Transcript Chapter 1: Introduction - Queen's Front Page | Queen's

An Introduction to
International Economics
Chapter 2: Comparative Advantage
Dominick Salvatore
John Wiley & Sons, Inc.
Dale R. DeBoer
University of Colorado, Colorado Springs
2-1
The basic questions of international
trade
• What is the basis of trade?
– Two answers to this question will be discussed in
this chapter: Absolute Advantage and
Comparative Advantage
Dale R. DeBoer
University of Colorado, Colorado Springs
2-2
The basic questions of international
trade
• What is the basis of trade?
• What are the gains from trade?
– The models of Absolute and Comparative
Advantage show that the gains from trade are
increased consumption gained through
specialization in production and trade.
Dale R. DeBoer
University of Colorado, Colorado Springs
2-3
The basic questions of international
trade
• What is the basis of trade?
• What are the gains from trade?
• What is the pattern of trade?
– What determines the pattern of specialization that
drives international trade?
Dale R. DeBoer
University of Colorado, Colorado Springs
2-4
The Mercantilists
• What is wealth?
– The Mercantilist answer was the stock of precious
metals possessed by a country.
Dale R. DeBoer
University of Colorado, Colorado Springs
2-5
The Mercantilists
• What is wealth?
• How can precious metals be obtained?
– Extraction from naturally occurring stocks
• This option is available to few countries
Dale R. DeBoer
University of Colorado, Colorado Springs
2-6
The Mercantilists
• What is wealth?
• How can precious metals be obtained?
– Extraction from naturally occurring stocks
– Earn precious metals through exports of goods
and services
• Since payment for exports is made with precious
metals, exporting causes precious metals to flow into a
country
• Similarly, since payment for imports is also made with
precious metals, importing causes precious metals to
flow out of country
Dale R. DeBoer
University of Colorado, Colorado Springs
2-7
The Mercantilists
• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!
Dale R. DeBoer
University of Colorado, Colorado Springs
2-8
The Mercantilists
• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!
• Can this condition hold for all countries?
– No!
– Therefore, the wealth of one country must come at
the expense of another country.
Dale R. DeBoer
University of Colorado, Colorado Springs
2-9
The Mercantilists
• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!
• Can this condition hold for all countries?
• Mercantilist policy
– Strict government control over economic activity
to ensure a positive trade balance
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 10
The Mercantilists
• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!
• Can this condition hold for all countries?
• Mercantilist policy
• A further look at the Mercantilists
– Federal Reserve Bank of San Francisco’s “Major
Schools of Economic Theory”
• FRBSF WWW link
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 11
Is “wealth” precious metals?
• To the Mercantilists, yes.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 12
Are precious metals “wealth”?
• To the Mercantilists, yes.
• Modern measures of wealth are based on a
country’s ability to produce the goods and
services that improve quality of life.
– Hence, the Mercantilist conclusion is based a
definition of wealth the differs significantly from
modern notions of wealth.
– This distinction leads to very different
conclusions about how to become a wealthy
nation.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 13
Absolute advantage
• Built on the ideas of Adam Smith
– The Library of Economic Liberty Biography of
Adam Smith
• WWW Link
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 14
Absolute advantage
• Built on the ideas of Adam Smith
• Absolute advantage exists between nations
when they differ in their ability to produce
goods.
– More specifically, absolute advantage exists when
one country is good at producing one item, while
another country is good at producing another
item.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 15
An example of absolute advantage
• Countries
– Scotland
– Mexico
• Goods
– Coffee beans
– Wool
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 16
An example of absolute advantage
• How does specialization
and trade advantage
Scotland?
– By reducing coffee bean
production, resources
are freed for producing
more wool
– Each hour of production
change costs 1 unit of
coffee beans but gains 4
units of wool
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 17
An example of absolute advantage
• How does specialization
and trade advantage
Scotland?
– Scotland can send 3
units of wool to Mexico
and receive 7 units of
coffee beans back
– Thus, by specializing in
production Scotland
gains 1 unit of wool and
6 units of coffee per hour
of production moved
Gains per hour of
production moved
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 18
An example of absolute advantage
• Does specialization and
trade also advantage
Mexico?
– By reducing wool
production, resources
are freed for producing
more coffee beans
– Each hour of production
change costs 2 units of
wool but gains 10 units
of coffee beans
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 19
An example of absolute advantage
• Does specialization and
trade also advantage
Mexico?
