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Comparative Advantage and Opportunity Cost

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					International Economics

 Chapter 1

         Classical Theories of
         International Trade
Chapter 1 Classical Theories of International Trade

      1.1 Mercantilism
      1.2 Trade Based on Absolute Advantage: Adam Smith
      1.3 Trade Based on Comparative Advantage: David
       Ricardo
      1.4 Comparative Advantage and Opportunity Cost
      1.5 Comparative Advantage with More Than Two
       Commodities and Countries
      1.6 Theory of Reciprocal Demand
      1.7 Offer Curve and Terms of Trade
1.1 Mercantilism

 The mercantilists advocated government regulation of
  trade to promote a favorable trade balance.
 If a country could achieve a favorable trade balance, it
  would receive payments from the rest of the world in the
  form of gold and silver. Such revenues would contribute
  to an increase in spending and thus a rise in domestic
  output and employment.
 Critics
   Possible only for short term
   Assuming static world economy
Chapter 1 Classical Theories of International Trade

      1.1 Mercantilism
      1.2 Trade Based on Absolute Advantage: Adam Smith
      1.3 Trade Based on Comparative Advantage: David
       Ricardo
      1.4 Comparative Advantage and Opportunity Cost
      1.5 Comparative Advantage with More Than Two
       Commodities and Countries
      1.6 Theory of Reciprocal Demand
      1.7 Offer Curve and Terms of Trade
1.2 Trade Based on Absolute Advantage: Adam Smith

   With free trade, countries could concentrate their
    production on the goods they could produce most
    cheaply and enjoy all the consequent benefits from
    the labor division.
    Cost  differences govern the international movement of
      goods. The concept of cost is founded upon the labor
      theory of value.
1.2 Trade Based on Absolute Advantage: Adam Smith

   Two assumptions, within each country:
    Labor is the only factor of production and is
     homogeneous (i.e. of one quality).
    The cost or price of a good depends exclusively upon
     the amount of labor required to produce it.
1.2 Trade Based on Absolute Advantage: Adam Smith

    An   arithmetic example
                          A Case of Absolute Advantage
                                        Output per Labor Hour
                Country                iPad                Cloth
                  U.K.                 5 sets            20 yards
                  U.S.                15 sets            10 yards

     The   U.S. has an absolute advantage in iPad production; its iPad workers'
     productivity (output per worker hour) is higher than that of the U.K, which
     leads to lower costs (less labor required to produce a set of iPad).
     In like   manner, the U.K has an absolute advantage in cloth production.
Chapter 1 Classical Theories of International Trade

      1.1 Mercantilism
      1.2 Trade Based on Absolute Advantage: Adam Smith
      1.3 Trade Based on Comparative Advantage: David
       Ricardo
      1.4 Comparative Advantage and Opportunity Cost
      1.5 Comparative Advantage with More Than Two
       Commodities and Countries
      1.6 Theory of Reciprocal Demand
      1.7 Offer Curve and Terms of Trade
1.3 Trade Based on Comparative Advantage: David
Ricardo

   Mutually beneficial trade can occur even when
    one country is absolutely more efficient in the
    production of all goods.
    The more efficient country should specialize in and
     export that good in which it is relatively more efficient
     (where its absolute advantage is bigger).
    The less efficient country should specialize in and
     export the good in which it is relatively less inefficient
     (where its absolute disadvantage is smaller).
1.3 Trade Based on Comparative Advantage: David
Ricardo

   Assumptions    of a simplified model
       There are only two countries with a fixed level of
        technology in the world;
       Each country owns only one input – labor, which is
        fixed endowed and homogenous and can move
        across industries but cannot flow across countries;
       Each country produces two commodities;
       Perfect competition and free trade prevail in
        markets.
1.3 Trade Based on Comparative Advantage: David
Ricardo
    An Example of Comparative Advantage
                     A Case of Comparative Advantage
                                        Output per labor hour
          Country
                              iPads         Cloth           Relative cost
             U.S.             5 sets      15 yards     1 iPad=3 yards of cloth
             China            1 set        5 yards     1 iPad=5 yards of cloth

