© Pilot Publishing Company Ltd. 2005

•
The law of comparative advantage
•
Distribution of gains from trade
•
Graphical illustration of international trade
•
International trade – Reasons and hindrance
•
Advanced Materials 10.1 : Graphical illustration of international trade –
Increasing production cost
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Necessary conditions for international trade
Factors of production cannot be moved across national boundaries but goods can. Why?
Production costs of the trading parties are different.
Why?
The transportation and the transaction costs involved do not exhaust the gains from trade. Why?
Protectionist measures are not prohibitive. Why?
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Absolute advantage
A country is said to have an absolute advantage over another country in the production of a good if it can produce a larger amount of the good than the other country with the same amount of resources .
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Reciprocal absolute advantage
Two countries are said to have a reciprocal absolute advantage over each other if each country has an absolute advantage over the other in producing one of the two goods.
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The principle
Given that two countries have a reciprocal absolute advantage over each other, if each specializes in producing the good in which it has an absolute advantage, then the world’s total output will increase
.
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Case I Food Clothing
Output of 1 unit of resources*
Country A 10 8
Country B 3 10
*1 unit of resources (a combination of labour, capital, and land)
Which country has an absolute advantage in the production of food ?
Country A
Which country has an absolute advantage in the production of clothing ?
Country B
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Specialization leads to increase in world’s output
If now country A shifts 1 unit of resources from the production of clothing to the production of food .
And country B shifts 1 unit of resources from the production of food to the production of clothing .
Food Clothing
Country A
Country B
World’s total output
10

8
3

10
+7 +2
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Case II Food Clothing
Output of 1 unit of resources*
Country A 100 80
Country B 3 10
*1 unit of resources ( a combination of labour, capital, and land)
Which country has an absolute advantage in the production of food ?
Country A
Which country has an absolute advantage in the production of clothing ?
Country A
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Comparative advantage
A country is said to have a comparative advantage over another country in the production of a good if it can produce the good at a lower opportunity cost than the other country.
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The law of comparative advantage
The law of comparative advantage or the law of comparative cost states that if each country specializes in the production of the good in which it has a comparative adv.
(or a lower production cost) , the world’s total output will increase
.
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Country A
Country B
Output of 1 unit of resources
100F
3F
80C
10C
Country A
Country B
Production cost of 1F Production cost of 1C
80C

0.80C
100
10 C

3 .
33 C
3
100 F

1 .
25 F
80
3 F

0 .
30 F
10
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Specialization leads to an increase in world’s output
If country A produces one more unit of food while country B produces one more unit of clothing
Food Clothing
Country A +1.0F
-0.8C
Country B
World’s total output
-0.3F
+0.7F
+1.0C
+0.2C
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Absolute advantage versus comparative advantage
1. Abs. adv. and comp. adv. are unrelated .

Abs. adv. compares productivity of the two countries
(the amount of output obtained per unit of resources) .

Comp. adv. compares production costs of the two countries
(the amount of another good forgone per unit of output).

However, if two countries have a reciprocal absolute advantage over each other, each will have a comparative advantage in the production of the good that it has an absolute advantage.
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2. It is possible for a country to have an absolute advantage in the production of all goods , but it is impossible for the country to have a comparative advantage in all production .
3. It is the comparative advantage (not the absolute advantage) that determines the allocation of resources and the direction of trade .

However, comparative advantage does not determine the volume of trade , the terms of trade or the balance of trade .
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Q10.4:
For each of the following typical cases, determine
(a) which country has an absolute advantage in the production of
(i) food (ii) clothing
(b) which country has a comparative advantage in the production of
(i) food (ii) clothing
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Case 1:
Food
Clothing
Case 2:
Country A
Country B
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Output of 1 unit of resources
Country A Country B
8 10
2 6
Output of 1 unit of resources
Food Clothing
8 10
2 6

Case 3:
Country A
Country B
Case 4:
Country A
Country B
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Amount of resources for producing
1 unit of output
Food Clothing
8 10
2 6
Production cost of 1 unit of output
Food Clothing
$8
£2
$10
£6

