Trade Theory Introducing Absolute and Comparative Advantage

Absolute Advantage  The capacity of one economy to produce a good or service with fewer resources than another

Some starting assumptions:  Only 2 countries (United States and Canada)  Only 2 goods (shirts and shoes)  Both countries can make both products. If they spend half of their working hours on each product they can produce the following:

Table A – No Specialization ShoesShirts United States Canada80100 United States has an absolute advantage in producing shoes. Canada has an absolute advantage in producing shirts.

Questions about Table A a) What would be the total production of shoes and shirts without specialization and trade? b) How many units of each good would the United States have? c) How many units of each good would Canada have? ShoesShirts United States Canada80100

What if each country specialized?  The United States would produce only…?  Canada would produce only….? ShoesShirts United States Canada80100ShoesShirts Canada Table A Table B

Table B – With Specialization ShoesShirts United States 2000 Canada0200

Questions about Table B d) How did specialization affect world production? e) How did specialization affect the standard of living in the United States? In Canada? ShoesShirts United States 2000 Canada0200

Summary  The world now has more of both shoes and shirts. The United States can trade 100 units of shoes for 100 units of shirts and both countries will benefit.  What if a country has an absolute advantage in the production of both products though? Would trade still occur?

Table C ShoesShirts United States Canada8075 The United States has an absolute advantage in both shoe and shirt production. Should it engage in trade?

Questions about Table C f) What would the total world production be without specialization and trade? g) How many units of each good would the United States have? h) How many units of each good would Canada have? ShoesShirts United States Canada8075

Which product would the US specialize in if it were to trade?  Look to the opportunity costs…….

US Opportunity Costs  Give up 100 shoes to get 80 shirts (or 100/80 = 1.25 shoes per shirt)  Give up 80 shirts to get 100 shoes (or 80/100 = 0.8 shirts per shoe) ShoesShirts United States 10080

Canada Opportunity Costs  Give up 80 shoes to get 75 shirts (or 80/75 = 1.06 shoes per shirt)  Give up 75 shirts to get 80 shoes (or 75/80 = 0.94 shirts per shoe) ShoesShirts Canada8075

Opportunity Cost Summary United States  Give up 100 shoes to get 80 shirts (or 100/80 = 1.25 shoes per shirt)  Give up 80 shirts to get 100 shoes (or 80/100 = 0.8 shirts per shoe) Canada  Give up 80 shoes to get 75 shirts (or 80/75 = 1.06 shoes per shirt)  Give up 75 shirts to get 80 shoes (or 75/80 = 0.94 shirts per shoe) Who should specialize in shoes and who shirts?

Comparative Advantage  United States should produce shoes because it costs them only 0.8 shirts per shoe compared to Canada’s cost of 0.94 shirts per shoe.  Canada should produce shirts because it costs them only 1.06 shoes per shirt compared to the United States’ cost of 1.25 shoes per shirt

Comparative Advantage The capacity of an economy to produce a good or service with comparatively fewer resources than another (e.g. having a lower opportunity cost)  The United States is said to have a comparative advantage in shoes.  Canada is said to have a comparative advantage in shirts.

Table D – With Specialization ShoesShirts United States 2000 Canada0150

Questions about Table D i) How did specialization affect world production? ShoesShirts United States 2000 Canada0150

How do we know whether the world is better off then? j) What if the United States made 8 units of shirts. How would this change the total production?

Table E – With Partial Specialization ShoesShirts United States 1908 Canada0150 So the world is better off with specialization. What about the United States? Is it really benefiting?

Questions about Table E k) What if Canada traded 75 units of shirts to the United States for 90 units of shoes? How would that change Table E? ShoesShirts United States 1908 Canada0150

Table F – Specialization With Trade ShoesShirts United States Canada9075

Compare Table C to Table F ShoesShirts United States Canada9075ShoesShirts Canada8075 Before TradeAfter Trade

Terms of Trade The rate at which a country’s exports are exchanged for their imports So the US will benefit from trade with Canada. How many shirts would the US insist on getting and how many shoes would they give up? Need to look at opportunity costs again.

US Opportunity Costs  Give up 100 shoes to get 80 shirts (or 100/80 = 1.25 shoes per shirt)  Give up 80 shirts to get 100 shoes (or 80/100 = 0.8 shirts per shoe) The US would be willing to give anywhere from 0 to 1.25 shoes per shirt. They want to get at least 0.8 shirts per shoe.

Canada Opportunity Costs  Give up 80 shoes to get 75 shirts (or 80/75 = 1.06 shoes per shirt)  Give up 75 shirts to get 80 shoes (or 75/80 = 0.94 shirts per shoe) Canada would be willing to give anywhere from 0 to 0.94 shirts per shoe. They want to get at least 1.06 shoes per shirt.

Terms of Trade The US would be willing to give anywhere from 0 to 1.25 shoes per shirt. Canada wants to get at least 1.06 shoes per shirt. Therefore the terms of trade will be between 1.06 and 1.25 shoes per shirt.

