Dale R. DeBoer

1
An Introduction to International Economics

• Chapter 2 Comparative Advantage
• Dominick Salvatore
• John Wiley Sons, Inc.

2
The basic questions of international trade

• What is the basis of trade?
• Two answers to this question will be discussed in
  this chapter Absolute Advantage and Comparative
  Advantage

3
The basic questions of international trade

• What is the basis of trade?
• What are the gains from trade?
• The models of Absolute and Comparative Advantage
  show that the gains from trade are increased
  consumption gained through specialization in
  production and trade.

4
The basic questions of international trade

• What is the basis of trade?
• What are the gains from trade?
• What is the pattern of trade?
• What determines the pattern of specialization
  that drives international trade?

5
The Mercantilists

• What is wealth?
• The Mercantilist answer was the stock of precious
  metals possessed by a country.

6
The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• Extraction from naturally occurring stocks
• This option is available to few countries

7
The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• Extraction from naturally occurring stocks
• Earn precious metals through exports of goods and
  services
• Since payment for exports is made with precious
  metals, exporting causes precious metals to flow
  into a country
• Similarly, since payment for imports is also made
  with precious metals, importing causes precious
  metals to flow out of country

8
The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion exports must exceed
  imports for a country to become wealthy!

9
The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion exports must exceed
  imports for a country to become wealthy!
• Can this condition hold for all countries?
• No!
• Therefore, the wealth of one country must come at
  the expense of another country.

10
The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion exports must exceed
  imports for a country to become wealthy!
• Can this condition hold for all countries?
• Mercantilist policy
• Strict government control over economic activity
  to ensure a positive trade balance

11
The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion exports must exceed
  imports for a country to become wealthy!
• Can this condition hold for all countries?
• Mercantilist policy
• A further look at the Mercantilists
• Federal Reserve Bank of San Franciscos Major
  Schools of Economic Theory
• FRBSF WWW link

12
Is wealth precious metals?

• To the Mercantilists, yes.

13
Are precious metals wealth?

• To the Mercantilists, yes.
• Modern measures of wealth are based on a
  countrys ability to produce the goods and
  services that improve quality of life.
• Hence, the Mercantilist conclusion is based a
  definition of wealth the differs significantly
  from modern notions of wealth.
• This distinction leads to very different
  conclusions about how to become a wealthy nation.

14
Absolute advantage

• Built on the ideas of Adam Smith
• The Library of Economic Liberty Biography of Adam
  Smith
• WWW Link

15
Absolute advantage

• Built on the ideas of Adam Smith
• Absolute advantage exists between nations when
  they differ in their ability to produce goods.
• More specifically, absolute advantage exists when
  one country is good at producing one item, while
  another country is good at producing another
  item.

16
An example of absolute advantage

• Countries
• Scotland
• Mexico
• Goods
• Coffee beans
• Wool

17
An example of absolute advantage

• How does specialization and trade advantage
  Scotland?
• By reducing coffee bean production, resources are
  freed for producing more wool
• Each hour of production change costs 1 unit of
  coffee beans but gains 4 units of wool

18
An example of absolute advantage

• How does specialization and trade advantage
  Scotland?
• Scotland can send 3 units of wool to Mexico and
  receive 7 units of coffee beans back
• Thus, by specializing in production Scotland
  gains 1 unit of wool and 6 units of coffee per
  hour of production moved

19
An example of absolute advantage

• Does specialization and trade also advantage
  Mexico?
• By reducing wool production, resources are freed
  for producing more coffee beans
• Each hour of production change costs 2 units of
  wool but gains 10 units of coffee beans

20
An example of absolute advantage

• Does specialization and trade also advantage
  Mexico?
• Mexico can send 7 units of coffee beans to
  Scotland and receive 3 units of wool back
• Thus, by specializing in production Mexico gains
  1 unit of wool and 3 units of coffee beans per
  hour of production moved

21
Policy recommendations from absolute advantage

• Specialization and trade advantage both countries
• Therefore, the best policy is to allow producers
  and consumers in both countries unfettered access
  to goods from both countries to maximize the
  number of advantageous trades that can occur.
• In other words, laissez-faire.
• The policy of minimum government interference
  with economic activity.

22
A fatal flaw?

• Absolute advantage requires one country to be
  better at production of one product and another
  country to be better at production of another
  good for specialization and trade to be mutually
  advantageous.
• What if one country is better at everything?
• The theory of comparative advantage provides this
  answer.

23
Comparative advantage

• Built on the ideas of David Ricardo
• The New School History of Economic Thought
  Biography of David Ricardo
• WWW Link

24
Comparative advantage

• Built on the ideas of David Ricardo
• The law of comparative advantage shows how
  mutually beneficial specialization and trade may
  be driven by relative advantages in production
  rather than absolute advantages in production.
• Given the somewhat counter-intuitive nature of
  the law of comparative advantage its implications
  are best seen through example.

