Comparative Advantage and International Trade This presentation will take you through description of global trade pattern (with special emphasis on the U.S.) and explain the principle of comparative advantage

An index of openness This is a simple measure of the relative importance of the foreign sector Let O denote the index of openness X is exports M is imports GDP is gross domestic product Thus, we have:

Imports + Exports as a Percent of U.S. GDP, percent

Source:

U.S. Balance of Trade in Merchandise and Services

Source: Bureau of Economic AnalysisBureau of Economic Analysis

Source: Bureau of Economic AnalysisBureau of Economic Analysis

Source: The Economist Current Account balance of selected nations, September 2004 to September 2005

Why do countries trade? Nations differ in endowments of natural, capital, and human resources. Example: Japan is poorly endowed in timber, petroleum, and metal ores—but well endowed in human and capital resources. International trade is (in theory, at least) based on mutually beneficial specialization among trading partners according to the principle of comparative advantage.

Labor Productivity in the U.S. and Japan On average a U.S. worker can manufacture 4 bottles of pharmaceuticals per hour. On average a U.S. worker can manufacture 1 digital watch per hour. On average a Japanese worker can manufacture 2 bottles of pharmaceuticals per hour. On average a Japanese worker can manufacture 0.8 digital watches per hour. Thus labor productivity is higher in both activities in the U.S.

A nation is said to have a comparative advantage in the production of a good or service if it can produce that good or service a lower opportunity cost than any other nation The U.S. has the comparative advantage in pharmaceuticals since it must only sacrifice ¼ watch for every bottle in produces; whereas Japan must sacrifice 2/5 of a watch per bottle. Japan has the comparative advantage in watches since it must sacrifice 2.5 bottles of pharmaceuticals per watch made; whereas the U.S. must sacrifice 4 bottles per watch. Opportunity cost in the U.S. and Japan

Costs of Production in the U.S. and Japan Assume that the hourly wage in the U.S. in both sectors is $ Hence the labor cost per bottle of pharmaceuticals produced is $15.00/4 bottles = $3.75 per bottle.The labor cost per digital watch is $15.00/1 watch = $15.00 per watch. Assume the hourly wage in Japan (both sectors) is 1,000 yen, then production costs in yen are given by: For pharmaceuticals: 1,000 yen/2 bottles = 500 yen per bottle; For digital watches: 1,000 yen/.8 watches = 1,250 yen per watch. If the exchange rate is $1 = 100 yen, then Japanese production costs in dollars convert to the numbers in the table above

The comparison of relative costs of production explains why Japan exports digital watches to the U.S. and the U.S. exports pharmaceuticals to Japan. Moral of the Story