Comparative Advantage
Tot in Comparative Advantage - Redux
• First, note the information given:
• Is this a productivity or opportunity cost?
• Assume that in an hour, Home can produce …
• Thus, this is a productivity case
• Remember: In Comparative Advantage case, relative prices of the
goods are equal to their opportunity cost.
• Also remember: productivity and cost are reciprocals of each other
• Once you find the price of one product for one country, the price of
another product is just the reciprocal
2
Exercise#1
𝒂𝑳𝑪
Home
5 hrs.
RoW
9 hrs.
𝒂𝑳𝑺
10 hrs.
3 hrs.
𝑎𝐿𝐶
𝑎𝐿𝑆
Home RoW
Pattern of Trade for H and RoW
5 hrs. 9 hrs.
10 hrs. 3 hrs.
5
1
𝐻
𝑂𝐶𝐶 =
10
𝑂𝐶𝐶R
=
2
= 0.5S
9
= = 3S
3
• 𝑂𝐶 𝑖𝑛 𝑐𝑙𝑜𝑡ℎ𝑖𝑛𝑔 𝑖𝑛 𝐻𝑜𝑚𝑒 < 𝑂𝐶 𝑖𝑛 𝑐𝑙𝑜𝑡ℎ𝑖𝑛𝑔 𝑖𝑛 𝑅𝑜𝑊
• Home to produce and export clothes and import shoes
• RoW to produce and export shoes and import clothes
Terms of Trade for Clothes
• Home:
1
1𝐶 = 𝑆 → 1𝑆 = 2𝐶
2
• RoW:
1
1𝐶 = 3𝑆 → 1𝑆 = 𝐶
3
Terms of Trade for Clothes:
OC of C for Home = ½S → Home would not accept less than ½ S for 1 unit of cloth
OC of C for RoW = 3S → RoW would not give more than 3S for 1 unit of cloth
1/2 ≤ 𝑇𝑜𝑇𝐶 ≤ 3
Terms of Trade for Shoes
• Home:
1
1𝐶 = 𝑆 → 1𝑆 = 2𝐶
2
• RoW:
1
1𝐶 = 3𝑆 → 1𝑆 = 𝐶
3
Terms of Trade for Shoes:
OC of S for Home = 2C → Home would not give more than 2C for 1 pair of shoes
OC of S for RoW = 1/3 C → RoW would not accept less than 1/3C for 1 pair of shoes
1/3 ≤ 𝑇𝑜𝑇𝑆 ≤ 2
ToT with Labor Availability
• Will not change…
• Suppose that Home has 200 labor hours available and RoW has 300
labor.
• Calculate the pre-trade and post-trade consumption possibility in the
world.
𝑎𝐿𝐶
𝑎𝐿𝑆
Home (L= 200) RoW (L=360)
5 hrs.
9 hrs.
10 hrs.
3 hrs.
Pre-Trade (Autarky)
𝐿 = 𝑎𝐿𝐶 𝑄𝑐 + 𝑎𝐿𝑆 𝑄𝑆
100 = 𝑎𝐿𝐶 𝑄𝑐 → 100 = 5𝑄𝑐 → 𝑄𝑐 =
100
= 20
5
100 = 𝑎𝐿𝑆 𝑄𝑆 → 100 = 10𝑄𝑆 → 𝑄𝑆 =
100
= 10
10
Home: 20C & 10S
𝐿 = 𝑎𝐿𝐶 𝑄𝑐 + 𝑎𝐿𝑆 𝑄𝑆
180 = 𝑎𝐿𝐶 𝑄𝑐 → 150 = 9𝑄𝑐 → 𝑄𝑐 =
180
= 20
9
180 = 𝑎𝐿𝑆 𝑄𝑆 → 180 = 3𝑄𝑆 → 𝑄𝑆 =
180
= 60
3
RoW = 20C & 60S
World: 40C & 70S
𝑸𝐶
𝑸𝑆
Home (L= 200) RoW (L=360) World
20
20
40
10
60
70
Pre-Trade (Autarky) PPF
40 C
Home PPF with 200 L
40 C
30
30
20
20
10
RoW PPF with 360 L
10
0
0
5
10
15
S
20
0
0
20
40
60
80
100
S
120
Post-Trade (after specialization)
𝐿 = 𝑎𝐿𝐶 𝑄𝑐 + 𝑎𝐿𝑆 𝑄𝑆
200
200 = 𝑎𝐿𝐶 𝑄𝑐 → 200 = 5𝑄𝑐 → 𝑄𝑐 =
= 40
5
Home: 40C & 0S
𝐿 = 𝑎𝐿𝐶 𝑄𝑐 + 𝑎𝐿𝑆 𝑄𝑆
360
360 = 𝑎𝐿𝑆 𝑄𝑆 → 360 = 3𝑄𝑆 → 𝑄𝑆 =
= 120
3
RoW = 0C & 120S
World: 20C & 120S
𝑎𝐿𝐶
𝑎𝐿𝑆
Home (L= 200) RoW (L=360)
5 hrs.
