© pilot publishing company ltd. 2005 chapter 10 international trade i --- the law of comparative...
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© Pilot Publishing Company Ltd. 2005
Chapter 10 International Trade I ---The Law of Comparative
Advantage
© Pilot Publishing Company Ltd. 2005
• 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
Contents:
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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?
Protectionist measures are not prohibitive. Why?
The transportation and the transaction costs involved do not exhaust the gains from trade. Why?
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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.
Absolute advantage
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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.
Reciprocal absolute advantage
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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
*1 unit of resources (a combination of labour, capital, and land)
Which country has an absolute advantage in the production of food?
Food Clothing
Output of 1 unit of resources*
Country A 10 8
Country B 3 10
Country A
Which country has an absolute advantage in the production of clothing? Country B
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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.
Country A 10 8
Country B 3 10
World’s total output
Food Clothing
+10 -8
-3 +10
+7 +2
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Case II
*1 unit of resources ( a combination of labour, capital, and land)
Which country has an absolute advantage in the production of food?
Food Clothing
Country A
Output of 1 unit of resources*
Country A 100 80
Country B 3 10
Which country has an absolute advantage in the production of clothing? Country A
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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 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.
The law of comparative advantage
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Production cost of 1F Production cost of 1C
Country A
Country B
0.80C100
80C F25.1
80
F100
F30.010
F3C33.3
3
C10
Output of 1 unit of resources
Country A 100F 80C
Country B 3F 10C
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Country A +1.0F -0.8C
Country B -0.3F +1.0C
World’s total output +0.7F +0.2C
Food Clothing
If country A produces one more unit of food
while country B produces one more unit of clothing
Specialization leads to an increase in world’s output
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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:Production cost of 1 unit of output
Food Clothing
Country A $8 $10
Country B £2 £6
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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
Production cost of 1Y is
Y good of units MP
MP
X
Y
X good of units MP
MP
Y
X
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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
Production cost of 1Y is
Y good of units MC
MC
Y
X
X good of units MC
MC
X
Y
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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
Production cost of 1Y is
Y good of units MC
MC
Y
X
X good of units MC
MC
X
Y
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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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Country A 8 lab 10 lab
Country B 10 lab 3 lab
Food Clothing
Amount of labour required to produce a unit of food and clothing in country A and country B
Illustration
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Production cost of 1F Production cost of 1C
Country A
Country B
0.80Clab 10
lab 8
0.30Flab 10
lab 33.33C
lab 3
lab 10
Calculation of gains from trade
Given exchange ratio: 1F=1C
World price of 1F (=1C) > Country A’s production cost of 1F (=0.8C) Country A exports foodCountry A exports foodCountry A exports foodCountry A exports food
From each unit of food exported, country A gains 0.2C (=1C-0.8C).
1.25Flab 8
lab 10
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Production cost of 1F Production cost of 1C
Country A
Country B
0.80Clab 10
lab 8
0.30Flab 10
lab 33.33C
lab 3
lab 10
Calculation of gains from trade
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).
1.25Flab 8
lab 10
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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).
M
X
P
PTOT=
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Implications of the terms of trade
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?
TOT It measures the amount of import that a country can exchange with a unit of its export
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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 affectedunder 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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Clothing
Food PPCA0
Slope = Cost of 1F = 1 600C/2 000 = 0.8C
1F1 600
2 0000
Country A: The situation without trade
COA0
POA0
= CPCA0
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Clothing
Food 0
Country B
450
1 500
PPCB0
Slope = Cost of 1F = 1 500C/450 = 3.33C
1F
COB0
POB0
= CPCB0
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2. The situation with trade
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.
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.
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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Clothing
Food
PPCA
1 600
2 0000
2 000
Country A
---- Possible consumption possibility curves
POA
Complete specialization
---- Outermost consumption possibility curve
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Clothing
Food 0450
1 500
1 500
PPCB
Country B
---- Possible consumption possibility curves
POB
Complete specialization
---- Outermost consumption possibility curve
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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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Clothing
Food
PPCA
1 600
2 0000
Country A2 000
1 000
1 000
CPCA
Graphical illustration
COA
POAExport
Import
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Clothing
Food 0
Country B
450
1 500
1 500P
PC
B
500
1 000
Export
ImportCPCB
POB
COB
Graphical illustration
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Clothing
Food
PPCA
1 600
2 000
2 000
0 1 000
1 000
C
F
0
PPCB
COA=COB
POA=POB
Illustration with a composite diagram – Constant production cost
C: Export of country B = Import of country A = 1 000 units of clothing
F: Export of country A = Import of country B = 1 000 units of food
Countries A & B
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Advanced Material 10.1
Graphical Illustration of International Trade
– Increasing Production Cost
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MCA0
MCB0
By production possibility curve and indifference curve
Without trade (the autarkic situation)
Country A Country B
COA0
POA0
COB0
POB0
Clothing Clothing
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With trade
POA1Export of
country A
Import of country A
COA1
Country A
ICA1 > ICA0
Clothing
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Country B
Export of country B
Import of country B
POB1
COB1
ICB1 > ICB0
Clothing
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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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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.
Correcting Misconceptions:
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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.
Correcting Misconceptions: