Ch3_Comparative Advantage

Ch3_Comparative Advantage - COMPARATIVE ADVANTAGE 1...

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Unformatted text preview: COMPARATIVE ADVANTAGE 1 Overview Questions • What is “merchantilism”? • What fundamental factors determine trade patterns? • What is absolute advantage? • What is comparative advantage? 3 Tenets of Merchantilism: • • Trade is a major source of national benefit National well-being is based on national holdings of gold and silver Conclusion:EXPORTS are good IMPORTS are bad Except for raw materials unavailable at home • • Government should regulate trade for maximum national advantage Trade is a zero-sum game 6 Why Do Countries Trade? • Adam Smith Absolute productivity advantages • David Ricardo Relative productivity advantages • Heckscher-Ohlin Relative abundance in factors of production • Other theories 8 Some Assumptions • Consider a simple situation: 2 countries, 2 goods produced only by labor Costs are constant Labor fully mobile domestically Labor not mobile internationally Full employment No trade barriers, perfect competition No MONEY, which means no money prices 9 Absolute Productivity Advantage (Adam Smith) Labor Requirement (Hours required per unit of production) The United States The Rest of the World 1 bushel of wheat 2 hours 2.5 hours 1 yard of cloth 4 hours 1 hour The U.S. is more productive in the production of wheat and less productive in the production of cloth 11 Levels of Productivity (Units produced per unit of labor) The United States Rest of the world Bushels of wheat in one hour 0.50 0.40 Yards of cloth in one hour 0.25 1.00 Relative prices without trade (Units of one good per one unit of the other) The United States Rest of the world Price of wheat 0.5 yards/bushel 2.5 yards/bushel Price of cloth 2.0 bushels/yard 0.4 bushels/yard 12 12 Consequences Of Trade • Arbitrage opportunities Traders in the U.S. can profit by selling domestic wheat for foreign cloth Traders in the rest of the world can profit by selling cloth for U.S. wheat • Production specialization As a result of the arbitrage opportunities, the demand for U.S. wheat increases while the demand for U.S. cloth decreases The opposite takes place in the rest of the world The U.S. specializes in the production of wheat and the rest of the world in the production of cloth 13 Consequences Of Trade (concl.) concl.) • Equalization of prices To insure that the demands of wheat and cloth are equalized to the production possibilities of the two countries, the arbitrage opportunities must be eliminated This requires price equalization • Consumption possibilities are increased Because the single equilibrium price must be between the pretrade prices, no country will be worse-off by trading At least one will be better off! 14 TO SUMMARIZE The theory of Absolute Productivity Advantages says: • A country imports the goods that can be produced more efficiently abroad, and • A country exports the goods that it can produce more efficiently than the other country What about a country that is less efficient in producing both goods? 15 15 Relative Productivity Advantage (David Ricardo) • Some countries are clearly less productive in most things than others Yet they trade and prosper Example: The U.S. is more productive industry-byindustry than almost all countries in the world Yet we import lots of stuff • More than absolute advantage is driving trade • Welcome to Comparative Advantage Comparative 16 Comparative Advantage Labor Requirement (Hours required per unit of production) The U.S. Rest of the World 1 bushel of wheat 2.0 hours 1.6 hours (was 2.5) 1 yard of cloth 4.0 hours 1.0 hours The U.S. is less productive in producing both wheat and cloth. But it is relatively more productive in producing wheat 18 Comparative Advantage (cnt) • WHY? The U.S. produces 2.0 bushels of wheat for 1 unit of cloth (2 hrs/bushel vs. 4 hrs/yard); 2.0 bushel/yard The RoW produces 1.6 bushels of wheat for 1 unit of cloth (1.6 hrs/bushel vs. 1 hrs/yard) 0.625 bushel/yard • Cloth is relatively expensive in the U.S. Therefore, wheat is relatively cheap in the U.S. 19 19 Levels of Productivity (Output produced with one unit of labor) The U.S. Rest of the World Bushels of wheat in 1 hr 0.50 0.625 (was 0.4) Yards