9 hrs.
10 hrs.
3 hrs.
𝐐𝐶
𝑸𝑺
Home (L= 200) RoW (L=360)
40
0
0
120
A Comparison of Pre-Trade and Post-Trade
Production in the World
𝑸𝐶
𝑸𝑆
Home (L= 200) RoW (L=360)
20
20
10
60
𝐐𝐶
𝑸𝑺
Home (L= 200) RoW (L=360) World
40
0
40
0
120
120
Exercise #2
• Assume that there are only two countries: Home and RoW, both
producing spoons and forks. These two countries have identical
demand, production technology, and resource endowment. Let Home
can produce 1000 spoons and 500 forks while RoW can produce 2000
spoons and 200 forks.
• Find out autarky and post-trade consumption opportunities for the world.
• What is the range of terms of trade for a pair of forks?
• What is the range of terms of trade for a pair of spoons?
12
Home and RoW Productivities in Spoons and
Forks
Home
𝐐𝐒
𝐐𝐅
RoW
1,000
500
2,000
200
Pattern of Trade
𝑂𝐶S𝐻
500
1
=
= = 0.5F
1000 2
𝑂𝐶SR
200
1
=
=
= 0.1F
2000 10
𝑂𝐶 𝑖𝑛 𝑠𝑝𝑜𝑜𝑛𝑠 𝑖𝑛 𝐻𝑜𝑚𝑒 > 𝑂𝐶 𝑖𝑛 𝑠𝑝𝑜𝑜𝑛𝑠 𝑖𝑛 𝑅𝑜𝑊
• Home to give up producing spoons. It should produce and export forks and
import spoons
• RoW to produce and export spoons and import forks.
Terms of Trade for Spoon
• Home:
1𝑆 = 0.5𝐹
RoW:
1𝑆 = 0.1𝐹
Terms of Trade for Spoon:
OC of S for Home = 0.5F → Home would not give more than 0.5 fork for 1
spoon
OC of S for RoW = 0.1F→ RoW would not accept less than 0.1 fork for 1
spoon
0.1 ≤ 𝑇𝑜𝑇𝑆 ≤ 0.5
Terms of Trade for Fork
• Home:
1
1𝑆 = 𝐹 → 1𝐹 = 2𝑆
2
RoW:
1𝑆 = 0.1𝐹 → 1𝐹 = 10𝑆
Terms of Trade for Fork:
OC of S for Home = 2S → Home would not accept less than 2S for 1 fork
OC of S for RoW = 10S → RoW would not give more than 10S for 1 fork
2 ≤ 𝑇𝑜𝑇𝐹 ≤ 10
Consumption Possibilities
Home
L = 4,000
𝐐𝐒
𝐐𝐅
RoW
L = 4,000
1,000
500
2,000
200
• Suppose that these countries have 4000 labor hours available and
devote their resources to each industry equally in autarky.
• Find out pre-trade and post-trade consumption for the world.
Pre-Trade Consumption
• Suppose that these countries have 4000 labor hours available and
devote their resources to each industry equally in autarky.
• Find out pre-trade and post-trade consumption for the world.
Pre-Trade Consumption for H and R
• Suppose that these countries have 4000 labor hours available and
devote their resources to each industry equally in autarky.
