Transcript Principles of Microeconomics

Comparative Advantage:
The Basis of Exchange
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Exchange and Supply
 Basis for exchange
 Principle of comparative advantage
 Production possibilities curve
 Economic efficiency
 International trade
 Multilateral trade agreements
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Basis for Exchange
 Why do peoples trade?
 A difference in the comparative advantage (or marginal
values to be precise) is a precondition for trade to be
mutually beneficial.
 The exchange benefits the two parties just as much as
if there had been a magical, costless increase in goods
to the two people.
 The following analyses presume costs of transaction are
negligible (this assumption will be relaxed later)
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Example 2.1. Basis for exchange
 Paul is a house painter whose roof needs replacing. Ron
is a roofer whose house needs painting.
 Although Paul is a painter, he also knows how to install
roofing. Ron, for his part, knows how to paint houses.
 Should Paul roof his own house? Should Ron paint his
own house?
Paul
Ron
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Example 1 Basis for exchange
Time required by each to complete each type of job:
Painting
Roofing
Paul
300 hrs
400 hrs
Ron
200 hrs
100 hrs
Ron has an absolute advantage over Paul at both painting and
roofing, which means that Ron takes fewer hours to perform each
task than Paul does.
Should Ron do the roofing and painting jobs for both houses?
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Example 1: Basis for exchange
Opportunity Cost for
1 Painting
Opportunity Cost for
1 Roofing
Paul
0.75 Roofing
1.33 Painting
Ron
2 Roofing
0.5 Painting
 For Paul, the opportunity cost of painting one house = the
number of roofing jobs he could do during the same time.
 So Paul’s opportunity cost of painting a house is .75
roofing jobs (=300 hrs per painting/400 hrs per roofing).
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Comparative advantage and opportunity cost
“To have a comparative advantage at a task”

(is the same as)
“To have a lower opportunity cost of performing it”
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Example 1 Basis for exchange
Time required by each to complete each type of job:
Painting
Roofing
Paul
300 hrs
400 hrs
Ron
200 hrs
100 hrs
However, Paul has a comparative advantage over Ron at
painting, which means that he is relatively more efficient at
painting than Ron is.
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Example 1 Basis for exchange
 Paul’s opportunity cost of painting a house is .75 roofing
jobs.
 Ron’s opportunity cost of painting a house is 2 roofing
jobs.
 Paul thus has a comparative advantage at painting,
because his opportunity cost of painting is lower than
Ron’s.
 Therefore it makes sense for Paul to do both painting
jobs and leave both roofing jobs for Ron.
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Example 1: Basis for exchange
Painting
Roofing
Paul
300 hrs
400 hrs
Ron
200 hrs
100 hrs
 If each person performed both tasks for himself, the
total time spent would be 700 hours for Paul and 300
hours for Ron.
 In contrast, when each specializes in his comparative
advantage, these totals fall to 600 for Paul (300 hrs x
2 houses) and 200 for Ron (100hrs x 2 houses), a
savings of 100 hours each. This is the gain from
exchange.
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Principle of Comparative Advantage
 Everyone does best when each person (or country)
concentrates on the activities in which he or she is
relatively most efficient.
 “Concentrates on the activities in which he or she is
relatively most efficient” means specialization.
 Specialization by comparative advantage provides the
rationale for market exchange.
 By performing only those tasks at which we are
relatively most efficient, we can produce vastly more
than if we each tried to be self-sufficient.
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Sources of Comparative Advantage
 Individual Level
 Inborn talent
 Education
 Training
 Experience
 National Level
 Natural resources
 Cultural
 Institutions
 Non-economic
 Adoption of a language
 Institutions
What can we do to change our comparative advantage?
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The Production Possibilities Curve
 A graph that describes the maximum amount of one
good that can be produced for every possible level of
production of the other good.
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Production Possibilities Curve:
One-person economy
 Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of
food.
 If Chris is the only person in the economy, describe the
economy's production possibilities curve.
Shelter (sq yd/wk)
6
4
2
0
12
4
8
Food (lb/wk)
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Production Possibilities Curve:
One-person economy
Production Possibilities Curve:
All combinations of shelter and
food that can be produced
with Chris’s labor.
Shelter (sq yd/wk)
6
4
2
0
12
4
8
Food (lb/wk)
The absolute value of the
slope of the production
possibility curve is 6/12 =
1/2.
