Transcript Ch 12 absolute comparative advantage

International Trade
Why countries trade and how citizens may or may not benefit from trade
International Trade Theory
 Trading among nations is obviously not a new
practice. Countries have been importing and
exporting goods with their neighbours for several
thousand years.
 Never before, however, has international trade made
up such a large percentage of GDP in so many
countries around the world.
Benefits from trade
 Countries would not trade with each other if it wasn’t
beneficial to both parties. What are some of the
benefits that countries receive from international
trade?
Benefit #1
Domestic production
and consumption will
increase due to
specialization
 Specialization allows a
country to concentrate
on making those goods
which it produces most
efficiently.
 By using scarce
resources most
efficiently, a country
can increase production
of these goods and then
exchange them for
goods made elsewhere
Benefit #1
(continued)
Specialization leads to
increased consumption
 Once a country
identifies and begins
producing the good(s) it
is most suited to
specialize in, it can
begin exporting these
goods to foreign
nations.
 In return, the country
will receive a variety of
goods and services that
are produced more
efficiently elsewhere
Benefit 1 (continued)
 Factor endowments, or the factors of production a
country is blessed with, determine what goods and
services a country will produce.
 A country with good natural harbours would tend to
specialize in shipping, while a landlocked country
would develop alternative areas to specialize in.
 The concepts of comparative advantage argues that
by specializing and trading, countries will mutually
benefit and use scarce resources most wisely
Benefit #2
By specializing in
production of
particular goods or
services, economies of
scale may be achieved.
I assume you remember
this, yes…?
Economies of Scale
 By specializing and increasing quantity produced,
countries may lower the average cost of production of
particular goods and services, and then trade with
foreign countries.
 Increasing output to provide for consumers beyond the
domestic market allows a country to lower the average
cost of production. Lower costs leads to greater
export competitiveness.
 Obviously, different
Benefit #3
Trade leads to greater
variety of goods
available to consumers
countries specialize in
producing different
goods and services.
 Trade allows countries
to enjoy goods and
services that are more
efficiently produced in
other parts of the world
Benefit #4
Trade allows countries
to acquire needed
resources
 Some countries have an
enormous amount of
natural resources that
are valued worldwide.
 Middle East oil
producers can trade oil
for other goods and
services, thus
benefitting themselves
and their trading
partners
Benefit #5
Trade results in
increased competition,
leading to greater
efficiency in production
 Domestic producers are
forced to maximize
efficiency when faced
with foreign
competition.
 In the Darwinian
business world, those
producers who produce
at the lowest cost will
survive, and those who
can’t compete will
disappear.
Benefit #6
Trade makes possible
the flow of new ideas
and technology
 As goods are traded
from one country to
another, knowledge and
skills are also shared
among countries,
leading to increased
efficiency, competition
and progress
Benefit #7
Trade makes countries
interdependent
 A relationship based on
trade can lead to closer
relations among
countries.
 If I need resources from
another country, it is in
my best interest to
remain on good terms
with that country. So
perhaps a more peaceful
world results
Benefit #8
International trade as
“an engine of growth”
 International trade
contributes to
specialization,
economies of scale,
resource exchange,
increased competition,
greater efficiencies in
production, technology
improvements and
expanding markets
which are all drivers of
economic growth
Benefit #9
Increased international
trade can lead to
economic and human
development
 The economic benefits
that may follow from
international trade may
allow a country to focus
on economic and
human development
objectives, which can
improve living
standards for millions
of people
Absolute and Comparative Advantage
For Mature Audiences Only (HL)
Absolute Advantage
 Introduced by our hero, Adam Smith, absolute
advantage refers to the ability of one country to
produce something with fewer resources than another
country (or produce more quantity of something with
the same amount of resources)
Absolute Advantage
 Absolute advantage is a very simple concept.
 Let’s take a look at the graph on the next slide and
make some simple observations about which country
has an absolute advantage in the production of two
different goods
Absolute Advantage
 The previous PPCs were straight lines, assuming
opportunity cost is constant as we move along the
PPC. Clearly, Country A has an absolute advantage in
rice production, while Country B has an absolute
advantage in iron ore production.
 Absolute advantage theory argues that the countries
should specialize in what they produce most
efficiently, and then trade with the other country for
the other product
Absolute Advantage and Opportunity Cost
 The opportunity cost of rice in Country A is equal to:
25 units of iron ore/100 units of rice = ¼
 The opportunity cost of rice in Country B is equal to:
100 units of iron ore/25 units of rice = 4
In order to produce an extra unit of rice, Country A must
sacrifice ¼ a unit of iron ore, Country B must sacrifice 4
units of iron ore
Absolute Advantage and Opportunity
Cost
 The opportunity cost of iron ore in Country A is equal to:
100 units of rice/25 units of iron ore/ = 4
 The opportunity cost of iron ore in Country B is equal to:
25 units of rice/100 units of iron ore/ = 1/4
In order to produce an extra unit of iron ore, Country A must
sacrifice 4 units of rice, Country B must sacrifice 1/4 unit of
rice
Gains from trade
 If Country A specializes in rice and country B
specializes in iron ore, adhering to the idea of
minimizing opportunity costs, what gains from trade
would occur if they traded on a 1:1 basis, rice for iron
ore?