• Find out pre-trade and post-trade consumption for the world.
𝐐𝐒
𝐐𝐅
Home
RoW
L = 4,000
L = 4,000
1,000*2000=2,000,000 2000*2000 = 4,000,000 6,000,000
500*2000 = 1,000,000
200*2000 = 400,000 1,400,000
Post-Trade Consumption
• Post-trade consumption for the world.
Home
L = 4,000
𝐐𝐒
𝐐𝐅
RoW
World
L = 4,000
0 2000*4000 = 8,000,000 8,000,000
500*4000 = 2,000,000
0 2,000,000
Misconceptions about Free Trade 1/4
• Trade would generate a winner and a loser as if trade were a contest.
• However, a pure exchange model demonstrates that trade is NOT a
zero-sum game.
• Instead, when two individuals make a voluntary exchange, they will
both benefit. This is sometimes calls a positive-sum game.
Misconceptions about Free Trade 2/4
• Free trade is beneficial only if a country is more productive than
foreign countries.
• But even an unproductive country benefits from free trade by avoiding the
high costs for goods that it would otherwise have to produce domestically.
• High costs derive from inefficient use of resources.
• The benefits of free trade do not depend on absolute advantage, rather they
depend on comparative advantage: specializing in industries that use
resources most efficiently.
Misconceptions about Free Trade 3/4
• Free trade with countries that pay low wages hurts high wage
countries.
• While trade may reduce wages for some workers, thereby affecting the
distribution of income within a country, trade benefits consumers and other
workers.
• Consumers benefit because they can purchase goods more cheaply (more
wine in exchange for cheese).
• Producers/workers benefit by earning a higher income (by using resources
more efficiently and through higher prices/wages).
Misconceptions about Free Trade 4/4
• Free trade exploits less productive countries.
• While labor standards in some countries are less than exemplary compared to
Western standards, they are so with or without trade.
• Are high wages and safe labor practices alternatives to trade? Deeper
poverty and exploitation (e.g., involuntary working) may result without export
production.
• Consumers benefit from free trade by having access to cheaply (efficiently)
produced goods.
• Producers/workers benefit from having higher profits/wages—higher
compared to the alternative.
Summary
1/4
• The terms of trade is defined as how much of one good trades for one
unit of another good in the market.
• The terms of trade between two goods (e.g., apples and oranges) is
equivalent to the ratio of the dollar prices of apples and oranges.
• The terms of trade is influenced by many different factors, including
product preferences, uncertainties over preferences, quantities and
qualities of the goods, persuasive capabilities, regularity of the
trading relationship, and government policies.
• Any trade pattern between individuals may be claimed to be mutually
advantageous as long as the trade is mutually voluntary.
Summary
2/4
• The terms of trade is defined as the ratio of the trade quantities of
the two goods.
• Greater competition (more sellers) in a market reduces the price of
that good and lowers the well-being of the previous sellers. (Sellers
dislike more sellers of the goods they sell.)
• Greater competition (more sellers) in a market raises the price of the
buyer’s goods and increases the well-being of the previous buyers.
(Buyers like more sellers of the goods they buy.)
• The changes described above assume individuals are profit seeking.
Summary
3/4
• Because export industries find more buyers for their products with
international trade, export industries benefit from trade.
• Because trade increases the number of competitors import-competing
industries face, trade harms import-competing industries.
• A free trade policy will cause lower income for each worker but also lower
prices for all the goods and services purchased.
• A protectionist policy will cause higher incomes but also high prices for all
the goods and services purchased.
• Given the choice between high income and high prices or low income and
low prices, monopoly concerns suggest the latter would be chosen.
Summary
4/4
• Trade is predicted to benefit both high productivity and low productivity
countries, although trade may change the distribution of income within
countries.
• High productivity or low wages give countries a cost advantage that allow them to
produce efficiently.
• Although empirical evidence supports trade based on comparative advantage,
transportation costs and other factors prevent complete specialization
in production.
In a Ricardian world, what would be the
pattern of trade?
Home
L = 4,000
𝐐𝐒
𝐐𝐅
RoW
L = 4,000
1,000
500
2,000
1,000