International Economics: Absolute vs. Comparative Advantage

1. Welcome to EC 382: International EconomicsBy:Dr. Jacqueline Khorassani Week Two

2. Week Two: Class One • Tuesday, September 1114:00-14:50AC 202 • The library does not have the book • You will need to purchase it

3. Last class we defined absolute advantage • If India can produce one yard of cloth using fewer resources than the US, then India has absolute advantage in production of cloth • Or • If India uses all of its resources it can produce more cloth than the US, then India has absolute advantage in production of cloth • According to the theory of absolute advantage: A country must export what they have absolute advantage in and import what they have absolute disadvantage in.

4. What is Production Possibilities Frontier (PPF) ? • A curve that shows the different combinations of two goods that a nation can produce efficiently, with a given amount of resources and a given technology in a given period of time.

5. PPFs in the US and India

6. Let’ look at the table again: Who has absolute advantage in what? • US has absolute advantage in production of machines • No one has absolute advantage in production of cloth • Based on the absolute advantage theory, US can export machines to India but India should not export anything to the US. • In a barter economy, trade will not take place. • India has nothing to offer US

7. Let’ look at the PPF table again • What is the opportunity cost of producing one machine in each nation? • 3 yards of cloth in US • 5 yards of cloth in India

8. Cloth Cloth INDIA U.S. 150 A A’ 100 0 50 Machines 0 40 Machines Let’s draw the PPF for each country Since OPP cost is always the same = constant cost 300 300 Opp cost of 1 machine=MRT= -3 Production and consumption in before trade Opp cost of 1 machine =MRT = -5 B B’ 100 50

9. The theory of comparative advantage • David Ricardo (1772(Netherlands)-1823) • A nation has comparative advantage in production of machines, if it can produce it at a lower opportunity cost.

10. In our example: • Who has comparative advantage in machines? • US with opp cost of 3 yards of cloth • Who has comparative advantage in cloth? • India with opp cost of 1/5 of machines

11. You asked • Do we need to know absolute advantage to find comparative advantage? • No • How can a country have comparative advantage but not absolute advantage? • Look at India

12. Trade based on comparative advantage • A nation should specialize in production of the good in which it has comparative advantage and trade that good for a good that it has comparative disadvantage in.

13. Assignment 1 • Do it in teams of 2 or 3.

14. International Economics • Week Two, Class 2 • 11:10-12:00 • Tyndall

15. Asst 1 PPFs

16. beer beer Germany U.S. 0 0 computers computers PPFs • The slope of US PPF = 0.5 = opp cost of 1 computer = MRT of beer for computer in the US • The slope of German PPF = 1 = opp cost of 1 computer = MRT of beer to computer in Germany 5 5 5 10

17. Which country has absolute advantage in production of what? • Neither has absolute advantage in production of beer. • US has absolute advantage in production of computers...

18. Based on the theory of absolute advantage who export what? • No trade • Because US can export computers but US does not want German beer.

19. Which country has comparative advantage in what?

20. Notes: • The opportunity cost of computer = slope of PPF • The opportunity cost of Beer = inverse of the slope of PPF • (This is always true.)

21. Which country has comparative advantage in what? • US has comparative advantage in production of computers • Germany has comparative advantage in production of beer. • This means that the US must trade computers for beer with Germany

22. beer beer Germany U.S. 2.5 0 0 3 5 computers computers choose a combination of computersand beer from the PPF Label this point on your graph. As point “B”. PPFs Pre-trade consumption & production Pre-trade consumption and production 5 5 B B 2 5 10 4.5

23. Pre-trade best points were picked arbitrarily • US best point represents 5 units of Computers and 2.5 bottles of Beer. • Germany’s best point represents 3 units of Computers and 2 bottles of Beer.

24. Who should specialize in production of what? • Since the US has comparative advantage in production of computers, it must specialize in production of computers. • Produce 10 Computers and 0 Beers • Since Germany has comparative advantage in production of beer, it must specialize in production of beer. • Produce 0 Computers and 5 Beers • Note: partial specialization is also possible.

