Unformatted text preview: Mechanisms at the Core of Global Economic Liberalism
Monday, October 30, 2006 Mechanisms at the Core of Global Economic Liberalism Absolute Advantage Comparative Advantage Balance of Payments Exchange Rate Mechanism Absolute Advantage Principle of international trade in 1800s. Assume each nation can produce something better than all the other nations: One is very good at producing corn, another semiconductors, another cars... Then nations should specialize in their absolute advantage and trade with other nations for products that they produce best What if one nation is better at everything? Suppose one nation holds an absolute advantage in production of every product Then according to principle of absolute advantage, they shouldn't trade at all they should make all of their products at home Is that what happens? Is that the most efficient choice? Comparative Advantage Nations actually work off of the principle of comparative advantage Suppose the U.S. makes every product more efficiently and for less cost than France But the U.S. makes computers much better than France, and wine only slightly better Then the U.S. enjoys a comparative advantage in computer technology How Comparative Advantage Works The U.S. enjoys a comparative advantage in computer technology U.S. makes computers better than wine The U.S. should produce more computers, and trade for other nations in products they have a comparative advantage in, such as wine in France The profits from trade in computers will be greater than the slightly increased costs in buying imported wine, and the buying power of the U.S. will be overall greater. Example - U.S. has an absolute advantage
over UK in both grain and textiles
Workers Produce U.S. 60 bshls/day 20 bshls/day 20 yds/day Grain Textiles UK 10 yds/day U.S. 3 to 1 U.S. 2 to 1 adv. adv. According to absolute advantage, U.S. should produce all of its grain AND textiles at home. UK should trade, but without anything to export, it won't have the money to import, so UK will also produce everything at home Comparative Advantage
Worker earns U.S. > Grain UK > Textiles 60 bshls/day 10 yds/day Trades for 2 bushels for 1 yard 1 yard for 3 bushels Cost of textiles cheaper in UK Both U.S. and UK should specialize, U.S. producing grain (31 adv with grain vs. 21 adv with textiles) and UK produces textiles Workers trade for other product U.S. worker trades his grain for UK textiles UK worker trades his textiles for U.S. grain Cost of grain cheaper in U.S. Increased Consumption Possibilities Absolute Advantage Each nation produces its own U.S. worker trades 3 bushels of grain for 1 yd. U.S. cloth UK worker trades 1 yd. cloth for 2 bushels UK grain Comparative Advantage Workers trade because products are relatively worth more in other state U.S. worker trades 3 bushels of grain for 1.5 yd UK cloth UK worker trades 1 yd cloth for 3 bushels U.S. grain Consumption Possibilities Utilizing comparative advantage causes increased specialization, increased international trade, and an increase in the consumption possibilities for each nation Workers from each nation should want to trade because they will be able to buy more with their earnings by trading with a different country than their own More Broadly... Every Country Has a Comparative Advantage in Something. Thus, Every Country Gains From Trade. The Gains From Trade: Are Realized By Society As a Whole. Take the Form of Consumption Gains: Society Can Consume More for Same Amount of Effort or Society Can Consume the Same Amount for Less Effort Factor Endowments: The Source of Comparative Advantage Factors of Production: Capital and Labor (and Land) Countries have Different Amounts of Factors of Production. Capital Abundant: Lots of Capital and Little Labor. Labor Abundant: Lots of Labor and Little Capital. Production of Different Goods Uses Factors in Different Amounts. Production of Cars: Requires Lots of Capital, and Relatively Little Labor Capitalintensive Goods Production of Apparel: Requires Lots of Labor, and Relatively Little Capital: Labor Intensive Production Process. Laborintensive Goods Price of Final Goods Determined by the Price of the Factors Used in their Production Price of Factors is in Turn Based on Their Relative Abundance. Abundant Factor Will be Cheaper Than Scarce Factor. Countries Abundant in Labor Can Produce Goods that Use Labor Intensively More Cheaply than They Can Produce Goods that Use Capital Intensively. Such Countries Have a Comparative Advantage in Labor Intensive Goods Countries Abundant in Capital... Such Countries Have a Comparative Advantage in Capital Intensive Goods. This Simple Model Leads us to Expect that Capitalintensive Goods Will be Traded for Laborintensive Goods. ...
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