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Trade Theory: The High Points

Trade Theory: The High Points. Comparative advantage. Comparative Advantage and Prices. Cloth (yards) Wine (bottles) Nation Labor Wage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.50 20 £0.25 UK 1 hr $8 10 $0.80 20 $0.40 (at $1.6 = £1) So What?.

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Trade Theory: The High Points

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  1. Trade Theory: The High Points Carbaugh, Chap. 2

  2. Comparative advantage Comparative Advantage and Prices Cloth (yards) Wine (bottles) Nation LaborWage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.50 20 £0.25 UK 1 hr $8 10 $0.80 20 $0.40 (at $1.6 = £1) So What? Carbaugh, Chap. 2

  3. What did we see? No matter how inefficient one nation is compared to another, it will always be least inefficient in something. That’s where it has a comparative advantage. That’s what it should specialize in. Prices adjust so that each nation has the lowest price for the good that it has a comparative advantage, the good that it sells to others. • Wages in a low-productivity country fall until something that it produces can be sold cheaply on the world market. • The currency of a low-productivity country depreciates until something that it produces looks cheap to those who buy it. Carbaugh, Chap. 2

  4. What else did we see? • Measured in the same currency, wages are higher in a high-productivity country than in a low-productivity country. • Low productivity workers must settle for lower wages to keep their jobs. • Exchange rate adjustments can substitute for wage adjustments. • There is generally less resistance to depreciation than to wage cuts. (There is often plenty of resistance to depreciation.) Carbaugh, Chap. 2

  5. Specialization and trade make it possible to consume bundles of goods that a nation could not possibly produce by itself. Trading possibilities line (terms of trade 1:1) B’ Trading possibilities line (terms of trade 1:1) tt D’ C’ E Wheat Wheat A’ C A F tt B D Carbaugh, Chap. 2

  6. Parable of the barefoot shoemaker: • At times, the terms of trade for what you specialize in are so favorable that you choose to trade away just about everything that you produce … in exchange for what others produce. Carbaugh, Chap. 2

  7. tt’ E D Barriers to trade:if you insist on pushing the production of something that you don’t have comparative advantage in, you can’t possibly consume as much as you could with specialization and free trade. tt C A Crude oil B Carbaugh, Chap. 2

  8. Increasing opportunity costs Production possibilities schedule under increasing costs Slope 1A = 1W A Slope 1A = 4W Wheat B Carbaugh, Chap. 2

  9. Trading possibilities line C B tt (1A =1W) Trading under increasing costs You stop short of complete specialization: after a point (pt B), it becomes more costly to produce more of your export good than you can sell it for, the terms of trade (tt). A tUS (1A = 0.33W) Wheat Carbaugh, Chap. 2

  10. Trading possibilities line B’ C’ tt (1A =1W) D’ Trading Under Increasing Costs Trade leads to cost and price convergence: in an ideal world, every nation produces to the point where its costs match the prevailing world price (terms of trade tt) tC (1A = 3W) Wheat A’ Carbaugh, Chap. 2

  11. Trading Under Increasing Costs In the real world, trade stops short of complete specialization and complete cost and price convergence. • Transportation and other transaction costs put a wedge between between cost of production in an exporting country and the price that covers total costs in an importing country. • As transportation and transaction costs fall, the volume of trade increases and prices across nations increasingly converge. • Everyplace begins to look the same. Welcome to Mc World Carbaugh, Chap. 2

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