Comparative advantage and the gains from trade

CHAPTER 3
OUTLINE
• Numerical examples of absolute and comparative advantage

• Gains from trade

• Comparative advantage vs competitiveness

• Economic restructuring
THE TRADE EXPERIMENT
• Dividing the class into four different countries

• Each student will get a candy representative of their

country’s assets

• Please don’t eat the candy until the end of the game

• Rate your happiness (on a scale of 0-10)

• Questions for discussion

Why might this
1. Did anyone’s utility fall once trade was allowed?
happen?

2. Was there a change in which country was richest or

poorest? Did income inequality in or
between countries change?
TRADE THEORISTS
• Mercantilists – earliest trade theorists

 Main idea – to become richer, a country has to accumulate

gold

• Adam Smith – criticized the mercantilist’s views

 His arguments against mercantilism

1. Imports enable countries to live better

2. Voluntary exchange benefits both sides
3. Trade extends the market and enables specialization
4. Trade barriers shrink the market size
ABSOLUTE ADVANTAGE
• Absolute advantage – fewer resources are used to produce a unit of the
good

• Smith argued that countries have an absolute advantage in producing

certain goods

• Example –
 Denmark has an advantage in producing bacon and other pork
products
 China and other Asian countries have an advantage with
manufactured goods • In country A, workers take two hours to
Cell Pota
phon
 Canada produce
toadvantage in
has an a cellproduction
agricultural phone
es chip
s • Smith argued both countries benefit
from trade if A specialized in cell phones
Country 2 6 and B in chips
A
Country 8 4 • Protectionism?
B
COMPARATIVE ADVANTAGE
• What if a country does not have an absolute
advantage? Cell Pota
• Country A has an absolute advantage in both
products phon to
es chip
• According to absolute advantage theory, s
country A should specialize in both products Country 2 4
A
• Stop trade between A and B
Country 8 10
• Ricardo proposed the theory of comparative B
advantage in 1817
• Comparative advantage – ability of a country/individual to
produce at a lower opportunity cost
RICARDIAN MODEL
• Assumptions of the simple Ricardian trade model

1. 2X2X1 model

2. Competitive markets

3. No technological changes

4. Constant returns to scale in production

5. No transportation or trade costs

6. No money

• Labor is homogeneous
• Labor cannot migrate outside borders
• But completely mobile between sectors
• Labor is fully employed
EXAMPLE – OC AND GAINS FROM TRADE
• Units of output per hour worked
Outpu United Canada
• Canada has an absolute advantage in
t States
bread
• U.S. has an absolute advantage in steel Bread 2 loaves 3 loaves
Steel 3 tons 1 ton
• In the U.S., opportunity cost of bread = 3/2 tons of steel
• In Canada, opportunity cost of bread = 1/3 tons of steel
• Labor can be used to produce bread or steel
• Every worker taken out of bread reduces production by 2
loaves
• But increases steel by 3 tons
OC is the domestic price of a
• When there is no trade good
TRADE PRICE
• In U.S., barter price of bread P
  B = = 1.5

• In Canada, barter price of bread P

  B = = 0.33

 • Trade prices of bread will settle somewhere

between

• 1.5 > PBW > 0.33

 • Similarly, trade prices of steel will be

• 3.0 > PSW > 0.6

• As long as trade price < OC of producing A country is better off

a good buying it
TRADE PRICE
• What if the price of steel is greater than 3 loaves of bread per
ton?

 Both U.S. and Canada will decide to produce steel

 End result: Neither country produces bread

 The price of bread rises and the price of steel falls

PRODUCTION POSSIBILITES CURVE (PPC)
• PPC – shows the trade-offs between the Bread
two goods C

• Hypothetical PPC for the U.S. B

  Slope =

• A constant trade-off of bread for steel

 ¿ 𝑜𝑓 𝑙𝑜𝑎𝑣𝑒𝑠 𝑜𝑓 𝑏𝑟𝑒𝑎𝑑 𝑓𝑜𝑟𝑔𝑜𝑛𝑒
• Slope of the PPC𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
- 𝑜𝑓 𝑠𝑡𝑒𝑒𝑙 𝑜𝑏𝑡𝑎𝑖𝑛𝑒𝑑
A

Steel
• Point B – efficient
• Point A – inefficient
• Point C - unattainable
PRODUCTION AND TRADE BEFORE SPECIALIZATION
Bread
•  Autarky – complete absence of trade
 Can only consume what they produce