25
An example of comparative advantage

• Countries
• Scotland
• Mexico
• Goods
• Coffee beans
• Wool
• The difference lies in the relative productivity
  of the countries
• In this case, Mexico is more productive at
  generating both goods.

26
An example of comparative advantage

• How does specialization and trade advantage
  Mexico?
• By reducing wool production, resources are freed
  for producing more coffee beans
• Each hour of production change costs 5 units of
  wool but gains 10 units of coffee beans

27
An example of comparative advantage

• How does specialization and trade advantage
  Mexico?
• Mexico can send 9 units of coffee beans to
  Scotland and receive 7 units of wool back
• Thus, by specializing in production Mexico gains
  1 unit of coffee beans and 2 units of wool per
  hour of production moved

28
An example of comparative advantage

• Does specialization and trade also advantage
  Scotland?
• It does. To see this consider consider Scotland
  trading two hours of output.
• Two hours of production change from coffee beans
  to wool costs 2 units of coffee beans but gains 8
  units of wool

29
An example of comparative advantage

• Does specialization and trade also advantage
  Scotland?
• Scotland can send 7 units of wool to Mexico,
  receiving 9 units of coffee beans in return
• Thus, by specializing in production Scotland
  gains 1 unit of wool and 7 units of coffee beans

30
Implications of comparative advantage

• Laissez-faire still holds
• Gains need not be equal
• Hours of work traded need not be equal but the
  advantage still exists
• Trade is based on the existence of relative not
  absolute production advantages

31
Does money alter the story?

• No
• Suppose the costs of production are as given
  below
• Mexico 100 pesos/hour
• Scotland 4 pounds/hour
• Suppose the exchange rate between pesos and
  pounds is 1 10P
• This gives the unit costs indicated in the chart

4 1 unit 4 per unit 4 x 10P/ 40P per
unit
32
Does money alter the story?

• No
• Suppose the costs of production are as given
  below
• Mexico 100 pesos/hour
• Scotland 4 pounds/hour
• Suppose the exchange rate between pesos and
  pounds is 1 10P
• This gives the unit costs indicated in the chart

4 4 units 1 per unit 1 x 10P/ 10P per
unit
33
Does money alter the story?

• No
• Suppose the costs of production are as given
  below
• Mexico 100 pesos/hour
• Scotland 4 pounds/hour
• Suppose the exchange rate between pesos and
  pounds is 1 10P
• This gives the unit costs indicated in the chart

100P 10 units 10P per unit
34
Does money alter the story?

• No
• Suppose the costs of production are as given
  below
• Mexico 100 pesos/hour
• Scotland 4 pounds/hour
• Suppose the exchange rate between pesos and
  pounds is 1 10P
• This gives the unit costs indicated in the chart

100P 5 units 20P per unit
35
Does money alter the story?

• At these prices goods will naturally flow from
  the cheaper market (Scotland for wool, Mexico for
  coffee beans) to the more expensive market.
• Again, this demonstrates the law of comparative
  advantage but through prices not relative outputs.

36
Does the source of the productive difference
matter?

• No
• The original idea of comparative advantage was
  based on the labor theory of value.
• The labor theory of value holds that costs and
  prices are solely determined by the labor content
  of an item.

37
Does the source of the productive difference
matter?

• No
• The original idea of comparative advantage was
  based on the labor theory of value.
• The examples given above rely on opportunity
  cost.
• Opportunity cost holds that the cost of an item
  is the amount of another item the must be given
  up to release sufficient resources to produce one
  more unit of the first item.

38
The production possibility frontier

• The production possibility frontier (PPF)
  identifies the maximum combinations of two
  products that a nation can produce by fully
  utilizing all factors of production with the best
  technology available.
• Consider the production possibilities schedule
  for an example

United States United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
39
Constructing the PPF
United States United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
40
Constructing the PPF
United States United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
41
Constructing the PPF
United States United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
42
Regions of the PPF
Productive maximum
Underutilized resources
Unattainable with existing resources and
technology
43
Trade with the PPF model

• Suppose the US and the UK have the PPFs given to
  the right

44
Trade with the PPF model

• Suppose the US and the UK have the PPFs given to
  the right
• Further suppose that each country produces and
  consumes at the marked spot in the absence of
  international trade

(90W, 60C)
(40W, 40C)
45
Trade with the PPF model

• Can specialization and trade lead to more
  aggregate production and consumption?
• If the US specialized in wheat production and the
  UK in cloth production, aggregate production
  would increase from 130W to 180W and from 100C to
  120C.

(90W, 60C)
(40W, 40C)
46
Trade with the PPF model

• This increased production would allow each
  country to consume at a point outside of its PPF
  as indicated by the blue lines in the graphs.
• The increased consumption is the gains from trade.

(110W, 70C)
Production
Production
(70W, 50C)