      The   U.S. labor has a 5-to-1 absolute advantage in the
      production of iPads. The U.S. labor also has a 3-to-1 absolute
      advantage in the production of cloth. The U.S. has a greater
      absolute advantage in producing iPads than in producing cloth.
      China  has an absolute disadvantage in the production of iPads
      and cloth. However, China’s absolute disadvantage is smaller in
      producing cloth than in producing iPads.
1.3 Trade Based on Comparative Advantage: David
Ricardo
    Gains from Specialization and Trade with Comparative
     Advantage
        The Change in the World Output Resulting from Specialization
                                         Change in the production of
               Country
                                        iPads                 Cloth
                   U.S.                       +5 sets                -15 yards
                  China                        -3 sets               +15 yards
       Change in the World Output             +2 sets                     0
        As  the U.S. transfers 1 worker from cloth production to iPad production, its
        output of iPads increases by 5 and cloth production falls by 15 yards.
        As   China transfers 3 workers from iPad production to cloth production, its
        cloth production increases by 15 yards and iPad production falls by 3.
        The   gain from production and trade is the increase in the world output that
        results from each country specializing in its production according to its
        comparative advantage.
1.3 Trade Based on Comparative Advantage: David
Ricardo
    Comparative Advantage in Money Terms
                  Comparative Advantage in Money Prices
                                                  iPad (sets)        Cloth (yards)
                             Hourly Wage
     Country Labor Input                       Quantity    Price    Quantity    Price
                                Rate

      U.S.         1              $20             5         $4         15       $1.33

     China         1               $5             1         $5         5           $1
        At   this wage rate, China’s average cost in dollars of producing cloth
        is less than the U.S. average cost. With perfectly competitive markets,
        China’s selling price of cloth is lower than its U.S. selling price, and
        China exports cloth to the U.S..
        Even    though China is not as efficient as the U.S. in the production of
        cloth, its lower wage rate in terms of dollars more than compensates for
        its inefficiency.
Chapter 1 Classical Theories of International Trade

      1.1 Mercantilism
      1.2 Trade Based on Absolute Advantage: Adam Smith
      1.3 Trade Based on Comparative Advantage: David
       Ricardo
      1.4 Comparative Advantage and Opportunity Cost
      1.5 Comparative Advantage with More Than Two
       Commodities and Countries
      1.6 Theory of Reciprocal Demand
      1.7 Offer Curve and Terms of Trade
1.4 Comparative Advantage and Opportunity Cost

   Opportunity Cost
       Opportunity cost is the quantity of one good that
        must be given up to release enough resources to
        produce one more unit of another good.
       The marginal rate of transformation (MRT) is the
        quantity of one good that it must abandon to
        produce each additional unit of another good.
1.4 Comparative Advantage and Opportunity Cost

    Gains from Specialization and Trade with Opportunity Costs
            Production and Consumption with and without Trade
             Based on an exchange ratio of 1 iPad=4 yards of cloth
                                                      Country
              Item
                                        U.S.                     China
 Production at Full                  100 iPads                  0 iPad
 Employment                        0 yard of cloth         300 yards of cloth
 Consumption with Trade              50 iPads                  50 iPads
                                 200 yards of cloth        100 yards of cloth
 Domestic Production and             50 iPads                  40 iPads
 Consumption without Trade       150 yards of cloth        100 yards of cloth
 Gains from Specialization and
                                  50 yards of cloth             10 iPads
 Trade

        Both   countries are better off when they specialize and trade .
1.4 Comparative Advantage and Opportunity Cost

    Production Possibilities Frontier and Constant
     Opportunity Costs
     A   production possibilities frontier (PPF) shows the different
       combinations of two goods that can be produced when all of a
       country’s factors of production are fully employed in their most
       efficient way.
      The slope of PPF is referred to as the marginal rate of
       transformation (MRT), which shows the amount of one product
       a country must sacrifice to get one additional unit of the other
       product.
      Without specialization and trade, the U.S. and China can
       produce and consume at any point along their respective
       production possibilities frontiers.
1.4 Comparative Advantage and Opportunity Cost
              PPF for the U.S. and China at Full Employment
                 U.S.                                  China
  Numbers of iPads      Yards of Cloth   Numbers of iPads   Yards of Cloth
        100                   0                60                 0
        90                   30                50                50
        80                   60                40                100
        70                   90                30                150
        60                   120               20                200
        50                   150               10                250
        40                   180                0                300
        30                   210

