REVIEW OF COMPARATIVE ADVANTAGE

Trade Theory: Ricardo and Comparative Advantage Lindertania Rest of the World Lindertania Rest of the World________________________________________ Labor cost required to make: 1 bushel of wheat 75 hours>50 hours I yard of cloth 100 hours>50 hours _________________________________________ Which country has an absolute advantage in wheat? In cloth? What is ROW’s comparative advantage? What is Lindertania’s least comparative disadvantage?

Trade Theory: Ricardo and Comparative Advantage Lindertania Rest of the World Lindertania Rest of the World________________________________________ Labor cost required to make: 1 bushel of wheat 75 hours>50 hours I yard of cloth 100 hours>50 hours _________________________________________ Comparative adv is the higher ratio of costs: Lind costs for wh/ROW costs for wh = 75/50=1.5 Lind costs for cloth/ROW costs for cloth = 100/50=2 Note: The ROW has the lower costs (is the denominator in the ratio). Its comp adv is where the ratio is highest (2>1.5).

Trade Theory: Comparative Advantage How much will each country produce if each has 750 hours of labor? Assume a division of labor in Lindertania of 350 hours for wheat and 400 hours for cloth, and for the ROW 350 for wheat and 400 for cloth.

Before Specialization Wheat Cloth Lind (=350/75) 4 (=400/100) ROW 7 (=350/50) 8 (=400/50) After Specialization WheatCloth Lind ROW

But can you calculate prices prevailing in the But can you calculate prices prevailing in the separate markets before the opening of trade? Inputs/BushInputs/Yd Lindert ROW50 50 Pre-trade Prices, Lindertania: 75/100 =.75 yd/bush 100/75 = 1.33 bush/yd 100/75 = 1.33 bush/yd ROW: 50/50 = 1 yd/bush or 50/50 = 1 bush/yd 50/50 = 1 bush/yd

Calculating pre-trade prices ROW Lindertania ROW Lindertania Price of wheat 1.0 yard/bushel.75 yd/bushel 1.0 yard/bushel.75 yd/bushel (=50/50) (=75/100) (=50/50) (=75/100) Price of cloth 1.0 bushel/yard 1.33 bushel/yd 1.0 bushel/yard 1.33 bushel/yd (= 50/50) (=100/75) (= 50/50) (=100/75) Notice the difference in prices here. Price of cloth 1.0 bushel/yd 1.33 bushels/yard

ARBITRAGE AND TRADE GAINS Now let trade be opened up. People notice potential for arbitrage gains. Now let trade be opened up. People notice potential for arbitrage gains. The principle: As long as prices differ in two places (by more than any cost of transportation), profit by arbitrage (buying in one location and selling in another). The principle: As long as prices differ in two places (by more than any cost of transportation), profit by arbitrage (buying in one location and selling in another). To arbitrage properly, sell your comparative advantage abroad. Take the foreign product you purchased back home to trade for lots more of the original product. To arbitrage properly, sell your comparative advantage abroad. Take the foreign product you purchased back home to trade for lots more of the original product.

Opening trade will lead under Ricardian conditions to specialization. What determines boundaries of trade prices, the lowest and highest number of yards per bushel? Opening trade will lead under Ricardian conditions to specialization. What determines boundaries of trade prices, the lowest and highest number of yards per bushel? In terms of (yards/bushel), In terms of (yards/bushel), 1.0 ≤ International price of cloth < ≤ International price of cloth < 1.33 (If ROW gets 1.0 or (If cloth isn’t cheaper (If ROW gets 1.0 or (If cloth isn’t cheaper less from Lind. it will just than 1.33 for Lindertania, less from Lind. it will just than 1.33 for Lindertania, take 1.0 at home.) through trade, it would simply buy at home. take 1.0 at home.) through trade, it would simply buy at home.

Suppose that the ratio settles at the price of 1 bushel = 1.25 yards. 1 bushel = 1.25 yards. Both nations will gain from trade after having pursued specialization according to their comparative advantages.

Now draw the PPC Curves Remember that we had, after specialization, WheatCloth Remember that we had, after specialization, WheatCloth Lind ROW To get the PPC curves, we need to know how much cloth Lind can produce if it puts all inputs into that product and how much wheat the ROW can produce if it puts all inputs into wheat. (We already have the amounts of wheat for Lind and cloth for ROW.)

Now draw the PPC Curves Remember that we had, a fter specialization, WheatCloth Remember that we had, a fter specialization, WheatCloth Lind /100 ROW 750/50 15 Or. Lind ROW 15 15

Now draw the PPC Curves Remember that we had, a fter specialization, WheatCloth Remember that we had, a fter specialization, WheatCloth Lind ROW Wht Cl Wht Cl Lindertania ROW

Wht Cl Wht Cl Lindertania ROW Lindertania can now get 1 yard of cloth for 1.25 bushels of wheat rather than the domestic price of 1.33 bushels per yard. The ROW can get 1.25 bushels of wheat per yard of cloth, rather than a mere 1 bushel of wheat, the domestic price.