Chapter 2 Comparative Advantage Theory 1. David Ricardo David Ricardo 2. Ricardo’s Model Ricardo’s Model 3. Summary Summary

Chapter 2 David Ricardo Son of a Jewish immigrant stockbroker 2. 3 rd of 17 children 3. Read WoN in Encouraged by James Mill 5. Principles of Political Economy Member of Parliament

Chapter 2 Ricardo’s Model 1. Basic Assumptions Basic Assumptions 2. Basis of Trade Basis of Trade 3. Measurements of Comparative Advantage Measurements of Comparative Advantage 4. Pattern of Production and Trade Pattern of Production and Trade 5. Effects of Trade Effects of Trade

Chapter 2 Basic Assumptions  Similar to AA Model  Different presentation, same meanings  Goods are identical  Perfect Competition  Perfect knowledge, no tariffs or other trade barriers.  No transaction costs

Chapter 2 Basis of Trade 1.Differences in Technologies (in relative term)  Relative productivity  Relative production cost  Relative commodity price  International Trade 2. Comparative AdvantageComparative Advantage

Chapter 2 A country is said to have a comparative advantage over another country in the production of a commodity if it can produce the commodity at a lower opportunity cost than the other country. Comparative Advantage

Chapter 2 Comparative Advantage u Compares producers of a good according to their opportunity cost.opportunity cost. u The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good.

Chapter 2 Opportunity Cost Opportunity Cost of some decision is value of the next best alternative which you have to give up because of the decision –Opportunity cost is the most desired goods or services that are forgone in order to obtain something else.

Chapter 2 Measurements of Comparative Advantage(1) 1. Relative labor productivity of Product 1 If then China has a comparative advantage in production of Product 1.

Chapter 2 Measurements of Comparative Advantage(2) 2. Relative input-requirement (physical cost) of Product 1 where a L1 is the input requirement in each unit of output of Product 1

Chapter 2 Measurements of Comparative Advantage(3) 3. Opportunity cost of Product 1: The cost of an activity in terms of sacrificed next best alternative uses of the assets involved. Can also be formulated as “amount of product 2 we must give up to produce a unit of product 1”.—— Marginal Rate of Technology Substitution (MRTS) of Product 1

Chapter 2 Measurements of Comparative Advantage(4) 4. Relative price of Product 1: The four measurements of CA are the same in results. Example

Chapter 2 A numerical example Only a small change AA model Comparative Advantage No Trade Trade

Chapter 2 Pattern of Production and Trade 1. Each country should specialize in and export the Product in which it has a comparative advantage 2. in this case, China should specialize in production of cloth and US should produce wheat.

Chapter 2 Effects of Trade  General equilibrium analysis:  Graph Graph  Numerical Numerical  Summary for trade effects Summary for trade effects

Chapter 2 General Equilibrium Analysis(Graphs) Trade Triangle QWQW Export QCQC China Trade Triangle Import ToT=1.52 E P C O QCQC QWQW US ToT= E P C O Export Import ?

Chapter 2 The Standard of Welfare Attentions: In the analysis of general equilibrium, the standard index measuring welfare is CIC, not the absolute consumptions of products. So the rise of the consumptions of both products can prove the gains of trade, but the gains of trade need not be the rise of the consumptions of both products.

Chapter 2 General equilibrium analysis （ Numerical ） P=Produce;C=Consumer Labor be used equally on the production of C&W Exchange Rate must between 1.1~2

Chapter 2 Exchange Rate China exchange 100 unit Cloth for Wheat not less than 50 unit, or else produce Wheat itself ； USA exchange 100 unit Wheat for Cloth not less than 110 Unit, or else produce Cloth itself ； So the exchange rate of Cloth/Wheat must between 1.1 (=110/100) and 2 (=100/50) 。

Chapter 2 Tradable Zone QCQC QWQW O not tradable for China not tradable for USA tradable for both

Chapter 2 General equilibrium analysis （ Numerical ） Gains ： China consume 52 Cloth and 32 Wheat. If produce itself, it has to input 116L (= 52×1 ＋ 32×2) ， so save 16L ；52×1 ＋ 32×2 USA consume 48 Cloth and 68 Wheat. If produce itself, it has to input 111.6L (=48×0.91 ＋ 68×1), so save 11.6L 。48×0.91 ＋ 68×1

Chapter 2 Summary for trade effects 1. To Price: the relative Price of export ( which has comparative advantage) goes upthe relative Price of export ( which has comparative advantage) goes up 2. Work division: Each country specializes in the Product in which it has a comparative advantage 3. Welfare: Each country is better off(consume more or produce frugally) produce frugally

Chapter 2 Summary u Interdependence and trade allow countries to enjoy a greater quantity and variety of goods and services. u The gains from trade are based on comparative advantage, not absolute advantage. u Comparative advantage applies to countries as well as to people.people

Chapter 2 Should Tiger Woods Mow His Own Lawn? ? ??