For Chris, this means that
the opportunity cost of an
additional pound of food
each week is 1/2 sq yd/wk
of shelter.
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Production Possibilities Curve:
One-person economy
A, B, C, D
E
6
4
2
0
Unattainable
F
Shelter (sq yd/wk)
Attainable and efficient
Attainable but inefficient
A
F
C
E
D
B
12
4
8
Food (lb/wk)
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Production Possibilities Curve:
Two-person economy
 Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If
Dana is the only person in the economy, describe the economy's
production possibilities curve.
Shelter (sq yd/wk)
Production Possibilities Curve:
All combinations of shelter and
food that can be produced
with Dana’s labor.
4
2
2
4
Food (lb/wk)
For Dana, the opportunity cost of an additional pound of food each
week is 1 sq yd/wk of shelter.
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Production Possibilities Curve:
Two-person economy
 For Chris, the opportunity cost of an additional pound of
food each week is 1/2 sq yd/wk of shelter.
 For Dana, the opportunity cost of an additional pound
of food each week is 1 sq yd/wk of shelter.
 Thus, Chris has a comparative advantage in producing
food, while Dana has a comparative advantage
producing shelter.
 To maximize an economy output, let Chris specialize in
producing food, while Dana in producing shelter.
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Production Possibilities Curve:
Two-person economy
 To derive the economy's production possibilities curve, let Chris
specialize in producing food until his full capacity is reached (i.e. 12
lb/wk of food). Then, let Dana produce food after that point.
Similarly, Let Dana produce shelter first until her full capacity is
reached (i.e. 4 sq yd/wk of shelter). Then, let Chris produce
shelter after that point.
Shelter (sq yd/wk)
Food (lb/wk)
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Production Possibilities Curve:
Two-person economy
Dana and Chris, a married couple, have decided to consume, jointly,
6 sq yd/wk of shelter and 8 lb/wk of food. How should they divide
the task of producing these quantities?
Shelter (sq yd/wk)
Dana works full time making
shelter; Chris works 1/3 week
on shelter, 2/3 week on food.
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6
4
8
12
16
Food (lb/wk)
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Production Possibilities Curve:
Two-person economy
Shelter (sq yd/wk)
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Dana works full time making shelter; Chris works
1/3 week on shelter, 2/3 week on food.
6
4
8
12 16
Food (lb/wk)
 Dana has a comparative advantage in producing shelter, but even if
she spends all his time producing shelter, she can make only 4 sq
yd/wk.
 So Chris will have to produce the additional 2 sq yd/wk for them to
achieve the desired 6 sq yd/wk.
 Since Chris is capable of producing 6 sq yd/wk of shelter on his
own, it will take him only 1/3 of a week to produce 2 sq yd.
 This leaves 2/3 of a week for him to produce food, which is exactly
how much time he needs to produce the desired 8 lb/wk.
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The Principle of Increasing Opportunity Cost
(Also called “The Low-Hanging-Fruit Principle”)
 In expanding the production of any good, first employ
those resources with the lowest opportunity cost, and
only afterward turn to resources with higher opportunity
costs.
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The Production Possibilities Curve for an
Economy with Many Workers
Food (lbs/wk)
Clothing (garments/wk)
Produce the initial units of clothing using the resources that
are relatively most efficient at clothing production, and only
then turn to those that are relatively less efficient at clothing
production.
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Economic Growth:
An Outward Shift in the Economy’s PPC
Factors Shifting the PPC
Coffee
(1000s of lb/day)
1. Increases in productive resources
(i.e. labor or capital)
New PPC
2. Improvements in knowledge and
technology
Original PPC
Nuts
(1000s of lb/day)
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Factors That Shift The Economy’s Production
Possibilities Curve
 Increasing Productive Resources
 Investment in new factories and equipment
 Population growth
 Improvements in knowledge and technology
 Increasing education
 Gains from specialization
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Factors That Shift The Economy’s Production
Possibilities Curve
 Why Have Countries Like Nepal Been So Slow to
Specialize?
 Low population density
 Isolation
 Factors that may limit specialization in other countries
 Laws
 Customs
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Gains from specialization will often be far more
spectacular!