of cloth in 1 hr 0.25 1.000 Relative prices without trade (Units of one good per unit of the other) The U.S. Rest of the World Price of wheat 0.50 yards/bushel 1.60 yards/bushel (2.5) Price of cloth 2.00 bushels/yard 0.625 bushels/yard (0.4) 20 What Really Drives Trade • From the consumer’s point of view Buy the product or service from where it is cheaper • From the producer’s point of view Sell the product or service where you can get the better price • Price differences will result in trade As long as trade is free • Various theories propose alternative ways in which autarky prices may differ 21 A Dissection of the Benefits of Trade • Assume the U.S. has 100 hours of labor It can produce 50 bushels or 25 yards Or anything in between • Suppose it produces 25 bushels and 12.5 yards Suppose we move 1 unit of labor to wheat The U.S. will produce only 12.25 yards and 25.5 bushels 1 less hour means 0.25 fewer yards; 1 more hour means 0.5 bushels This is another way to see how the price is set 22 22 A Dissection of the Benefits of Trade • Now the U.S. can sell the ½ bushel abroad It can get 0.625*0.5 = 0.3125 yards of cloth Compare to the 0.25 yard it stopped making • If the production costs don’t change, it can do that for many bushels of wheat It may even produce only wheat! • This is why comparative advantage is what determines trade patterns 23 A Dissection of the Benefits of Trade • As long as the ratio of the productivities is ratio different, the autarky prices will be different “Ratio of the productivities different” means that each country is relatively better at something relatively • If autarky prices are different there are mutual benefits to trade Absolute productivity does not influence prices; relative productivity does! 24 24 A Dissection of the Benefits of Trade • Relative costs determine prices in the absence of trade (autarky) • What would have been the cheap good gets exported • What would have been the expensive good gets imported If trade is taking place, market prices are not going to reveal comparative advantage reliably 26 26 Behavior Of a Small Economy • If the U.S. is a small economy, the prevailing small prices after the opening will be the “World Prices”, i.e., 0.625 B/C By the definition of a small economy • What will the U.S. produce in this case? At 0.625 bushels/yard, Cloth is cheaper than the U.S. can produce it at (2.0 W/C)! But at 1.6 yards/bushel Wheat is more expensive than it would be in the U.S. (0.5 W/C) 27 Behavior Of a Small Economy • The U.S. will benefit the most by specializing in producing wheat and trading for cloth • The rest of the world will continue to produce both wheat and cloth • The new consumption opportunity set for the U.S. now is: 28 Graphical Analysis Each country has 100 hours available W = Wheat (bushels of) C = Cloth (yards of) Wheat United States PUS = 2W/C W = 50 – 2C; production opportunity set 50 At 0.625 B/C, U.S. can exchange 50 W for 80 C Clearly the U.S. benefits Consumption opportunity set 25 80 Cloth 29 29 Behavior Of a Small Economy • The U.S. benefits Note that “full employment” is crucial to this conclusion • Does the rest of the world benefit? • Lesson: With benefits from trade come price and output changes! If that doesn’t happen there is no benefit from trade! 30 Behavior Of a Large Economy • If the U.S. is a large economy, the prevailing large prices after the opening will be different than in either original prices The new price will be between 0.625 B/C and 2.0 B/C By the definition of a large economy • What will production look like? 38 Behavior Of a Large Economy • Assume the price settles at 1.0 B/C • In the U.S. producing cloth is uneconomical Can’t produce for that low a price profitably • In the rest of the world producing wheat is uneconomical Same reason as above • Both countries specialize in what they do relatively better relatively 39 39 Graphical Analysis Each country has 100 hours available W = Wheat (bushels of) C = Cloth (yards of) Wheat 100 Wheat United States 100 Rest of the World W = 62.5 – 0.625 C New price is 1.0 62.5 W = 50 – 2C 50 PUS = 2W/C PRoW = 0.625 W/C 25 50 Cloth 100 Cloth 40 Gains From Trade Again • Add community utility surfaces to this to see the full equilibrium Why does the price settle at 1.0 