BBB4MBBB4MBenefits ofBenefits of

International International TradeTrade

Source: http://www.ifpri.cgiar.org/training/material/economicconcepts/training_econcon6.ppt

Principle of Absolute Advantage

A country has "absolute advantage" in the production of a good e.g. oranges, if its production costs are lower than other countries' (at prevailing prices and exchange rates).

One country can produce goods with fewer resources than another country. Florida has an absolute advantage in orange

production over Ontario Ontario can grow oranges, but it does not make

sense, as the costs are more per orange to produce because of need for greenhouses, heaters etc. (more resources) to keep the orange trees warm during the winter.

Absolute Advantage

U.S. has absolute advantage in Medicine (produces more per hour)

China has absolute advantage in clothing production.

Each country can focus on what they are good at, and trade for the other product.

Medicine(Med)

Clothes (CL)

U.S.A. 8 6

China 6 8

Output per hour worked

Conclusion:

The principle of absolute advantage appeals to common sense. i.e. focus on what you are good at based on your climate, resources, soils, skills, technology, etc.

What if a nation has an absolute advantage in all its products because of size, very cheap labor, abundant resources, or highly sophisticated technology?

- Is there still an advantage to trading?

- What goods or services to import or export?

- What amounts should they import or export?

The logic of absolute advantage suggests that this nation would export products but import nothing.But....

- Does the country have infinite resources? (No)

- Can the country possibly produce everything? (No)

- What would it do with its export earnings – i.e. revenue from selling exports? (Buy other goods – i.e. import them)

These questions and others led economists to develop the alternative idea of "comparative advantage."

Principle of Comparative Advantage

Opportunity Cost

Economic Scarcity Not enough resources to satisfy all our wants. Resources are limited, wants are unlimited.

Decisions or ‘tradeoffs’ are required more of one thing means less of another. E.g. If Canada produces more cars, then we

have less workers and factories to produce computers.

E.g. If you have two exams on the same day, one hour of math studying means less time to study history.

What you lose or ‘give up’ is the opportunity cost of your choice.

The Principle of Comparative Advantage

Resources (land, labour, capital) are finite (limited) A country must allocate (use) resources carefully! To maximize or ‘optimize’ economic production, you must

consider the cost of producing additional units of any one product in terms of the reduction needed in the output of other goods. We ‘compare’ the relative costs of each product.

E.g. 1 - To grow more units of wheat, Canada needs to change resource usage to ‘give up’ the opportunity to produce some units of corn.

Thus, the theory suggests that we compare these "opportunity costs" of producing a commodity between countries.

Comparative Advantage

On Valentine’s Day the U.S. demand for roses is about 10 million roses

Growing roses in the U.S. in the winter is difficult. Heated greenhouses should be used. The costs for energy, capital, and labor are

substantial.

Resources for the production of roses could be used to produce other goods, e.g. computers.

Opportunity Cost The opportunity cost of roses in terms of

computers is the number of computers that could be produced with the same resources as a given number of roses – e.g. 10 million roses can be produced with the same resources as it takes to make 100,000 computers.

Comparative Advantage A country has a comparative advantage in

producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries.

Comparative Advantage

In the U.S. 10 million roses can be produced with the same resources as 100,000 computers.

In Mexico 10 million roses can be produced with the same resources as 30,000 computers.

Comparative Advantage

If each country specializes in the production of the good with lower opportunity costs, trade can be beneficial for both countries. Roses have lower opportunity costs in Mexico. Computers have lower opportunity costs in the U.S.

The benefits from trade can be seen by considering the changes in production of roses and computers in both countries.

If each country exports the goods in which it has comparative advantage (lower opportunity costs), then all countries can in principle gain from trade.

Comparative Advantage:

Comparative Advantage:

Where one country can produce goods at a lower

opportunity cost – it sacrifices less resources in production

Example 1: Imagine two countries, A and B, where there are only two products – grapes and pineapples. We will analyze the production for one unit of labour (i.e. one worker)

Each country has a different climate, soil, technology The ‘yield’ (harvest) of grapes is different for country A and

country B Question – based on the next slide, who should focus only

on grape production? Why?

A

B

In terms of the numbers of grapes, pineapples are cheaper to produce in Country A than in Country B.

Country A should specialize in pineapples and Country B in grapes.

The Principle of Comparative Advantage

The theory of comparative advantage compares the "opportunity costs" of producing a product between countries.