        20                   240
        10                   270
         0                   300
1.4 Comparative Advantage and Opportunity Cost

        Cloth                U.S.                Cloth                       China
          300                                         300

                         C
                                                                        C'
                    B                                        B'
          150            A
                                     MRT= −3                                  MRT= −5
                                                      100          A'




                0       50          100        iPad      0        40    60              iPad

        Points below the PPF, say, Point B or B', represent possible production
         combinations that can be produced but are inefficient because there would
         be some unemployed resources.
        Points above the PPF, say, Point C or C', represent production combinations
         that are not possible for a country to produce with available resources and
         technology.
1.4 Comparative Advantage and Opportunity Cost
        Cloth                     U.S.                       Cloth                          China
                                                                     D'
         300                                                 300

                              E Trading possibilities line
         200                                             export
                                 (terms of trade:                                 Trading possibilities line
                                 1 ipad = 4 cloth)
                              A                                                         (terms of trade:
         150
                                                                                        1 ipad = 4 cloth)
                    import                                           F'      A'    E'
                                                              100
                                                                         import


                              F           D
                0            50 export 100            iPad           0        40 50 60                         iPad

      With each country specializing in the production of the good in which it has
       a comparative advantage, 10 more iPads and 50 more yards of cloth are
       produced in the world.
      With trade, the set of consumption points that a country can achieve is
       determined by the terms of trade – the relative price of trading iPads for
       cloth, and vice versa.
      Both countries are better off by specializing and trade than they would be
       without trade.
1.4 Comparative Advantage and Opportunity Cost

   Changes       in the Gains from Specialization and Trade
           Production and Consumption with and without Trade
           Based on an exchange ratio of 1 iPad=3.5 yards of cloth
                                                       Country
                  Item
                                               U.S.                  China
                                            100 iPads             0 iPad
   Production at Full Employment
                                          0 yard of cloth    300 yards of cloth
                                             50 iPads            50 iPad
   Consumption with Trade
                                         175 yards of cloth 125 yards of cloth
   Domestic Production and                   50 iPads           40 iPads
   Consumption without Trade             150 yards of cloth 100 yards of cloth
                                              0 iPad             10 iPads
   Gains from Specialization and Trade
                                         25 yards of cloth   25 yards of cloth
1.4 Comparative Advantage and Opportunity Cost

    As the international exchange ratio (terms of trade) changes
     from 1 iPad for 4 yards of cloth to 1 iPad for 3.5 yards of cloth,
     the trading possibilities curve moves for each country.
     Cloth                                Cloth
                           U.S.                                     China
      300                                      300 D'

                       E
      200
      175          G
      150          A                                          G'
                                               125
                                               100       A'   E'



                                   D
             0      50            100   iPad         0   40 50 60           iPad

                 Changes in the Terms of Trade for the U.S. and China
1.4 Comparative Advantage and Opportunity Cost

   Distribution of   the Gains from Trade
       Changes in a country’s terms of trade over time indicate
       whether a country can obtain more or less quantity of
       imports per unit of exports.
         – A change in a country’s terms of trade may reflect a
           change in either international or domestic economic
           conditions.
         – When the terms of trade change as a result of a change
           in domestic economic conditions, the effect on the
           country’s welfare is uncertain.
1.4 Comparative Advantage and Opportunity Cost

 Complete   Specialization
    Each country specializes completely in the production
     of the good in which it has a comparative advantage
     and imports the other good.
    Complete specialization occurs because as production
     expands in the industry with a comparative advantage,
     the domestic cost of producing the product does not
     rise. Constant costs are assumed to prevail over the
     entire range of production.
1.4 Comparative Advantage and Opportunity Cost

       The firm’s cost curves and the product’s supply
        curves are horizontal.
      Yards of                       Cloth
      Cloth per
        iPad                          300           U.S.


