1. Comparative Advantage and Trade, Part 2
Terms of Trade

2. Graph the Following PPCs
Values represent all resources spent on one good
(the other value is 0)
Shirts
(millions)
Wheat
(millions of bushels)
China 25 50
USA
200
Which country has an absolute advantage in shirts?
Which country has an absolute advantage in wheat?
What are the opportunity costs of each good for each country?
Which country has comparative advantage in shirts?
Which country has comparative advantage in wheat?

3. 1. The USA has an absolute advantage in shirts
(millions)
Wheat
(millions of bushels)
200
100 25 50
1. The USA has an absolute advantage in shirts
2. The USA has an absolute advantage in wheat
PPC USA
PPC China

4. 3. Opportunity Costs
Shirts
Wheat
China
(50 wheat lost/25 shirts gained) = 2 wheat
(25 shirts lost/50 wheat gained) = ½ shirts
USA
(200 wheat lost/50 shirts gained) = 4 wheat
(50 shirts lost/200 wheat gained) = ¼ shirts
4. China has a smaller opportunity cost and thus a comparative advantage in shirts
5. The USA has a smaller opportunity cost and thus a comparative advantage in wheat

5. Terms of Trade
What if the USA proposes to trade 20 million bushels of wheat to China in exchange for 7.5 million shirts?
Will the trade benefit both sides?
How do we know?

6. Terms of Trade
The “price” in terms of one good for another should fall between the opportunity costs for both countries
Price of a shirt: (20 wheat/7.5 shirts) = 2.66 wheat
This falls between China’s opportunity cost of 2 wheat and the USA’s opportunity cost of 4 wheat

7. Homework Example
In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. Before we can answer the question, we need to convert to production per worker:
Automobiles
Washing Machines
Italy
(8 workers = 1 auto) or 1/8 auto
(3 workers = 1 wm) or 1/3 wm
USA
(6 workers = 1 auto) or 1/6 auto
(2 workers = 1 wm) or 1/2 wm

8. Homework Example
In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. a. Which country has an absolute advantage in the production of automobiles? In washing machines?
Automobiles
Washing Machines
Italy
(8 workers = 1 auto) or 1/8 auto
(3 workers = 1 wm) or 1/3 wm
USA
(6 workers = 1 auto) or 1/6 auto
(2 workers = 1 wm) or 1/2 wm
The USA has an absolute advantage in both goods, because in each case it takes fewer workers to make the good.

9. Homework Example
In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. b. Which country has a comparative advantage in the production of automobiles? In washing machines?
Automobiles
Washing Machines
Italy
(1/3 wm / 1/8 auto) = 2 2/3 wm
(1/8 auto / 1/3 wm) = 3/8 auto
USA
(1/2 wm / 1/6 auto) = 3 wm
(1/6 auto / 1/2 wm) = 1/3 auto
The USA has a comparative advantage in washing machines, while Italy has a comparative advantage in automobiles.

10. Homework Example
In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day. c. What type of specialization results in the greatest gains from trade between the two countries?
The USA will specialize in washing machines, while Italy will specialize in automobiles.

11. Work Together on Handout
Assume USA is left graph and England is right graph
Assume that “normal” production levels are represented by given points on graphs (with dashed lines)
Assume that specializing leads to production of only one good.