Calculation of production costs
1. Given the amount of good X and good Y produced per unit of resources (marginal products), i.e., MP
X and MP
Y
:
Production cost of 1X is 
MP
Y
MP
X units of good Y
Production cost of 1Y is 
MP
X
MP
Y units of good X
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Calculation of production costs
2. Given the amount of resources required to produce one unit of good X and good Y (real marginal costs in terms of resources), i.e., MC
X and MC
Y
:
Production cost of 1X is 
MC
X
MC
Y units of good Y
Production cost of 1Y is

MC
Y
MC
X units of good X
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Calculation of production costs
3. Given the amount of money required to produce one unit of good X and good Y (nominal marginal costs in terms of money), i.e., MC
X and MC
Y
:
Production cost of 1X is 
MC
X
MC
Y units of good Y
Production cost of 1Y is

MC
Y
MC
X units of good X
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Principle
Specialization raises the world’s total output, while trade distributes the output among trading parties .
The world price (or exchange ratio or terms of trade) of a good is determined by its D & S in the world market.
From the trading of a good, a country gains the difference between its production cost of the good and the good’s world price.
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Illustration
Amount of labour required to produce a unit of food and clothing in country A and country B
Food Clothing
Country A
Country B
8 lab
10 lab
10 lab
3 lab
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Calculation of gains from trade
Production cost of 1F Production cost of 1C
Country A
Country B
8 lab
10 lab
10 lab

3.33C
3 lab

0.80C
10 lab

1.25F
8 lab
3 lab

0.30F
10 lab
Given exchange ratio: 1F=1C
World price of 1F ( =1C ) >
Country A’s production cost of 1F ( =0.8C
)
Country A exports food
From each unit of food exported, country A gains
0.2C
( =1C-0.8C
).
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Calculation of gains from trade
Production cost of 1F Production cost of 1C
Country A
Country B
8 lab
10 lab
10 lab

3.33C
3 lab

0.80C
10 lab

1.25F
8 lab
3 lab

0.30F
10 lab
Given exchange ratio: 1F=1C
World price of 1F ( =1C ) <
Country B’s production cost of 1F ( =3.33C
)
Country B imports food
From each unit of food imported, country B gains
2.33C
( =3.33C-1C ).
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Terms of trade ( TOT ) is the ratio of a country’s export price (P
X
) to its import price
(P
M
).
P
X
TOT=
P
M
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Implications of the terms of trade
TOT

It measures the amount of import that a country can exchange with a unit of its export

An improvement (or deterioration) in the terms of trade reflects an increase (decrease) in the gain from trade per unit of export .

A change in the terms of trade has no implication on the amount of trade, the total gain from trade or the balance of trade . Why?
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Terms of trade index
The terms of trade index
= the unit value index for total exports the unit value index for imports measured in the same base period
The unit value index for total exports (or imports )
 is the weighted average of the export prices
(or the import prices).
 where the weight of a good is equal to the proportion of its value in the total value of exports (or the total value of imports).
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Q10.6
How will the terms of trade of Hong Kong be affected under the following situations?
(a) A rise in the price of foodstuff imported from the mainland.
(b) An improvement in the labour productivity in
Hong Kong.
(c) A rise in the exchange value of Japanese yen.
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A. Illustration with two separate diagrams – constant production cost
Given information:
Production possibility curves of countries A & B
Indifference maps of countries A & B
A price line with its slope representing the world price
(or the exchange ratio or the terms of trade) of good X in terms of good Y
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1. The situation without trade (the autarkic situation)
- Without trade, a country is self-sufficient. It can consume what it can produce only, i.e., its production possibility curve
(PPC) = its consumption possibility curve (CPC).
- To maximize social welfare, the country’s consumption optimum ( CO ) is the tangency point of its PPC and the highest indifference curve achievable, which is also its production optimum ( PO ) under self-sufficiency.
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Country A: The situation without trade
Clothing
1F
1 600
Slope = Cost of 1F
= 1 600C/2 000 = 0.8C

CO
A0
PO
A0
0
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PPC
A0
= CPC
A0
Food
2 000

Country B
Clothing
1 500
1F
Slope = Cost of 1F
= 1 500C/450 = 3.33C
PO

B0
CO
B0
0
PPC
B0
= CPC
B0
450
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Food

2. The situation with trade
 From the PPCs, the amount of output of the two countries can be compared. However, without information on their amount of resources endowed, absolute advantage cannot be determined.

