1. Chapter 1 appendix Comparative Advantage Management 3460 Institutions and Practices in International Finance Fall 2003 Greg Flanagan

2. 2 Comparative Advantage Production and Trade Possibilities Curves

3. 3 Comparative advantage Differing opportunity costs consumption possibilities through trade are greater than a country’s production possibilities.

4. 4 Production & Trade Possibilities Curves Quantity of milk (Opp cost = 1) Quantity of bread (Opp cost = 1) 30 PPC 30 |Slope| = 1 Country A |Slope| = 2 The PPC slope for Country B 60 Produce bread and trade for milk 0< Terms of Trade <1 45 Trade Possibilities Curve: |Slope| = 1.5 TPC

5. 5 Production & Trade Possibilities Curves Quantity of milk (Opp cost =.5) Quantity of bread (Opp cost = 2) Country B 20 |Slope| = 1 The PPC slope for Country A Produce Milk and trade for bread 0< Terms of Trade <1 15 Trade Possibilities Curve: |Slope| = 1.5 TPC PPC |Slope| = 2 20 10

6. 6 Textbook Problem Solutions 1. The opportunity cost of producing food instead of textiles is one yard of textiles per 7/4 = 1.75 pounds of food. A pound of food has an opportunity cost of 4/7 =.57 yards of textiles. 4 7 Food Textiles

7. 7 Textbook Problems 2. Examination of the no-trade input/output table indicates that Country X has an absolute advantage in the production of food and textiles. Country X can “trade off” one unit of production needed to produce 17 pounds of food for five yards of textiles. Thus, a yard of textiles has an opportunity cost of 17/5 = 3.40 pounds of food, or a pound of food has an opportunity cost of 5/17 =.29 yards of textiles. Analogously, Country Y has an opportunity cost of 5/2 = 2.50 pounds of food per yard of textiles, or 2/5 =.40 yards of textiles per pound of food. In terms of opportunity cost, it is clear that Country X is relatively more efficient in producing food and Country Y is relatively more efficient in producing textiles. Thus, Country X (Y) has a comparative advantage in producing food (textile) is comparison to Country Y (X).

8. 8 Textbook Problems 2. When there are no restrictions or impediments to free trade the economic-well being of the citizens of both countries is enhanced through trade. Suppose that Country X shifts 20M units from the production of textiles to the production of food where it has a comparative advantage and that Country Y shifts 60M units from the production of food to the production of textiles where it has a comparative advantage. Total output will now be (90M x 17 =) 1,530M pounds of food and [(20M x 5 =100M) + (90M x 2 =180M) =] 280M yards of textiles. Further suppose that Country X and Country Y agree on a price of 3.00 pounds of food for one yard of textiles, and that Country X sells Country Y 330M pounds of food for 110M yards of textiles. Under free trade, the following table shows that the citizens of Country X (Y) have increased their consumption of food by 10M (30M) pounds and textiles by 10M (10M) yards.

9. 9 Production & Trade Possibilities Curves Food (..29) Textiles (3.4) Country X 6.8 |Slope| = 2.5 The PPC slope for Country X Produce Food and trade for Textiles 0< Terms of Trade <1 Trade Possibilities Curve: 2.5 < |Slope| < 3.4 i.e. 3 TPC PPC |Slope| = 3.4 17 5

10. 10 Production & Trade Possibilities Curves Food (.4) Textiles (2.5) 2 PPC 5 |Slope| = 2.5 Country Y |Slope| = 3.4 The PPC slope for Country X 6.8 Produce textiles and trade for food 0< Terms of Trade <1 Trade Possibilities Curve: 2.5 < |Slope| < 3.4 i.e. 3 TPC