Terms of Trade Canada would be willing to give anywhere from 0 to 0.94 shoes per shirt. The US wants to get at least 0.8 shirts per shoe. Therefore the terms of trade will be between 0.8 and 0.94 shirts per shoe.

Practice in “Economics Now” Page 383 #1 to 5 (add (#6) What would be the range of terms of trade?) Page 399 #6 (add (d) What would be the range of terms of trade?)

Page 383 #1 Steel (tonnes/1000 hours) Coal (tonnes/1000 hours) Arcticona410 Tropicona32 Arcticona has an absolute advantage in producing steel (4 is more than 3). Arcticona has an absolute advantage in producing coal (10 is more than 2).

Page 383 #2  Give up 4 steel to get 10 coal (or 4/10 = 0.4 steel per coal)  Give up 10 coal to get 4 steel (or 10/4 = 2.5 coal per steel) SteelCoal Arcticona410

Page 383 #2  Give up 3 steel to get 2 coal (or 3/2 = 1.5 steel per coal)  Give up 2 coal to get 3 steel (or 2/3 = 0.67 coal per steel) SteelCoal Tropicona32

Page 383 #3 Comparative Advantage  Arcticona should produce coal because it costs them only 0.4 steel per coal compared to Tropicona’s cost of 1.5 steel per coal.  Tropicona should produce steel because it costs them only 0.67 coal per steel compared to the Arcticona’s cost of 2.5 coal per steel

Page 383 #4 Table A – No Specialization – 4000 labour hours – half of the labour is spent producing each product SteelCoal Arcticona820 Tropicona64 Total1424

Page 383 #4 Table B – Specialization – 4000 labour hours SteelCoal Arcticona040 Tropicona120 Total1240  Is there a benefit? 40 coal instead of 24 (almost double) 12 steel instead of 14 (a small drop). Want to be sure? What about partial specialization?

Page 383 #4 Table C – Partial Specialization SteelCoal Arcticona430 Tropicona120 Total1630  Is there a benefit? 30 coal instead of 24; 16 steel instead of 14. Specialization meant more of both produced.

Page 383 #5 Tropicona Opportunity cost – steel specialization  Give up 3 steel to get 2 coal (or 3/2 = 1.5 steel per coal)  Domestically they would GAIN 4 coal by giving up 6 steel (trading 6 steel for 3 coal would therefore be unacceptable)

Arcticona (specialize in coal)  Give up 4 steel to get 10 coal (or 4/10 = 0.4 steel per coal)  Give up 10 coal to get 4 steel (or 10/4 = 2.5 coal per steel) Arcticona would be willing to give anywhere from 0 to 2.5 coal per steel. They want to get at least 0.4 steel per coal.

Tropicona (specialize in steel)  Give up 3 steel to get 2 coal (or 3/2 = 1.5 steel per coal)  Give up 2 coal to get 3 steel (or 2/3 = 0.67 coal per steel) Tropicona would be willing to give anywhere from 0 to 1.5 steel per coal. They want to get at least 0.67 coal per steel.

Terms of Trade  Arcticona would be willing to give anywhere from 0 to 2.5 coal per steel.  Tropicona wants to get at least 0.67 coal per steel.  Therefore the terms of trade will be between 0.67 and 2.5 coal per steel.

Terms of Trade  Tropicona would be willing to give anywhere from 0 to 1.5 steel per coal.  Arcticona wants to get at least 0.4 steel per coal.  Therefore the terms of trade will be between 0.4 and 1.5 steel per coal. (note the question is asking whether Tropicona would accept an amount of 2 steel per coal – outside the range)

Page 383 #6 Steel (tonnes) Coal (tonnes) Arcticona040 Tropicona120 Total1240 Steel (tonnes) Coal (tonnes) Arcticona430 Tropicona120 Total1630

Page 399 #6 (a) Showshoes Running Shoes Myopia85 Utopia1025 Utopia has an absolute advantage in producing showshoes and running shoes.

Page 399 #6 (b) Comparative Advantage  Myopia should produce snowshoes because it costs them only running shoes per snowshoe compared to Utopia’s cost of 2.5 running shoes per snowshoe.  Utopia should produce running shoes because it costs them only 0.4 snowshoes per running shoe compared to the Myopia’s cost of 1.6 snowshoes per running shoe.

Terms of Trade  Myopia would be willing to give anywhere from 0 to 1.6 snowshoes per running shoe.  Utopia wants to get at least 0.4 snowshoe per running shoe.  Therefore the terms of trade will be between 0.4 and 1.6 showshoes per running shoe.

Terms of Trade  Utopia would be willing to give anywhere from 0 to 2.5 running shoes per snowshoe.  Myopia wants to get at least running shoes per snowshoe.  Therefore the terms of trade will be between and 2.5 running shoes per snowshoe.