Foundations of Modern Trade Theory: Comparative Advantage Chapter 2 Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Mercantilists popular from 1500-1800 in Europe assumption that a trade surplus (exports > imports) would lead to a nation obtaining more gold which would lead to increased domestic production and employment policy implication was for domestic government to limit trade through tariffs, import quotas, and other methods

Price-Specie-Flow Doctrine David Hume counter argument to mercantilism trade surplus possible only in short run inflow of gold or other form of wealth will lead to an increase in the price of domestic goods higher prices for domestic goods will eventually lead to increased imports and decreased exports

Absolute Advantage Adam Smith – Wealth of Nations cost differences determine the patterns of international trade based on natural and acquired resources labor theory of value – amount of labor required determines the cost of any good principle of absolute advantage – trade is beneficial when each country is a least cost producer of one of the goods being traded

Absolute Advantage - Example Since the U.S. can produce more cloth, we should produce cloth and trade it to the U.K. for wine, for which the U.K. has greater capacity.

Comparative Advantage David Ricardo trade as mutually beneficial even if one country is more efficient than another principle of comparative advantage – each nation should specialize in production of those goods for which it is relatively more efficient with a lower opportunity cost not possible for one country to have a comparative advantage in everything

Comparative Advantage - Example The U.S. can produce twice as much wine as the U.K. but four times as much cloth. Therefore the U.S. should specialize in producing cloth while the U.K. specializes in producing wine.

Production Possibilities Schedule (PPS) PPS - various combinations of two goods that a nation can produce using all available factor inputs

Marginal Rate of Substitution (MRT) amount of one good a country must sacrifice to get one more unit of another good synonymous with opportunity cost equal to the absolute value of the slope of the production possibilities schedule ∆ good Y ∆ good X MRT =

MRT (cont.) In this graph the MRT equals 0.5 because wheat output falls by 20 when auto rises by 40

Basis for Trade The MRT or opportunity cost for each nation will indicate the direction of trade. The MRT or opportunity cost can also indicate the potential gains from trade. We begin with an assumption of constant opportunity costs. Benefits will be measured in terms of both improved production and consumption.

Gains from Specialization 1 additional auto in the U.S. => loss of 0.5 bushel of wheat 1 additional auto in Canada => loss of 2 bushels of wheat

Gains from Specialization (cont.) Since the U.S. has a lower opportunity cost of auto production, it will be mutually beneficial for the U.S. to produce autos and trade them to Canada for wheat.

Production Gains Without trade or specialization, world production is 80 autos and 120 bushels of wheat. If both nations specialized based on their comparative advantages, world production would increase to 120 autos and 160 bushels of wheat.

Consumption Gains If the U.S. trades 60 autos for 60 bushels of wheat, then consumption will increase in each country.

Consumption Gains (cont.) Graphically consumption could increase from A to C for the U.S. and A to C  for Canada or elsewhere along the Trading Possibilities Lines.

Distributing Gains from Trade comparative advantage => only outer limits for the terms of trade based on domestic cost ratios form no-trade boundaries and region of mutually beneficial trade

Equilibrium Terms of Trade John Stuart Mill – Theory of Reciprocal Demand terms of trade determined by the relative strength of each nation’s demand for the other nation’s product nations of roughly equal size => gains from trade distributed roughly equally one nation larger => smaller nation attains most of the gains from trade because trade occurs closer to the larger nation’s existing price ratio – “importance of being unimportant”

Terms of Trade Estimates export price index import price index terms of trade = × 100 prices of exports rise in relation to imports shows improvement 2006 terms of trade data using 2000 as the base year

Dynamic Gains from Trade increased income leads to increased savings which leads to increased investment greater options in supply chain increased output level can lead to benefits from economies of scale improved competition can lead to lower prices for consumers and a greater variety of products offered to consumers

Changes in Comparative Advantage Thus far our analysis has assumed comparative advantage did not change. However, if productivity changed at different rates, comparative advantage could shift from one nation to another.

Increasing Opportunity Costs result of diminishing marginal productivity cost of producing one good increases as more of that good is produced production possibilities schedule has concave shape MRT will increase as we move around the curve towards the intercepts

Trade with Increasing Opportunity Costs specialize until relative costs are equal line tt becomes terms of trade for both the U.S. and Canada

Gains – Increasing Cost Case If the U.S. specializes and trades 7 autos for 7 bushels of wheat, consumption would increase in each country.

Impact of Trade on U.S. Jobs little to no impact on overall employment will impact mix of jobs and specific industries

Many Products Various products have different comparative costs resulting in different degrees of comparative advantage. Each nation will produce and export the goods for which it has the greatest comparative advantage subject to supply and demand constraints.

Many Countries multilateral trade implies bilateral trade balance is unlikely result

Outsourcing – Pros & Cons reduced costs and increased competitiveness for domestic companies increased exports to countries in which new jobs are created higher level of repatriated earnings reinvested into domestic economy Cons reduced employment in specific industries lower wages, particularly for unskilled workers