– Mexico can send 7 units
of coffee beans to
Scotland and receive 3
units of wool back
– Thus, by specializing in
production Mexico gains
1 unit of wool and 3 units
of coffee beans per hour
of production moved
Gains per hour of
production moved
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 20
Policy recommendations from
absolute advantage
• Specialization and trade advantage both
countries
• Therefore, the best policy is to allow
producers and consumers in both countries
unfettered access to goods from both
countries to maximize the number of
advantageous trades that can occur.
• In other words, laissez-faire.
– The policy of minimum government interference
with economic activity.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 21
A fatal flaw?
• Absolute advantage requires one country to
be better at production of one product and
another country to be better at production of
another good for specialization and trade to
be mutually advantageous.
• What if one country is better at everything?
– The theory of comparative advantage provides
this answer.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 22
Comparative advantage
• Built on the ideas of David Ricardo
– The New School History of Economic Thought
Biography of David Ricardo
• WWW Link
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 23
Comparative advantage
• Built on the ideas of David Ricardo
• The law of comparative advantage shows how
mutually beneficial specialization and trade
may be driven by relative advantages in
production rather than absolute advantages in
production.
– Given the somewhat counter-intuitive nature of
the law of comparative advantage its implications
are best seen through example.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 24
An example of comparative
advantage
• Countries
– Scotland
– Mexico
• Goods
– Coffee beans
– Wool
• The difference lies in
the relative productivity
of the countries
– In this case, Mexico is
more productive at
generating both goods.
Dale R. DeBoer
University of Colorado, Colorado Springs
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Mexico
2 - 25
An example of comparative
advantage
• How does specialization
and trade advantage
Mexico?
– By reducing wool
production, resources
are freed for producing
more coffee beans
– Each hour of production
change costs 5 units of
wool but gains 10 units
of coffee beans
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 26
An example of comparative
advantage
• How does specialization
and trade advantage
Mexico?
– Mexico can send 9 units
of coffee beans to
Scotland and receive 7
units of wool back
– Thus, by specializing in
production Mexico gains
1 unit of coffee beans
and 2 units of wool per
hour of production
moved
Dale R. DeBoer
University of Colorado, Colorado Springs
Gains per hour of
production moved
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Mexico
2 - 27
An example of comparative
advantage
• Does specialization and
trade also advantage
Scotland?
– It does. To see this
consider consider
Scotland trading two
hours of output.
– Two hours of production
change from coffee
beans to wool costs 2
units of coffee beans but
gains 8 units of wool
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 28
An example of comparative
advantage
• Does specialization and
trade also advantage
Scotland?
– Scotland can send 7
units of wool to Mexico,
receiving 9 units of
coffee beans in return
– Thus, by specializing in
production Scotland
gains 1 unit of wool and
7 units of coffee beans
Gains per hour of
production moved
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 29
Implications of comparative
advantage
• Laissez-faire still holds
• Gains need not be equal
• Hours of work traded need not be equal but
the advantage still exists
• Trade is based on the existence of relative –
not absolute – production advantages
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 30
Does money alter the story?
• No
• Suppose the costs of
production are as given
below
– Mexico: 100 pesos/hour
– Scotland: 4 pounds/hour
• Suppose
4£ ÷ 1 the
unit exchange
= 4£ per unit
rate between pesos and
4£ x is
10P/£
= 40P
pounds
1£ =
10Pper unit
• This gives the unit
costs indicated in the
chart
Dale R. DeBoer
University of Colorado, Colorado Springs
Peso price per unit of
output
40
35
30
Coffee
beans
Wool
25
20
15
10
5
0
Scotland
Mexico
2 - 31
Does money alter the story?
• No
• Suppose the costs of
production are as given
below
– Mexico: 100 pesos/hour
– Scotland: 4 pounds/hour
• Suppose
4£ ÷ 4 the
unitsexchange
= 1£ per unit
rate between pesos and
1£ x is
10P/£
= 10P
pounds
1£ =
10Pper unit
• This gives the unit
costs indicated in the
chart
Dale R. DeBoer
University of Colorado, Colorado Springs
Peso price per unit of
output
40
35
30
Coffee
beans
Wool
25
20
15
10
5
0
Scotland
Mexico
2 - 32
Does money alter the story?
• No
• Suppose the costs of
production are as given
below
Peso price per unit of
output
40
– Mexico: 100 pesos/hour
– Scotland: 4 pounds/hour
35
• Suppose
the exchange
100P ÷ 10 units
= 10P per unit
rate between pesos and
pounds is 1£ = 10P
• This gives the unit
costs indicated in the
chart
25
Dale R. DeBoer
University of Colorado, Colorado Springs
30
Coffee
beans
Wool
20
15
10
5
0
Scotland
Mexico
2 - 33
Does money alter the story?