• U.S.A. is producing at point A

A Slope = -
• Suppose, OC for steel in the US and Canada: 0.67
PPC
Steel
• 3.0 > PS
W > 0.6
PRODUCTION AND TRADE BEFORE SPECIALIZATION
Bread

CPC
• Countries that trade can consume outside Slope = - 2
their PPC… How?
A Slope = -
• Let’s say the world price of steel is 2 loaves
per ton 0.67
PPC

• Trading possibilities of the U.S. are shown by Steel

CPC

• Each ton of steel can be traded for 2 loaves

of bread

• With trade, the U.S. can consume outside the

PPC
PRODUCTION TO MAXIMIZE INCOME
• Why would U.S. choose to make bread? Bread

CPC CPC1
• U.S. specializes in steel production
C
• Pre-trade production and consumption point is
at A A

• Point B represents complete specialization in B

steel production Steel
PPC
• With the trade, production is at B and U.S.
could trade up along CPC1

• By moving to a higher consumption bundle

compared to A

• Note: production at B maximizes U.S. income

CANADA’S GAINS FROM TRADE
• Canada also benefits from trade by Bread
specializing in bread production B

• Pre-trade production point is at A

C
A
• After trade, Canada produces at B
CPC
• World price of steel is 2 loaves per ton PPC
Steel
• Canada consumes at a point C

• Outside PPC and to the right of A

NUMERICAL EXAMPLE (GAINS FROM TRADE)
• When the U.S. increases steel output by 1 ton, it loses 0.67 loaves of
bread

 But it gains 2 loaves when it trades with Canada

 Net gains from trade: 2 – 0.67 = 1.33 loaves of bread

• When Canada increases bread output by 2 loaves, it loses 0.67 tons of

steel

 But it trades 2 loaves of bread for 1 ton of steel

 Net gains from trade: 1 – 0.67 = 0.33 tons of steel

ACTIVE LEARNING
 • In our earlier analysis, we assumed the following

• Trade prices of steel will settle somewhere between

• 3.0 > PSW > 0.6

• What would happen if

a. PSW = 4

b. PSW = 0.5
WHAT IF A COUNTRY HAS NO ABSOLUTE ADVANTAGE?
 • Japan has an absolute advantage in both cars Output per hour
and steel worked
Japa Malay
n sia
• Japan has a comparative advantage in cars
Car 2 0.5 car
• 2 > PcW > 1 s cars
 • Let the world price be 1.5 Ste 2 1 ton
el tons
Opportunity
• Japan moves to specialize in car production cost
OC of OC of 1
• For each additional car, it can trade for 1.5 1 car ton
tons of steel J 1 ton ofcar
1 steel
of
• Net gain of 0.5 tons over its own production
M steel
2 tons 0.5 car
of
steel
CASE STUDY: SOUTH KOREA
18000 120
• South Korea developed 16000
rapidly since 1953 14000
100

12000 80
• It gradually increased its
10000
comparative advantage in 60
8000
higher valued products GDP per capita (US$)
Trade-GDP ratio
6000 40

• Export industries played a key 4000

20
role 2000

0 0
1 2 3 4
Year
COMPARATIVE VS COMPETITIVE ADVANTAGE
Selling
• Competitive advantage : at a lower
cost
Having
• Comparative advantage : a lower
OC
• Competitive advantage = Comparative advantage

 Prices of outputs and inputs indicate their relative scarcity

• Competitive advantage ≠ Comparative advantage

 Market sometimes fail to produce optimal outcomes

COMPARATIVE VS COMPETITIVE ADVANTAGE
• Example – Indonesia tried to develop an aircraft industry

 Lacked comparative advantage in aircraft production

 Government policies made it competitive

 Optimal use of scarce resources perspective – a mistake

 Business perspective – profitable to make airplanes

• Important distinction between nations and business enterprises

ECONOMIC RESTRUCTURING (1 OF 2)
• When trade begins, economies move from one point to another on
their PPC

• The U.S. bread industry and the Canadian steel industry

disappeared

• Both economies underwent economic restructuring

• Both Canada and the U.S. benefitted, but not necessarily every
individual
ECONOMIC RESTRUCTURING (2 OF 2)
• In our simple model

 Everyone is employed

 No costs to change jobs

 Workers are equally adept at both industries

• In the real world

 Not easy to find a job

 Not equally adept at any industry

 Costs money to change jobs

• Most countries have programs to ease the burden of job losses

• In the U.S. it is called Trade Adjustment Assistance (TAA)