B/C? • Unambiguously both parties benefit 41 Graphical Analysis Each country has 100 hours available W = Wheat (bushels of) C = Cloth (yards of) United States 100 100 Rest of the World 62.5 D 50 B C A 25 Cloth 100 Cloth 100 42 42 Lessons • Countries gain from trade even if trade is based only on comparative advantage • Trade is a positive sum game Contrary to Mercantilism Both countries benefit Remember that generally there are winners & losers within each country 43 Lessons • Exporting is not inherently better than importing! You have to export if you want to import! Exporting gives you the means of importing means Many countries don’t act like they see things that way 44 Lessons • Direct comparison of the absolute labor cost of production is irrelevant for trade If it wasn’t, we would not be trading with China and most other countries But income inequalities may give rise to the charge of exploitation by the developed countries 45 45 Lessons • The bigger the comparative advantage differences the greater the benefit • Ricardian model implies extremely high degree of specialization A great deal of trade 46 Graphical Analysis Each country has 100 hours available W = Wheat (bushels of) C = Cloth (yards of) 100 United States 100 Rest of the World 62.5 50 100 25 Cloth 100 Cloth 47 Some Issues • The model implies large shifts in production patterns • What happens to workers? The “producers” are the workers here! • If the cloth workers can “costlessly” become wheat farmers, then everyone benefits everyone No losers! It is a special model 49 49 Absolute Advantage Again • Is there any benefit to absolute advantage? 51 Absolute Advantage Again • Is there any benefit to absolute advantage? Note that the opportunity frontier of the RoW is much higher than the U.S. line Same number of workers (100) This is because RoW is more efficient The “opportunity frontier” is also the budget constraint It is NOT the production-possibility frontier NOT Therefore, the more efficient country has the higher income (& wages), and more consumption 52 Absolute Advantage Again • What is the wage rate in the U.S. and the RoW? 53 53 Key Summary Points • Comparative advantage is all that is required for beneficial trade • Absolute advantage means higher income • The Ricardian model predicts a great deal of specialization • The full-employment assumption is important 57 Absolute Advantage Matters for Wages 58 Example • • • Consider two countries: Japan and Taiwan Japan has 1,000 units of labor and Taiwan 500 units There are two commodities: shoes and shirts In Japan, one unit of labor produces 2 thousands shoes or 2 thousand shirts In Taiwan, one unit of labor produces 1 thousand shoes or 2.5 thousand shirts Questions: 1. Which country has the “comparative” and “absolute” advantages in producing shoes and shirts? 2. If there is no trade between Japan and Taiwan, what will be the price of shirts in terms of shoes (shoes needed to buy one shirt)? 3. Given the absolute and comparative advantages, what does this imply for free-trade? (Production, imports and exports) 4. After free trade, prices will be equalized. What is the range of possible prices? 63 63 Example • • • Consider two countries: Japan and Taiwan Japan has 1,000 units of labor and Taiwan 500 units There are two commodities: shoes and shirts In Japan, one unit of labor produces 2T shoes or 2T shirts In Taiwan, one unit of labor produces 1T shoes or 2.5T shirts Questions: 1. Which country has the “comparative” and “absolute” advantages in producing shoes and shirts? Japan has a comparative advantage in shoes while Taiwan has a comparative advantage in shirts Absolute advantage goes the same way in this case 64 Key Summary Points 1. Why do countries trade? What is the basis for trade, especially the product (commodity) composition? 2. What are the overall gains (or losses) from trade for each country? 3. What are the effects of trade on each country’s economic structure? Production, Consumption? 4. What are the effects of trade on the distribution of income within each country? Winners, Losers? 68 THE END 70 70 ...
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This note was uploaded on 02/15/2011 for the course FBE 462 at USC.

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