Canada should import goods when the international price is less than the opportunity cost of producing an additional unit in Canada.

Canada should export products when the international price is higher than the opportunity cost of producing an additional unit in Canada.

Through international trade, we can obtain a lower cost and a more abundant and wider selection of goods and services.

The Principle of Comparative Advantage

International trade depends on differences between countries in the rates at which production of one item can be replaced by another (the opportunity cost) through internal reallocation of resources.

Note that the principle of comparative advantage is symmetrical.

If a country has a comparative advantage in the production of one or more goods, then it must have a comparative disadvantage in the production of some other goods.

A

B

In terms of the numbers of pineapples -- grapes are cheaper to produce in Country B (one grape = ¼ pineapple) than in Country A (one grape = ½ pineapple).

Country B should specialize in Grapes and Country A in pineapples.

A

B

Comparative Advantage

Oil (Barrels) Whisky (Litres)

Russia 10 or 5

Scotland 20 or 40

One unit of labour in each country can produce either oil OR whisky.A unit of labour in Russia can produce either 10 barrels of oil per period OR 5 litres of whisky.A unit of labour in Scotland can produce either 20 barrels of oil OR 40 litres of whisky.

Comparative Advantage

Opportunity Cost (OC)= sacrifice or giving up something

Russia:

Moving 1 unit of labour from whisky to oil means losing 5 litres of whisky but gaining 10 barrels of oil (OC = 5/10 = ½)

Moving 1 unit of labour from oil to whisky production means losing 10 barrels of oil to gain 5 litres of whisky (OC of whisky is 10/5 = 2)

TO CALCULATE OPPORTUNITY COST-DIVIDE WHAT YOU ARE LOSING BY WHAT YOU GAINScotland: Moving 1 unit of labour from whisky to oil means losing 40 litres of whisky but gaining 20 barrels of oil (OC = 40/20 = 2)

Moving 1 unit of labour from oil to whisky means losing 20 barrels of oil to gain 40 litres of whisky (OC of whisky is 20/40 = ½ )

For Scotland the OC of oil is four times higher than that in Russia (2 compared to ½)

In Russia, oil can be produced cheaper than in Scotland Russia only gives up 1 litre of whisky to produce 2 extra barrels

of oil. Scotland gives up 2 litres of whisky to produce 1 barrel of oil Note – Russia gives up ‘less’ to get more oil

There can be gains from trade if each country specialises in the production of the product in which it has the lower opportunity cost – Russia should produce oil; Scotland, whisky.

Comparative Advantage

Oil (Barrels) Whisky (Litres)

Russia 5 2.5

Scotland 10 20

Total Output 15 22.5

Oil (Barrels) Whisky (Litres)

Russia 10 0

Scotland 0 40

Total Output 10 40

Before trade – each country divides labour between the two products:

After specialisation – each country devotes its resources to that in which it has a comparative advantage.

Comparative Advantage

Total Output of both oil and whisky has risen Trade can be arranged at a mutually agreed rate that

will leave both countries better off than without trade.

The trading rate has to be somewhere between the OC ratios (in this case 2 and ½) to be agreeable to both countries.

e.g. If the trade were arranged at 1 barrel of oil for 1 litre of whisky the end result would be:

Comparative Advantage

Oil (Barrels) Whisky (Litres)

Russia 5 2.5

Scotland 10 20

Total Output 15 22.5

Before Trade:

After Trade:Oil (Barrels) Whisky (Litres)

Russia 5 10

Scotland 5 30

Total Output 10 40

Comparative Advantage

Suppose China were only ½ as productive – now, it has absolute advantage in nothing!

Can it still gain from trade?

Remember: Comparative advantage = lower opportunity cost

Medicine (Med)

Clothes (CL)

U.S. 8 6

China 3 4

Output per hour work

Answer --- Yes! China still has comparative advantage.

Computing opportunity cost In U.S., 1 Med needs

1/8 hr. from CL. Lose 6 CL/hr. 1/8 hr. = 6/8 = ¾ of a CL.

to get 1 Med, need to give up ¾ of a CL.

Comparative advantage in Med: U.S. (gives up less CL for 1 Med than China)

Comparative advantage in CL: China

Output per hr.

Medicine (Med)

Clothes (CL)

U.S. 8 6

China 3 4

Op. Costs Op. Cost

(Med)

Op. Cost

(CL)

U.S. ¾ CL 4/3 DR

China 4/3 CL ¾ DR