                           SU.S.

                                                   MRT= −3
             3                        150      A




             0           100       iPad 0     50     100     iPad

                  Supply Curves of a Good and the PPF
1.4 Comparative Advantage and Opportunity Cost

   Trade under Increasing Opportunity Costs
    Increasing        Costs and the PPF
    Cloth                                Yards of Cloth
                                           per iPad
              D
      300 A        B

                         E

                             F                                   C



                                 C
                                                          B

                                     G
                                 H
        0                        100      iPad        0          100      iPad

              The PPF and Supply Curve under Increasing Cost Conditions
1.4 Comparative Advantage and Opportunity Cost

   The   slope of the PPF at any point is represented
    graphically by the slope of a tangent to that point.
    A country has increasing opportunity costs.
      the tangent FG is steeper than DE.
   Two reasons:
      the factors of production used to produce the
       products are specialized in the production of a
       particular product.
      the premise that all resources are identical in the
       sense that all workers and capital have the same
       productivity in the production of both commodities
       is unrealistic.
1.4 Comparative Advantage and Opportunity Cost

    Production andConsumption without Specialization and Trade
       Without specialization and trade, the U.S. and China can
        produce and consume at any point on their PPF.
    Production and      Consumption with Specialization and Trade

       Cloth             F                     Cloth
                   C                                   F'

                                 K

                             A
                                     Trade Triangle              H'
                                                                           C'
                                        D
                                 J     H
                                                                                Trade Triangle
                                                                      A'
                                                                                   K'
                                              G             J'
                                                                                D' G'
           0                                 iPad 0                                              iPad

               Specialization and Trade under Increasing Cost Conditions
1.4 Comparative Advantage and Opportunity Cost

 Specializing  in and exporting the good in which the
  country has a comparative advantage and trading for the
  other good enables both countries to become better off by
  consuming beyond their respective PPFs.
 Production under increasing cost conditions constitutes a
  mechanism that forces prices to converge and results in
  neither country specializing completely in the production
  of the good in which it has a comparative advantage.
 In the case of increasing costs, both countries continue
  to produce both goods after trade and it is called as
  partial specialization.
Chapter 1 Classical Theories of International Trade

      1.1 Mercantilism
      1.2 Trade Based on Absolute Advantage: Adam Smith
      1.3 Trade Based on Comparative Advantage: David
       Ricardo
      1.4 Comparative Advantage and Opportunity Cost
      1.5 Comparative Advantage with More Than Two
       Commodities and Countries
      1.6 Theory of Reciprocal Demand
      1.7 Offer Curve and Terms of Trade
1.5 Comparative Advantage with More Than
Two Commodities and Countries
   Comparative Advantage with More Than 2 Commodities
    Each country will then have a comparative advantage
      in the commodities that it exports at the particular
      equilibrium exchange rate established .
                  Commodity Prices in the U.S. and U.K.

          Commodity       Price in the U.S. ($) Price in the U.K. (£)

              A                    2                      6
              B                    4                      4
              C                    6                      3
              D                    8                      2
              E                   10                      1
1.5 Comparative Advantage with More Than
Two Commodities and Countries
      If the exchange rate is £ 1=$2, the dollar prices of the
       commodities in the U.K. would be:
            Commodity            A    B    C      D      E
       Dollar price in the U.K   12   8    6      4      2

   The U.S. will export Commodities A and B to the U.K. and
   import Commodities D and E from the U.K., leaving
   Commodity C not traded.
1.5 Comparative Advantage with More Than
Two Commodities and Countries
      If the exchange rate becomes £1=$3. The dollar prices of the
       commodities in the U.K. would be:

            Commodity            A    B    C       D       E
       Dollar price in the U.K   18   12    9      6       3


    The U.S. will export Commodities A, B and C to the U.K. and
   import Commodities D and E from the U.K.
1.5 Comparative Advantage with More Than
Two Commodities and Countries
      If the exchange rate turns to be £1=$1, the dollar prices of the
       commodities in the U.K. would be:

             Commodity            A    B      C       D        E
        Dollar price in the U.K   6    4      3       2        1


    The U.S. would export only Commodity A to the U.K. and
   import all other commodities, with the exception of
   Commodity B.
1.5 Comparative Advantage with More Than
Two Commodities and Countries
   Comparative Advantage with More Than 2 Countries
           Ranking of Countries in Terms of International PW/PC

           Country     A          B         C         D         E
           PW/PC        1         2         3         4         5
     Given   the equilibrium PW/PC=3 with trade, Countries A and B will export
     wheat to Countries D and E in exchange for cloth. Country C will not engage
     in international trade in this case because its pre-trade PW/PC equals the
     equilibrium PW/PC with trade.
     Given   a trade equilibrium PW/PC=4, Countries A, B and C will export wheat
     to Country E in exchange for cloth, and Country D will not engage in the
     international trade.
     Ifthe equilibrium turns to be PW/PC=2 with trade, Country A will export
     wheat to all the other countries except Country B, in exchange for cloth.
Chapter 1 Classical Theories of International Trade

      1.1 Mercantilism
      1.2 Trade Based on Absolute Advantage: Adam Smith
      1.3 Trade Based on Comparative Advantage: David
       Ricardo
      1.4 Comparative Advantage and Opportunity Costs
      1.5 Comparative Advantage with More Than Two
       Commodities and Countries
      1.6 Theory of Reciprocal Demand
      1.7 Offer Curve and Terms of Trade
1.6 Theory of Reciprocal Demand

 Theory of reciprocal demand suggests that the actual
  price at which trade takes place depends on the trading
  partners’ interacting demands.
 According to the theory of reciprocal demand, final terms
  of trade will be closer to the domestic price ratio of the
  country with stronger demand for the imported good.
 The reciprocal demand theory contends that the
  equilibrium terms of trade depend on the relative strength
  of each country’s demand for the other country’s product.
1.6 Theory of Reciprocal Demand

   Thestronger Canadian demand for autos relative to U.S.
   demand for wheat, the closer the terms of trade will be to
   Canadian domestic price ratio, and vice versa.
          Wheat             Canada Price Ratio (2:1)
                                          Improving U.S.
                                          Terms of Trade
                                                            Terms of Trade
                                                                (1:1)
              2                       C
                                                           Improving Canadian
                                                             Terms of Trade


                      D                                       U.S. Price Ratio (0.5:1)
              1
                                      A                E


             0.5                   B


              0       0.5         1                2               Autos

                   Equilibrium Terms-of-Trade Limits
1.6 Theory of Reciprocal Demand

 The reciprocal demand theory best applies when both
  countries are of equal economic size, so that the demand
  of each country has a noticeable effect on the market
  price.
 If one country is significantly larger than the other, the
  larger country attains fewer gains from trade while the
  smaller country attains most of the gains from trade. This
  situation is characterized as the importance of being
  unimportant.
Chapter 1 Classical Theories of International Trade

      1.1 Mercantilism
      1.2 Trade Based on Absolute Advantage: Adam Smith
      1.3 Trade Based on Comparative Advantage: David
       Ricardo
      1.4 Comparative Advantage and Opportunity Cost
      1.5 Comparative Advantage with More Than Two
       Commodities and Countries
      1.6 Theory of Reciprocal Demand
      1.7 Offer Curve and Terms of Trade
1.7 Offer Curve and Terms of Trade

   Offer Curve
    The  offer curve (or reciprocal demand curve) of a
     country indicates the quantity of imports and exports
     the country is willing to buy and sell on the world
     market at all possible relative prices.
    In short, the curve shows the country’s willingness to
     trade at various possible terms of trade.
    The offer curve really is a combination of a demand
     curve and a supply curve.
1.7 Offer Curve and Terms of Trade

  Deriving         an offer curve: trade triangle approach

    Y                                       Y
                                            Y3            C'

