Ch 10 International trade
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Transcript Ch 10 International trade
Chapter 10
International Trade I --The Law of Comparative
Advantage
© Pilot Publishing Company Ltd. 2005
Contents:
• 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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The Law of Comparative
Advantage
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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
Country B
10
3
8
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
Country B
the production of clothing?
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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
10
+10
-88
Country B
-3
3
+10
10
World’s total output
+7
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+2
Case II
Food
Clothing
Output of 1 unit of resources*
Country A
Country B
100
3
80
10
*1 unit of resources ( a combination of labour, capital, and land)
Which country has an absolute advantage in
Country A
the production of food?
Which country has an absolute advantage in
Country A
the production of clothing?
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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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Output of 1 unit of resources
Country A
100F
80C
Country B
3F
10C
Production cost of 1F
Production cost of 1C
Country A
80C
0.80C
100
100 F
1.25 F
80
Country B
10C
3.33C
3
3F
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
-0.3F
+1.0C
World’s total output
+0.7F
+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:
Output of 1 unit of resources
Country A
Country B
Food
8
10
Clothing
2
6
Case 2:
Output of 1 unit of resources
Food
Clothing
Country A
8
10
Country B
2
6
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Case 3:
Amount of resources for producing
1 unit of output
Food
Clothing
Country A
8
10
Country B
2
6
Case 4:
Country A
Country B
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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., MPX and MPY:
Production cost of 1X is MP Y units of good Y
MP X
Production cost of 1Y is
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MP X
units of good X
MP Y
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., MCX and MCY:
Production cost of 1X is MC X units of good Y
MC Y
Production cost of 1Y is
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MC Y
units of good X
MC X
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., MCX and MCY:
Production cost of 1X is MC X units of good Y
MC Y
Production cost of 1Y is
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MC Y
units of good X
MC X
Distribution of
Gains from Trade
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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
8 lab
10 lab
Country B
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 lab
0.80C
3.33C
10 lab
8 lab
3 lab
1.25F
0 .3 0 F
1 0 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 lab
0.80C
3.33C
10 lab
8 lab
3 lab
1.25F
0 .3 0 F
1 0 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
Terms of trade (TOT) is the ratio of a
country’s export price (PX) to its import price
(PM).
PX
TOT=
PM
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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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Graphical Illustration of
International Trade
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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
1 600
1F
Slope = Cost of 1F
= 1 600C/2 000 = 0.8C
COA0
POA0
0
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PPCA0 = CPCA0
2 000
Food
Country B
Clothing
1 500
1F
Slope = Cost of 1F
= 1 500C/450 = 3.33C
COB0
POB0
0 PPCB0= CPCB0
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 PPCA has a gentler slope than PPCB, 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 Qd
of the importing country equals Qs 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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Country A
Clothing
2 000
---- Possible consumption
possibility curves
1 600
---- Outermost consumption
possibility curve
PPCA
0
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Complete specialization
POA
Food
2 000
Country B
Clothing
Complete specialization
1 500 POB
PPCB
---- Outermost consumption
possibility curve
0
---- Possible consumption
possibility curves
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
Country A
2 000 CPCA
1 600
1 000
PPCA
COA
POA
0
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Export
1 000
2 000
Food
Graphical illustration
Clothing
1 500
POB
500
0
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Country B
Import
COB
CPCB
450
1 000
1 500
Food
Illustration with a composite diagram –
Constant production cost
Countries A & B
Clothing
2 000
1 600
F: Export of country A
= Import of country B
= 1 000 units of food
COA=COB
0 C: Export of country B
PPCA
PPCB
1 000
C
0
1 000
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= Import of country A
= 1 000 units of clothing
POA=POB
F
2 000
Food
Advanced Material 10.1
Graphical Illustration of
International Trade
– Increasing Production Cost
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By production possibility curve and
indifference curve
Without trade (the autarkic situation)
Clothing
Clothing
Country A
COA0
MCB0
POA0
Country B
MCA0
COB0
POB0
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With trade
Clothing
Country A
Import of
country A
COA1
ICA1 > ICA0
Export of
country A
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POA1
Clothing
Country B
Export of
country B
ICB1 > ICB0
POB1
Import of
country B
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COB1
International Trade
--- Reasons and Hindrance
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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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