International Trade The Law of Comparative advantage Sec. 4.1

International Trade The process of buying goods and services from the rest of the world (importing) and that of selling goods and services to the rest of the world (exporting) is referred to as international trade

Reasons for Trade Lower prices Lower prices Differences in factor endowments Differences in factor endowments Variety and quality of goods Variety and quality of goods Gains from specialization Gains from specialization

Absolute Advantage A country has an absolute advantage in the production of a good when it can produce more of that good than another country with the same resources. Kilos of Lamb M.of Cloth Australia61 China43 Total104 Australia has an absolute advantage in the production of lamb while China in cloth. Suppose that by using x units of resources…

WineComputers France502 US603 The US has an absolute advantage in the production of wine and computers

Absolute Advantage

Comparative Advantage The US has an absolute advantage in the production of both goods. Do you think it would benefit from trading with France? The US has an absolute advantage in the production of both goods. Do you think it would benefit from trading with France? Yes, since France is relatively more efficient than the US in the production of Wine. Yes, since France is relatively more efficient than the US in the production of Wine. When a country can produce a good relatively more efficient than another, it is said that this country has a comparative advantage in the production of that good. When a country can produce a good relatively more efficient than another, it is said that this country has a comparative advantage in the production of that good.

How do we know that a country has a comparative advantage in the production of a good? How do we know that a country has a comparative advantage in the production of a good? A country has a comparative advantage in the good it can produce at a lower opportunity cost than its trading partner. A country has a comparative advantage in the good it can produce at a lower opportunity cost than its trading partner. WineComputers France502 US603 Note that the opportunity cost of 1 case of wine in France is 1/25 computers, whereas the opportunity cost of 1 case of wine in the US is 1/20 computers. Note that the opportunity cost of 1 case of wine in France is 1/25 computers, whereas the opportunity cost of 1 case of wine in the US is 1/20 computers.

Since France can produce wine relatively more efficiently (cheaper) than the US, France is said to have a comparative advantage in wine production. WineComputers France502 US603 Note that the opportunity cost of 1 computer in France is 25 wine cases, whereas the opportunity cost of 1 computer in the US is 20 wine cases. Note that the opportunity cost of 1 computer in France is 25 wine cases, whereas the opportunity cost of 1 computer in the US is 20 wine cases. The US has a comparative advantage in the production of computers. The US has a comparative advantage in the production of computers.

David Ricardo A famous economist named David Ricardo ( ) came up with the law of comparative advantage. A famous economist named David Ricardo ( ) came up with the law of comparative advantage. According to this law, specialization and free trade benefits all trading partners. According to this law, specialization and free trade benefits all trading partners. Countries should specialize in those goods they have a comparative advantage in.Countries should specialize in those goods they have a comparative advantage in.

The law of comparative advantage According to the law of comparative advantage, France should specialize in the production of wine and the US should specialize in the production of computers. According to the law of comparative advantage, France should specialize in the production of wine and the US should specialize in the production of computers. The law predicts that both countries would benefit from specialization and free trade. The law predicts that both countries would benefit from specialization and free trade. Let us test this law with an example. Let us test this law with an example.

Note that in order for the theory of comparative advantage to work the opportunity cost facing both countries has to be different otherwise there would be no point in trading. Note that in order for the theory of comparative advantage to work the opportunity cost facing both countries has to be different otherwise there would be no point in trading.

Example Suppose that both France and the US were endowed with 20x units of resources. Suppose that both France and the US were endowed with 20x units of resources. France could produce 1000 wine cases with 20x units. France could produce 1000 wine cases with 20x units. The US could produce 60 computers. The US could produce 60 computers. Suppose that France and the US agreed to exchange 1 computer for 21 wine cases. Suppose that France and the US agreed to exchange 1 computer for 21 wine cases.

WinePCs France10000 US060 Specialization Self-sufficiencyWinePCsFrance50020 US60030 With specialization, France could exchange 500 cases of wine with 23 computers. France is better off. The US could exchange 30 computers with 630 wine cases. The US is better off. Specialization benefits both trading partnersWinePCsFrance50023 US63030 Post Trade

Nice Trick! The country with a flatter PPF has a comparative advantage in the good on the x-axis.

What gives a country a comparative advantage Comparative advantage is based on the country’s factor endowments. Comparative advantage is based on the country’s factor endowments. The abundance of a particular factor will make its price relatively lower.The abundance of a particular factor will make its price relatively lower. This will make the opportunity cost of the goods and services using that factor lower than it would be in other countries.This will make the opportunity cost of the goods and services using that factor lower than it would be in other countries.

Limitations of the theory of comparative advantage The comparative advantage theory is based on certain assumptions that may not hold in reality, hence limits its application in real life. The theory assumes the following: There are no transport costs. In reality transport costs may erode the comparative advantage of a country. There are no transport costs. In reality transport costs may erode the comparative advantage of a country. Goods being traded are identical, which is usually not the case, they may vary in quality. Goods being traded are identical, which is usually not the case, they may vary in quality. Perfectly free trade among countries prevails. In reality trade barriers exist in many industries. Perfectly free trade among countries prevails. In reality trade barriers exist in many industries. The factors of production stay in the country. However, FOPs rather than goods might move from one country to the other. The factors of production stay in the country. However, FOPs rather than goods might move from one country to the other. The trade off between the two goods is not always constant (the PPF is not a straight line) in reality The trade off between the two goods is not always constant (the PPF is not a straight line) in reality

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