The slope of a PPC shows the marginal production cost of good
X in terms of good Y. On the other hand, its inverse shows the marginal production cost of good Y in terms of good X.

As PPC
A has a gentler slope than PPC
B
, country A has a lower cost in producing good X (food) while country B has a comparative advantage in producing good Y (clothing).
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
The world price is determined by demand & supply at which Q d of the importing country equals Q s of the exporting country.

With the existence of international market, a country can sell what it produces to buy what it wants to consume. This can be represented by a movement along the price line passing through the
PO.

To maximize wealth , the new PO is the point through which the outermost price line passes.

The outermost price line is the new CPC.
 To maximize social welfare , the CO is the point at which the new CPC touches the highest indifference curve achievable.
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Clothing
2 000
1 600 

PPC
A 
0
Country A
---- Possible consumption possibility curves
---- Outermost consumption possibility curve
Complete specialization
PO
A

2 000
Food
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Country B
Clothing
1 500
PO
B
Complete specialization
---- Possible consumption
PPC
B possibility curves

---- Outermost consumption possibility curve
0

450
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1 500
Food

Amount of trade

If PO > CO, the excess amount of the good is exported.
On the other hand, if PO < CO, the insufficient amount is imported.
 Country A’s export is country B’s import and vice versa.
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Graphical illustration
Clothing
2 000
CPC
A
1 600
1 000
PPC
A
 CO
A
Country A
0
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Export
1 000 2 000
PO
A
Food

Graphical illustration
Clothing
1 500
PO
B
Country B
500
0
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Import

CO
B
450 1 000
CPC
B
Food
1 500

Illustration with a composite diagram –
Constant production cost
Clothing
F : Export of country A
= Import of country B
= 1 000 units of food
2 000
Countries A & B
CO
A
=CO
B
1 600
1 000
PPC
A

PPC
B
0 C : Export of country B
= Import of country A
= 1 000 units of clothing
C
0 1 000
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F

2 000
PO
A
= PO
B
Food

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By production possibility curve and indifference curve
Without trade (the autarkic situation)
Clothing
Clothing

CO
A0
PO
A0
Country A Country B
MC
B0
MC
A0

CO
B0
PO
B0
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With trade
Clothing

CO
A1
Import of country A
Export of country A

PO
A1
Country A
IC
A1
> IC
A0
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Clothing
Country B
Export of

PO
B1 country B

CO
B1
Import of country B
IC
B1
> IC
B0
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Reasons for international trade
1. Incapable of being self-sufficient
2. Difference in production costs
3. Economies of scale and learning by doing
4. A wider range of goods and services
5. Improvement in technology and productivity
6. Suppression of domestic monopoly
7. Price stability
8. Intangible benefits
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Hindrance to international trade
1. Transportation cost
2. Protectionism
3. Lack of a mutually acceptable exchange ratio
4. International tension
5. Internal instability
6. Fluctuations in exchange rate
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Correcting Misconceptions:
1. If a country has an absolute advantage in the production of good X, it will also have a comparative advantage in its production.
2. It is possible for a developed country to have an absolute advantage as well as a comparative advantage over a developing country in the production of all goods.
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Correcting Misconceptions:
3. Comparative advantage determines the direction of trade, the terms of trade, the amount of trade as well as the balance of trade.
4. The terms of trade is the ratio of a country’s amount of import to its amount of export.
5. The terms of trade determines the gain from trade, the amount of trade as well as the balance of trade.
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Correcting Misconceptions:
6. If the terms of trade of a country becomes more favourable, the country will be better off.
7. Trade enables a country to produce and consume beyond its production possibility curve.
8. Difference in opportunity cost is both the necessary and sufficient conditions for international trade.
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