scotland Moving 1 unit of labour from whisky
to oil means losing 40 litres of whisky but
gaining 20 barrels of oil (OC 40/20
2) Moving 1 unit of labour from oil to whisky
means losing 20 barrels of oil to gain 40 litres
of whisky (OC of whisky is 20/40 ½ )
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• For Scotland the OC of oil is four times higher
  than that in Russia (2 compared to ½)
• In Russia, oil can be produced cheaper than in
  Scotland
• Russia only gives up 1 litre of whisky to produce
  2 extra barrels of oil.
• Scotland gives up 2 litres of whisky to produce 1
  barrel of oil
• Note Russia gives up less to get more oil
• There can be gains from trade if each country
  specialises in the production of the product in
  which it has the lower opportunity cost Russia
  should produce oil Scotland, whisky.

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Comparative Advantage
Before trade each country divides labour
between the two products
After specialisation each country devotes its
resources to that in which it has a comparative
advantage.
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Comparative Advantage

• Total Output of both oil and whisky has risen
• Trade can be arranged at a mutually agreed rate
  that will leave both countries better off than
  without trade.
• The trading rate has to be somewhere between the
  OC ratios (in this case 2 and ½) to be agreeable
  to both countries.
• e.g. If the trade were arranged at 1 barrel of
  oil for 1 litre of whisky the end result would
  be

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Comparative Advantage
Before Trade
After Trade
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Comparative Advantage
Output per hour work

• Suppose China were only ½ as productive now, it
  has absolute advantage in nothing!
• Can it still gain from trade?
• Remember Comparative advantage lower
  opportunity cost

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• Answer --- Yes! China still has comparative
  advantage.

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• Computing opportunity cost
• In U.S., 1 Med needs 1/8 hr. from CL. Lose 6
  CL/hr. ? 1/8 hr. 6/8 ¾ of a CL.
• to get 1 Med, need to give up ¾ of a CL.
• Comparative advantage in Med U.S. (gives up
  less CL for 1 Med than China)
• Comparative advantage in CL China