• No
• Suppose the costs of
production are as given
below
– Mexico: 100 pesos/hour
– Scotland: 4 pounds/hour
• Suppose
the =exchange
100P ÷ 5 units
20P per unit
rate between pesos and
pounds is 1£ = 10P
• This gives the unit
costs indicated in the
chart
Dale R. DeBoer
University of Colorado, Colorado Springs
Peso price per unit of
output
40
35
30
Coffee
beans
Wool
25
20
15
10
5
0
Scotland
Mexico
2 - 34
Does money alter the story?
• At these prices goods
will naturally flow from
the cheaper market
(Scotland for wool,
Mexico for coffee
beans) to the more
expensive market.
• Again, this
demonstrates the law of
comparative advantage
but through prices not
relative outputs.
Peso price per unit of
output
40
35
30
Coffee
beans
Wool
25
20
15
10
5
0
Scotland
Dale R. DeBoer
University of Colorado, Colorado Springs
Mexico
2 - 35
Does the source of the productive
difference matter?
• No
• The original idea of comparative advantage
was based on the labor theory of value.
– The labor theory of value holds that costs and
prices are solely determined by the labor content
of an item.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 36
Does the source of the productive
difference matter?
• No
• The original idea of comparative advantage was
based on the labor theory of value.
• The examples given above rely on opportunity
cost.
– Opportunity cost holds that the cost of an item is
the amount of another item the must be given up
to release sufficient resources to produce one
more unit of the first item.
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 37
The production possibility frontier
• The production
possibility frontier (PPF)
identifies the maximum
combinations of two
products that a nation
can produce by fully
utilizing all factors of
production with the best
technology available.
• Consider the production
possibilities schedule
for an example:
Dale R. DeBoer
University of Colorado, Colorado Springs
United States
Wheat
Cloth
180
0
150
20
120
40
90
60
60
80
30
100
0
120
2 - 38
Constructing the PPF
United States
Cloth
140
120
Wheat
Cloth
100
180
0
80
150
20
60
120
40
40
90
60
60
80
30
100
0
120
20
0
0
50
100
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
150
200
2 - 39
Constructing the PPF
United States
Cloth
140
120
Wheat
Cloth
100
180
0
80
150
20
60
120
40
40
90
60
60
80
30
100
0
120
20
0
0
50
100
150
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
200
2 - 40
Constructing the PPF
United States
Cloth
140
120
Wheat
Cloth
100
180
0
80
150
20
60
120
40
40
90
60
60
80
30
100
0
120
20
0
0
50
100
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
150
200
2 - 41
Regions of the PPF
140
Productive maximum
120
100
Cloth
Underutilized resources
80
Unattainable with existing
resources and technology
60
40
20
0
0
50
100
150
200
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 42
Trade with the PPF model
US
Cloth
• Suppose the US and the
UK have the PPFs given
to the right
140
120
100
80
60
40
20
0
0
20
40
60
80 100 120 140 160 180 200
Wheat
Cloth
UK
140
120
100
80
60
40
20
0
0
20
40
60
80 100 120 140 160 180 200
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 43
Trade with the PPF model
Cloth
US
140
120
100
80
60
40
20
0
(90W, 60C)
0
20
40
60
80 100 120 140 160 180 200
Wheat
UK
Cloth
• Suppose the US and the
UK have the PPFs given
to the right
• Further suppose that
each country produces
and consumes at the
marked spot in the
absence of international
trade
140
120
100
80
60
40
20
0
(40W, 40C)
0
20
40
60
80 100 120 140 160 180 200
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 44
Trade with the PPF model
Cloth
US
140
120
100
80
60
40
20
0
(90W, 60C)
0
20
40
60
80 100 120 140 160 180 200
Wheat
UK
Cloth
• Can specialization and
trade lead to more
aggregate production
and consumption?
• If the US specialized in
wheat production and
the UK in cloth
production, aggregate
production would
increase from 130W to
180W and from 100C to
120C.
140
120
100
80
60
40
20
0
(40W, 40C)
0
20
40
60
80 100 120 140 160 180 200
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 45
Trade with the PPF model
Cloth
US
140
120
100
80
60
40
20
0
(110W, 70C)
Production
0
20
40
60
80 100 120 140 160 180 200
Wheat
Production
Cloth
• This increased
production would allow
each country to
consume at a point
outside of its PPF as
indicated by the blue
lines in the graphs.
• The increased
consumption is the
gains from trade.
140
120
100
80
60
40
20
0
UK
(70W, 50C)
0
20
40
60
80 100 120 140 160 180 200
Wheat
Dale R. DeBoer
University of Colorado, Colorado Springs
2 - 46