Management 3460
Institutions and Practices in
International Finance
Fall 2003
Greg Flanagan
Chapter 1 appendix
Comparative Advantage
Comparative Advantage
Production and Trade Possibilities
Curves
2
Comparative advantage
Differing opportunity costs
consumption possibilities
through trade are greater than
a country’s production
possibilities.
3
Production & Trade Possibilities Curves
60
Quantity
of milk
(Opp cost
= 1) 45
Produce bread and trade for milk
0< Terms of Trade <1
Country A
Trade Possibilities Curve: |Slope| = 1.5
TPC
|Slope| = 1
30
|Slope| = 2
The PPC slope for Country B
PPC
30
4
Quantity of bread
(Opp cost = 1)
Production & Trade Possibilities Curves
Quantity
of milk
(Opp cost
= .5) 20
Country B
Produce Milk and trade for bread
0< Terms of Trade <1
Trade Possibilities Curve: |Slope| = 1.5
|Slope| = 2
|Slope| = 1
The PPC slope for Country A
PPC
TPC
10
5
15
20
Quantity of bread
(Opp cost = 2)
Textbook Problem Solutions
1. The opportunity cost of producing food
instead of textiles is one yard of textiles
per 7/4 = 1.75 pounds of food. A pound of
food has an opportunity cost of 4/7 = .57
yards of textiles.
Food
7
6
4
Textiles
Textbook Problems
 2. Examination of the no-trade input/output table indicates
that Country X has an absolute advantage in the production of
food and textiles. Country X can “trade off” one unit of
production needed to produce 17 pounds of food for five
yards of textiles. Thus, a yard of textiles has an opportunity
cost of 17/5 = 3.40 pounds of food, or a pound of food has an
opportunity cost of 5/17 = .29 yards of textiles. Analogously,
Country Y has an opportunity cost of 5/2 = 2.50 pounds of
food per yard of textiles, or 2/5 = .40 yards of textiles per
pound of food. In terms of opportunity cost, it is clear that
Country X is relatively more efficient in producing food and
Country Y is relatively more efficient in producing textiles.
Thus, Country X (Y) has a comparative advantage in
producing food (textile) is comparison to Country Y (X).
7
Textbook Problems
 2. When there are no restrictions or impediments to free trade
the economic-well being of the citizens of both countries is
enhanced through trade. Suppose that Country X shifts 20M
units from the production of textiles to the production of food
where it has a comparative advantage and that Country Y
shifts 60M units from the production of food to the production
of textiles where it has a comparative advantage. Total output
will now be (90M x 17 =) 1,530M pounds of food and [(20M x
5 =100M) + (90M x 2 =180M) =] 280M yards of textiles.
Further suppose that Country X and Country Y agree on a
price of 3.00 pounds of food for one yard of textiles, and that
Country X sells Country Y 330M pounds of food for 110M
yards of textiles. Under free trade, the following table shows
that the citizens of Country X (Y) have increased their
consumption of food by 10M (30M) pounds and textiles by
10M (10M) yards.
8
Production & Trade Possibilities Curves
Food
(..29)
Country X
17
Produce Food and trade for Textiles
0< Terms of Trade <1
Trade Possibilities Curve: 2.5 < |Slope| < 3.4
i.e. 3
|Slope| = 3.4
|Slope| = 2.5
The PPC slope for Country X
PPC
TPC
5
9
6.8
Textiles
(3.4)
Production & Trade Possibilities Curves
Food
(.4)
Country Y
Produce textiles and trade for food
0< Terms of Trade <1
6.8
TPC
Trade Possibilities Curve: 2.5 < |Slope| < 3.4
i.e. 3
|Slope| = 2.5
5
PPC
|Slope| = 3.4
The PPC slope for Country X
2
10
Textiles
(2.5)