dale r. deboer university of colorado, colorado springs 2 - 1 an introduction to international...
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Dale R. DeBoerUniversity of Colorado, Colorado Springs
2 - 1
An Introduction to International Economics
Chapter 2: Comparative Advantage
Dominick Salvatore
John Wiley & Sons, Inc.
2 - 2Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
2 - 3Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 4Dale R. DeBoerUniversity of Colorado, Colorado Springs
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?
2 - 5Dale R. DeBoerUniversity of Colorado, Colorado Springs
The Mercantilists
• What is wealth?– The Mercantilist answer was the stock of precious
metals possessed by a country.
2 - 6Dale R. DeBoerUniversity of Colorado, Colorado Springs
The Mercantilists
• What is wealth?
• How can precious metals be obtained?– Extraction from naturally occurring stocks
• This option is available to few countries
2 - 7Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
2 - 8Dale R. DeBoerUniversity of Colorado, Colorado Springs
The Mercantilists
• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed imports for a country to become wealthy!
2 - 9Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 10Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
2 - 11Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
2 - 12Dale R. DeBoerUniversity of Colorado, Colorado Springs
Is “wealth” precious metals?
• To the Mercantilists, yes.
2 - 13Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 14Dale R. DeBoerUniversity of Colorado, Colorado Springs
Absolute advantage
• Built on the ideas of Adam Smith– The Library of Economic Liberty Biography of
Adam Smith• WWW Link
2 - 15Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 16Dale R. DeBoerUniversity of Colorado, Colorado Springs
An example of absolute advantage
• Countries– Scotland– Mexico
• Goods– Coffee beans– Wool
Units produced per hour
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Scotland Mexico
Coffeebeans
Wool
2 - 17Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
0
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2
3
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Scotland Mexico
Coffeebeans
Wool
2 - 18Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
012
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89
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Scotland Mexico
Coffeebeans
Wool
2 - 19Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
0
1
2
3
4
5
6
7
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9
10
Scotland Mexico
Coffeebeans
Wool
2 - 20Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
012
34567
89
10
Scotland Mexico
Coffeebeans
Wool
2 - 21Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 22Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 23Dale R. DeBoerUniversity of Colorado, Colorado Springs
Comparative advantage
• Built on the ideas of David Ricardo– The New School History of Economic Thought
Biography of David Ricardo• WWW Link
2 - 24Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 25Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
Units produced per hour
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
2 - 26Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
2 - 27Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
Gains per hour of production moved
012
34567
89
10
Scotland Mexico
Coffeebeans
Wool
2 - 28Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
0
1
2
3
4
5
6
7
8
9
10
Scotland Mexico
Coffeebeans
Wool
2 - 29Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
012
34567
89
10
Scotland Mexico
Coffeebeans
Wool
2 - 30Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
2 - 31Dale R. DeBoerUniversity of Colorado, Colorado Springs
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 rate between pesos and pounds is 1£ = 10P
• This gives the unit costs indicated in the chart
Peso price per unit of output
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5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool4£ ÷ 1 unit = 4£ per unit
4£ x 10P/£ = 40P per unit
2 - 32Dale R. DeBoerUniversity of Colorado, Colorado Springs
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 rate between pesos and pounds is 1£ = 10P
• This gives the unit costs indicated in the chart
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool4£ ÷ 4 units = 1£ per unit
1£ x 10P/£ = 10P per unit
2 - 33Dale R. DeBoerUniversity of Colorado, Colorado Springs
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 rate between pesos and pounds is 1£ = 10P
• This gives the unit costs indicated in the chart
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool100P ÷ 10 units = 10P per unit
2 - 34Dale R. DeBoerUniversity of Colorado, Colorado Springs
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 rate between pesos and pounds is 1£ = 10P
• This gives the unit costs indicated in the chart
Peso price per unit of output
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool100P ÷ 5 units = 20P per unit
2 - 35Dale R. DeBoerUniversity of Colorado, Colorado Springs
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
0
5
10
15
20
25
30
35
40
Scotland Mexico
Coffeebeans
Wool
2 - 36Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 37Dale R. DeBoerUniversity of Colorado, Colorado Springs
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.
2 - 38Dale R. DeBoerUniversity of Colorado, Colorado Springs
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:
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
2 - 39Dale R. DeBoerUniversity of Colorado, Colorado Springs
Constructing the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
2 - 40Dale R. DeBoerUniversity of Colorado, Colorado Springs
Constructing the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
2 - 41Dale R. DeBoerUniversity of Colorado, Colorado Springs
Constructing the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
United States
Wheat Cloth
180 0
150 20
120 40
90 60
60 80
30 100
0 120
2 - 42Dale R. DeBoerUniversity of Colorado, Colorado Springs
Regions of the PPF
0
20
40
60
80
100
120
140
0 50 100 150 200
Wheat
Clo
th
Productive maximum
Underutilized resources
Unattainable with existing resources and technology
2 - 43Dale R. DeBoerUniversity of Colorado, Colorado Springs
Trade with the PPF model
• Suppose the US and the UK have the PPFs given to the right
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
2 - 44Dale R. DeBoerUniversity of Colorado, Colorado Springs
Trade with the PPF model
• 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
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
(90W, 60C)
(40W, 40C)
2 - 45Dale R. DeBoerUniversity of Colorado, Colorado Springs
Trade with the PPF model
• 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.
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
(90W, 60C)
(40W, 40C)
2 - 46Dale R. DeBoerUniversity of Colorado, Colorado Springs
Trade with the PPF model
• 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.
US
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
UK
020406080
100120140
0 20 40 60 80 100 120 140 160 180 200
Wheat
Clo
th
(110W, 70C)
(70W, 50C)
Production
Production