 Division of labor according to talent and
temperament
 Learning by doing
 Specialized capital equipment
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Adam Smith on specialization:
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Adam Smith on specialization:
“One man draws out the wire, another straightens it, a third cuts it, a
fourth points it, a fifth grinds it at the top for receiving the head; to
make the head requires two or three distinct operations... I have
seen a small manufactory of this kind where only ten men were
employed... [who] could, when they exerted themselves, make
among them about twelve pounds of pins in a day. There are in a
pound upwards of four thousand pins of middling size. Those ten
persons, therefore, could make among them upwards of forty-eight
thousand pins in a day. Each person, therefore, making a tenth part
of forty-eight thousand pins, might be considered as making four
thousand eight hundred pins in a day. But if they had all wrought
separately and independently, and without any of them having been
educated to this peculiar business, they certainly could not each of
them have made twenty, perhaps not one pin in a day...”
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Too much specialization?
 Specialization boosts
productivity, but it
also entails costs.
 Variety is one of the
first casualties.
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Comparative Advantage and International Trade
 The same logic that leads the
individuals in an economy to
specialize and exchange goods
with one another also leads
nations to specialize and trade
among themselves.
David Ricardo
(1772-1823)
 As with individuals, each trading
partner can benefit from
exchange, even though one may
be more productive than the
other in absolute terms.
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Comparative Advantage and International Trade
 mainland
 can produce 4,000 lengths of tape/day or
 Can produce 1,333 cases/day
 o.c. of 1 case is 3 lengths of tape
 o.c. 1 length of tape is 0.333 case
 Taiwan
 can produce 1,333 lengths of tape/day or
mainland
 can produce 4,000 cases/day
 o.c. of 1 case is 0.333 lengths
 oc. of 1 length of tape is 3 cases
Taiwan
Opportunity cost of
One
length of
tape
one case
1/3 cases
3 length of
tape
3 cases
1/3 length
of tape
Cases (thousands per hour)
Comparative Advantage and International Trade
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4
3
2
1
Taiwan’s
PPF
mainland’s
PPF
1
2
3
4
Tape (thousands of lengths per hour)
Cases (thousands per hour)
Comparative Advantage and International Trade
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4 b'
mainland’s opportunity cost:
1 tape costs 1/3 case,
and 1 case costs 3 tape
Taiwan’s opportunity cost:
1 tape costs 3 cases,
and 1 case costs 1/3 tape
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Taiwan’s
PPF
2
1
c
Trade line
a
mainland’s
PPF
1
b
2
3
4
Tape (thousands of lengths per hour)
Comparative Advantage and International Trade
 Each country now affords a greater bundle of tape
and cases that is unavailable without international
trade.
 The mainland gains from it even though it is a
technologically less developed country (note the
former’s population size!)
 Taiwan gains from it even though it is a
technologically more developed country!
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Economic Naturalist
 If trade between nations is so beneficial, why are freetrade agreements so controversial?
 Three reasons:
 There are losers and gainers from free trade.
 There are theories that suggest less freer trade is
better for a country (infant industry argument,
increasing returns to scale, etc.)
 World trade system is not fair
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Is free trade necessarily good?
 Developed countries underwent a stage of
protectionism before they began to embrace freer trade
 Documented in Chang Ha-Joon (2002), Kicking Away
the Ladder: Development Strategy in Historical
Perspective
 This history is not honestly told to developing countries
 An infant industry needs protection before maturing
enough to compete with foreign firms (infant industry
argument)
 Counterargument: under protection, the industry never
gets mature because of private interest lobbying!
 Remedy: same tariff rate across the board
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External Economies suggest that some government protection may be
good
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Evolution of world trade system: GATT
 International Trade Organization (ITO) failed to be
established.
 Post WWII trade negotiations took place under the
auspices of General Agreement on Tariffs and Trade
(GATT), established on a provisional basis as a draft
charter of ITO, on Tariffs and Trade).
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Earlier Rounds
 Developing countries played only a small role in
the first seven rounds of trade negotiations
 Article XVIII in GATT allows them to “implement
programmes and policies of economic
development designed to raise the general
standard of living of their people, to take
protective or other measures affecting imports.”
 Developed countries were far more interested in
each others’ market than in those of developing
countries
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Kennedy Round (63-67)
 The initial creation of the European Common Market in
the late 1050s was one of the key motivations for the
American initiative to launch the Kennedy Round in the
early 1960s.
 The US wanted to reduce the newly created
discrimination against American exports.
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Tokyo Round (1973-79)
 The extension of its discrimination in important new
markets, was an important factor in the American
decision to insist on the Tokyo Round in the 1970s.
 As a result, the word trade system was tailored to the
interests of the developed countries.
 Protection was progressively reduced on the goods of
export interest to developed countries, but remained on
goods exported intensively by developing countries.
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Outcome
 The GATT came to cover trade in all goods except
agriculture and textiles.
 Textiles were covered by the Multifiber Arrangement
(MFA), through which developing countries had quotas
on the amount of textiles they could export to
developed countries.
 Developed countries didn’t impose any restrictions on
textile imports from other developed countries.
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Unfair trade
 “When they [the developed countries] do not
discriminate against those countries [the developing
countries] in the form proscribed by the most-favorednation principle,… their policies are in effect
discriminatory in that the most serious barriers are
erected in goods which the less developed countries
typically have a comparative advantage in producing —
agricultural commodities in raw or processed form, and
labor-intensive, technologically unsophisticated
consumer goods” (Johnson 1967)
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Uruguay Round (86-94)
 The round started in 1986 and ended in 1993.
 Expanding service trade
 trade-related aspects of intellectual property rights
(TRIPs)
 trade-related investment measures (TRIMs).
 Dispute settlement scheme
 To form WTO
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Outcome
 Many of the new obligations imposed significant burdens
on developing countries.
 “the developing countries took bound commitments to
implement in exchange for unbound commitments of
assistance”
 It is estimated that the vast majority of the gains from
the Uruguary Round accrue to developed countries, with
most of the rest going to a relatively few large exportoriented developing countries.
 Some estimates report that the 48 least developed
countries are actually losing a total of US$600M a year
as a result of the Uruguay Round.
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Outcome
 After the implementation of Uruguay Round
commitments, the average OECD tariff on
imports from developing countries is four times
higher than on imports originating in the OECD.
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Doha Round
 Seattle Round: started and ended on November 30,
1999.
 Doha Round: started in Nov 2001
 The developed countries promised to make the talks
a “development round”; to redress the imbalances of
previous rounds.
 Cancun, 2003
 Hong Kong, 2005
 Basically dead
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Agriculture Subsidies
 “The aggregate agriculture subsidies of the US, EU, and
Japan (including hidden subsidies, such as water), if
they do not actually exceed the total income of subSaharan Africa, amount to at least 75% of that region’s
income.” (Stiglitz, MGW, p.85)
 “The US is the world’s largest cotton exporter, Some
25,000 very rich cotton farmers get to divide $3 billion
to $4billion in subsidies” (Stiglitz MGW, p.85)
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Sub-Sahara Africa isn’t tiny!
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Service Trade
 The Uruguay Round expanded trade negotiations into
the area of services.
 It covered liberalization in services such as banking,
insurance, and information technology, while leaving
unskilled services, such as shipping and construction,
off the agenda.
 The US, and some other 40 countries, have laws
requiring the use of local ships for transporting goods
domestically.
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Service Trade
 The Jones Act of 1920 requires not only the ships be
owned by Americans but that they be built in American
shipyards and manned by Americans.
 It was estimated that as far as 1986, the Jones Act cost
the America US$250,000 for every job in the shipping
industry it saved.
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Nontariff Barriers: Safeguards
 Safeguards—temporary tariffs that are supposed to help
a country adjust as it faces an unanticipated large
increase in the level of imports, a “surge.”
 a real increase in imports (an absolute increase), or
 an increase in the imports’ share of a shrinking
market, even if the import quantity has not increased
(relative increase).
 Safeguards are usually seen as responses to fair trade
behavior, as opposed to responses to unfair trade
practices such as dumping or subsidy
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Nontariff Barriers: Safeguards
 Supposed to be used only in very specific
circumstances, with compensation (or accepting
retaliation from exporting countries), and on a universal
basis, i.e. a member restricting imports for safeguard
purposes will have to restrict imports from all other
countries.
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Nontariff Barriers: Safeguards
 A safeguard measure should not last more than four
years, extendable up to eight years. Measures imposed
for more than a year must be progressively liberalized.
 The exporting country, in absence of compensation, has
to wait for three years after the measure was
introduced before it can retaliate— e.g., if it is taken as
a result of an increase in the quantity of imports from
the exporting country.
 Exceptions to this non-discriminatory rule are provided
for in the Agreement on Safeguards itself as well as in
some ad hoc agreements. In this last respect it is
worthwhile noting that China has accepted that
discriminatory safeguards may be imposed on its
exports to other WTO members until 2013.
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