    Y1          C

                            S1                                             S2

    Y2      R          P

                                   PX              R'               P'
                                          Y4                               PX 
                                   PY 1                                    
                                                                             PY  2

                                      V                                    V'
        O   X1        X2                X        O    X3             X4                X
                      (a)                                      (b)



                    Trade Triangles at Two Possible Terms of Trade
1.7 Offer Curve and Terms of Trade

   The construction of the offer curve is completed by connecting
    all possible points at which a country is willing to trade.
              Imports of                 OCI
               Good Y                          (PX/PY)4
                                                 (PX/PY)3
                                      T"'          (PX/PY)2

                                                       (PX/PY)1
                                         T"

                      Y6               T'


                      Y5          T




                       O         X5 X6                Exports of
                                                       Good X
         Alternative Terms of Trade and Export-Import Combinations
                              on the Offer Curve
1.7 Offer Curve and Terms of Trade

   Equilibrium Terms of Trade
     Point E is the trading equilibrium. TOTE is the market-clearing
      price ratio.
                       I's Imports of Good Y           OCI    (PX/PY)E or TOTE
                      II's Exports of Good Y
                                                                      (PX/PY)1 or TOT1
                 Y2                                                     OCII
                 YE                                               B
                                                   E

                 Y1                            A




                  O                            X1 XE         X2    I's Eports of Good X
                                                                  II's Imports of Good X
                           Trading Equilibrium
1.7 Offer Curve and Terms of Trade

 Shifts      of Offer Curves
      I's Imports                OCI
                      OCI"                   OCI'
      of Good Y
                                                    TOT2    Reasons for Shifts:
                                                 H'         A change in tastes for the
        Decreased
        Willingness                                    TOTE
                                                            imported good;
         to Trade
                                               G'           A rise in income that leads to
                                 H
                                                       TOT1 an increased demand for
                             G                              imports;
                                       F'
                                                            An improvement in
                                             Increased
                       F                    Willingness     productivity in Country I’s
                                              to Trade      export industries.
  O
                                       I's Exports of Good X
          Shifts in Country I’s Offer Curve
1.7 Offer Curve and Terms of Trade

   When offer curves shift, the equilibrium terms of trade and volume
    of trade change.
                        I's Imports of Good Y    OCI    OCI'
                       II's Exports of Good Y                 TOTE
              Y2                                            E''
                                                                TOT1

             Y1                                        E'
                                                                  OCII
             YE                                  E




                   O                            XE     X1 X2 I's Exports of Good X
                                                             II's Imports of Good X
                       Increased Demand for Imports by Country I
1.7 Offer Curve and Terms of Trade

  Terms    of Trade Estimates
     The  relative price ratio PX/PY in the offer curve diagram is
      called as the commodity terms of trade, or net barter terms
      of trade .
     The economic interpretation of the terms of trade:
        – As the price of exports rises relative to the price of
          imports, each unit of a country’s exports is able to
          purchase a larger quantity of imports. Thus, more
          imports, which like any other goods bring utility to
          consumers, can be obtained with a given volume of
          exports, and the country’s welfare on the basis of those
          price relations alone has improved.
1.7 Offer Curve and Terms of Trade

     Incalculating the terms of trade for any given
     country, a price index must therefore be calculated
     for exports and imports.
       – The price index is a weighted average of the prices of
         many goods, calculated for comparison with a base year.
          » The base-year price indices are then set at values of
            100, and other years can be compared with them.
     Over a long period, terms of trade illustrates how a
     country’s share of the world gains from trade
     changes and gives a rough measure of the fortunes
     of a country in the world market.
1.7 Offer Curve and Terms of Trade

   Other Concepts of the Terms of Trade
    Income     Terms of Trade
        TOTY   = (PX/PM)×QX or (PX×QX)/PM
           – where QX is the quantity index of exports.
     Single Factoral Terms of Trade
        TOTSF = (PX/PM)×OX
           – where OX is the productivity index.
     Double Factoral Terms of Trade
        TOTDF = (PX/PM)×(OX/OM)
           – where OM represents the foreign productivity index for
             the home country’s imports.

				
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