25. beer beer Germany U.S. 2.5 0 0 3 5 computers computers Production points after trade are points P & P Post-trade production Post-trade production 5 P 5 B B 2 P 5 10 4.5

26. Determination of the range of the mutually beneficial terms of trade • The terms of the trade must be acceptable to both countries. • An acceptable term of trade is a price less than domestic opportunity cost. • The opportunity cost of producing 1 beer in the US is 2 computers. • Or the opportunity cost of 2 computers is 1 beer. • Therefore, US will only trade 2 computers for more than 1 beer. • That is, the US would like the 2 computers to be more valuable than 1 beer. • We can show this constraint this way: • 2 computers > 1 beer)

27. Determination of the range of the mutually beneficial terms of trade • The opportunity cost of producing 1 computer in Germany is 1 beer. • Or the opportunity cost of 1 beer is 1 computer. • Therefore, Germany will only trade 1 beer for more than 1 computer. • That is, Germany would like 1 beer to be more valuable than 1 computer. • We can show this constraint this way: • 1 beer > 1 computer)

28. Determination of the range of the mutually beneficial terms of trade • Putting US and Germany’s constraints together • 2 computers > 1 beer > 1 computer • This is the range of the mutually beneficial terms of trade • This means that 1 beer needs to be traded for more than 1 computer but less than 2 computers in order for both nations to benefit. • So the two nations can choose any terms that fall in this range. • 1 beer for 1.5 computers • Or, 1 beer for 1.75 computers

29. Let’s say that they agree to trade 1 beer for 1.5 computers • Which means that 3 beers will be trade for 4.5 computers. • United States trades 4.5 units of computers to Germany for 3 bottles of beer

30. After Trade • US will produce 10 computers and no beer • Gives 4.5 to Germany for 3 beers. • So it is left with 5.5 Computers and 3 Beer • Before trade it had 2.5 beer and 5 computers. • After trade it has 0.5 more beer and 0.5 more computers than pre-trade. • US is better off by 0.5 computers and 0.5 beer

31. After Trade • Germany will produce 5 beers and no computers • Gives 3 beer to US for 4.5 computers • So it is left with 4.5 Computers and 2Beer • Before trade it had 2 beer and 3 computers. • After trade it has 1.5 more computers than pre-trade. • Germany is better off by 1.5 computers • Note that before trade the world production of computers was 8 and now it is 10. • Note that before trade the world production of beer was 4.5 and now it is 5. • So the world production of both goods has increases.

32. World production

33. beer beer Germany U.S. Exports 2.5 3 2 Imports Imports Exports 0 0 4.5 3 5 computers computers Let’s look at our PPFs again • The red lines are the trading possibility curves and consumption possibilities curves • The slope of the trading possibility curves = the terms of trade = 3/4.5 = 1/1.5=0.67= international price of 1 computer 5 P 5 C B C B P 5 5.5 10

34. International Economics • Week Two: Class 3 • Wednesday, September 12 • 15:10-16:00 • AC201

35. In Assignment 1 • Remember that the range of mutually beneficial terms of trade was • 2 computers >1 beer>1 computer • What affects the exact position of the exchange rate within this range? • 1 beer for 1.5 computers, or • 1 beer for 1. 75 computers?

36. The theory of reciprocal demand suggests that • The stronger the US demand for German beer, the closer the rate to 1 beer for 2 computers • The stronger the German demand for US computer, the closer the rate to 1 beer for 1 computer

37. beer Price of Computer in terms of forgone beer Supply computers computers Note: Under constant cost assumption (linear PPFs), the supply curve of a good in each country is horizontal. The Price of computer in terms of the number of forgone beer is always constant US US 0.5 5 10

38. beer Price of computers Supply 5 A B 4.5 C D 2 E F 1 9 10 computers computers Supply Curves of a Good and theProduction Possibilities Frontier Under Increasing Cost Conditions • The opportunity coat of first computer is 0.5 beer. • The opportunity cost of 10th computer is 2 beers. 2 0.5 1 10

39. beer 5 A B 4.5 C D 2 E F 1 9 10 computers Why is there increasing cost? • Resources are not homogenous • Some labor is more productive in production of beer and some can produce computers better

40. Trade Under Increasing Opportunity Costs • Study Figure 2.8 , Page 47 carefully • Notice that the only difference between this and constant cost case is • At any given point on PPF the slope of the tangency line = opportunity cost of the good measured on horizontal axis. • The blue line (the line representing the exchange rate) is tangent to PPF at the production level after trade. • Complete specialization is not possible under increasing cost assumption because if a nation wants to completely specialize in production of a good, its cost of producing that good will be extremely high.

41. Static/ Dynamic Gains From Trade • Static Gains from trade • Gains in word output • Dynamic gains from trade • Gains from trade over time • Increased efficiency and productivity

42. Chapter 3: • Why does Germany have comparative advantage in production of beer? • How would trade change the distribution of income in each nation? • Several theories try to answer the above questions. • Each theory is developed based on certain assumptions an draws some conclusions