 Before trade, Country A could produce 20 rice and 20
iron ore. If they make only rice they could produce
100 rice and trade 20 rice to Country B for 20 iron ore,
and thus reach a point beyond it’s original PPC.
 Obviously, Country A is better off…..
Gains from trade
 Country B should benefit as well from this
relationship. What gains from trade would occur if
they traded on a 1:1 basis, iron ore for rice?
 Before trade, Country B could also produce 20 rice
and 20 iron ore. If they make only iron ore they could
produce 100 iron ore and trade 20 iron ore to Country
B for 20 rice, and thus reach a point beyond it’s
original PPC.
 Obviously, Country B is also better off…..
Gains from trade
 Specialization and trade have resulted in both
increased production and consumption, and both
countries benefitted.
 Before specialization, Country A and B produced 40
units of both rice and iron ore. After specialization,
100 units of both rice and iron ore were produced.
 So absolute advantage theory argues for specialization
and trade to increase production and consumption,
and move countries beyond their initial PPCs
Comparative Advantage
 Well the idea of absolute advantage is pretty
straightforward and it probably didn’t take a genius to
articulate it. David Ricardo went a step further with
the concept of comparative advantage. Yup, another
fine looking economist…
Comparative Advantage
 Ricardo argued that countries could benefit from trade
even if one country had an absolute advantage in both
goods being considered.
 Ricardo theorized that whichever country had the
lower opportunity cost for a particular good should
specialize in that good, and trade with the other
country for the good that that country produced at a
lower opportunity cost
Comparative Advantage
Country A
Country B
Wheat
20
25
Computers
10
50
Opportunity cost of
wheat
10/20 = .5
50/25 = 2
Opportunity cost of
computers
20/10 = 2
25/50 = .5
Comparative Advantage
 Country B can obviously produce more of both wheat
and computers that Country A, but Country A has a
lower opportunity cost for wheat production, while
Country B has a lower opportunity cost for computer
production.
 Ricardo argued that Country B should specialize in
computers, while Country A should specialize in
wheat. Let’s see what happens with the 1:1 trade
scenario…..
Comparative Advantage
 Let’s assume before specialization, Country A was
producing 10 wheat and 5 computers.
 If they specialize in wheat, they can produce 20, but
no computers. Country A can then trade 10 wheat for
10 computers and reach a point beyond it’s original
PPC.
 Country A clearly is better off. What about Country
B?
Comparative Advantage
 Let’s assume before specialization, Country B was
producing 5 wheat and 40 computers.
 If they specialize in computers, they can produce 50,
but no wheat. Country B can then trade 10 computers
for 10 wheat and reach a point beyond it’s original
PPC. Country B is also is better off.
 Overall, instead of producing 15 wheat, we have 20,
and instead of 45 computers, we have 50. Global
production and consumption increases!
The moral of the story
 The law of comparative advantage states that if
opportunity costs in two or more countries differ, it
will be possible for all countries to gain from
specialization and trade according to their
comparative advantage, even though one country may
have the absolute advantage in all goods.
What if……?
 If 2 countries have parallel PPCs, then their
opportunity costs for both goods are identical. There
would be no gains from trade or specialization in this
example, but this is a rarity anyway…
So it’s that simple?
 Well, even though many countries use the law of
comparative advantage as the basis for their trade
policies, there are many criticisms surrounding it….
Unrealistic assumptions?
 Critics claim that the law of comparative advantage
depends on unrealistic assumptions, such as:
 Factors of production being fixed and immobile, and not
changing in quality
 Technology being fixed
 The existence of perfect competition
 Full employment of resources
 Imports and exports balancing each other
 All governments practicing free trade
More criticisms
 Transport costs can’t be ignored
 Comparative advantage doesn’t account for structural
changes in a country’s economy (shifting from
primary sector to secondary/tertiary)
 Absolute specialization can pigeon-hole a country to
an extreme, making it vulnerable to external economic
forces such as recession or natural disaster….If a
country is only producing a few goods, if
circumstances change, they could be in big trouble…
Comparative Advantage
 Criticisms aside, comparative advantage continues to
play a major role in the global trading scene, and it’s
not going away anytime soon….