Chapter 3 Why Everybody Trades: Comparative Advantage

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1 International Economics Thomas Pugel 16th Edition Solutions Manual Completed download: Test Bank for International Economics 16th Edition by Thomas Pugel Download link: Chapter 3 Why Everybody Trades: Comparative Advantage Overview This chapter extends the analysis of international trade to consider trade in a multiple-product economy. An economy composed of two products is useful to bring out insights about international trade. This general equilibrium approach explicitly shows the effects of resource reallocations between industries. The chapter culminates in showing the importance of comparative advantage for understanding why countries trade. The story begins with Adam Smith and absolute advantage. (A box on mercantilism summarizes the view that Smith opposed and shows how mercantilist thinking continues today.) The analysis focuses on the productivity of labor (output per hour) in producing each of two products (wheat and cloth) in two countries (the United States and the rest of the world). Smith examined the case of absolute advantage, in which labor productivity in producing one product is higher in one country and labor productivity in producing the other product is higher in the other country. With no trade each country must produce both products to meet national demands. The discussion of the Smith case focuses on the increase in global production efficiency achieved by shifting production in each country toward the product in which it has the higher labor productivity. National demands can be met by international trade apparently excess supplies can be exported and apparently excess demands can be met by imports. The increase in total world production is the evidence of gains from international trade. Smith's approach does not indicate what would happen if the same country has absolute advantage in both products. Ricardo took up this case and demonstrated the principle of comparative advantage a country will export products that it can produce at low opportunity cost and import products that it would otherwise produce at high opportunity cost. The Ricardian example is developed in more detail. The ratio of resource costs (labor hour input-output coefficients, the inverse of labor productivities) indicates the opportunity costs or relative prices of the products in each country with no trade. The difference in prices with no trade sets up the opportunity for arbitrage, with each good being exported from the initially low-price country and imported by the initially high-price country. The shift to a free trade equilibrium results in an 17

2 equilibrium international price. Without information on demand, we cannot say exactly what this price will be, but we do know that it is in the range bordered by the two no-trade price ratios. The chapter uses the Ricardian example to introduce a key analytical device the production possibility curve, which shows all combinations of outputs of different goods that an economy can produce with full employment of resources and maximum productivity. The resource costs of producing each product in the country and the total amount of labor hours available in the country are used to graph the country's production possibility curve, a straight line whose slope equals the (negative of the) extra (or marginal) cost of additional cloth. The straight line indicates that the marginal or opportunity cost of each good in each country is constant, following Ricardo's assumptions. The slope of this line also indicates the relative price of cloth (the good on the x-axis) with no trade. If free trade results in an equilibrium international price ratio that is strictly between the two notrade price ratios (because both countries are "large countries"), then each country specializes completely in producing only the good in which it has the comparative advantage. Each trades at the equilibrium international price ratio (along a trade line or price line) to reach its consumption point. Both countries gain from trade. Each is able to consume more of both goods than it consumed with no trade. Tips This chapter begins the full sweep of the development of thinking about comparative advantage as an explanation of the pattern of trade, starting with absolute advantage, and continuing with comparative advantage according to Ricardo. Most instructors will want to emphasize the continuity of thinking by tying this chapter closely to Chapter 4, which presents Heckscher and Ohlin's insight that comparative advantage can be based on differences in factor proportions and factor endowments. We have divided the discussion of comparative advantage into these two chapters (3 and 4), because students (especially students who find this conceptual material challenging to master) are likely to appreciate that the reading comes in more manageable sizes. This chapter has the first of a series of boxes that Focus on Labor. Issues of wages and work conditions are prominent in criticisms of globalization. These boxes should be of major interest to many students, as they take up these issues. The box in this chapter examines the link between (real) wages and productivity. It argues that wages in developing countries are low because labor productivity is low. This is not caused by international trade or foreign exploitation wages will be low with or without trade. The key to raising wages and living standards is raising productivity, perhaps through education, better health, and better government policies toward labor markets. Problem 9 at the end of the chapter focuses on the calculation of real wages in a Ricardian example. Suggested answer to case study discussion question Mercantilism: Older than Smith And Alive Today: Key features of mercantilism include that it places most value on domestic production and exports, that it deemphasizes domestic consumption and denigrates general imports of products, and that it views international trade as a 18

3 zero-sum activity. The proponents of national competitiveness are using a version of mercantilist thinking. The emphasis is on national producers and their share of world sales. Domestic consumers who buy imports are bad because they are reducing domestic firms share of global sales. And, the emphasis on market share creates a zero-sum game, because the market shares must by definition total 100 percent. 19

4 Suggested answers to end of chapter questions and problems 1. Disagree. This statement describes absolute advantage. It would imply that a country that has a higher labor productivity in all goods would export all goods and import nothing. Ricardo instead showed that mutually beneficial trade is based on comparative advantage trading according to maximum relative advantage. The country will export those goods whose relative labor productivity (relative to the other country and relative to other goods) is high, and import those other goods whose relative labor productivity is low.. Agree. Imports permit the country to consume more (or do more capital investment using imported capital goods). Anything that is exported is not available for domestic consumption (or capital investment). Although this loss is bad, exports are like a necessary evil because exports are how the country pays for the imports that it wants. 3. Disagree. Mercantilism recommends that a country should export as much as it can because of the purported benefits of large exports. In its original form mercantilism argued that exports were good because the country could receive gold and silver in payment for its exports. In its modern form exports are good because they create jobs in the country. Mercantilism does not hold local consumption to be as important an objective as gold and silver (original version) or employment (modern version). 4. If the countries trade with each other at the relative price of 1 W/C, then shifting only half way to complete specialization in production would be worse for each country than shifting to complete specialization. If the United States shifted only half way, then its new trade line would be parallel to the trade line shown in Figure 3.1, and it would start from the point on the ppc that is half way between S0 and S1. While this new trade line would allow the United States to consume at a point that had more consumption than at the initial S0, the United States could do even better by shifting production all the way to points S1 and consuming along the trade line shown in Figure 3.1. Consuming at a point like C would have even more consumption than consuming at a point on the new halfway trade line. Essentially the same reasoning can be used for the rest of the world, for a new trade line that is parallel to the rest of the world s trade line shown in Figure 3.1, but that begins at a point on the rest of the world s ppc that is half way between S0 and S1. 5. Using the information on the number of labor hours to make a unit of each product in each country, you can determine the relative price of cloth in each country with no trade. With no trade, the relative price of cloth is W/C (= 4/) in the United States, and it is 0.4 W/C (= 1/.5) in the rest of the world. Using the arbitrage principle of buy low sell high, you acquire cloth in the rest of the world, giving up 0.4 wheat unit for each cloth unit that you buy. Your profit is 1.6 (=.0 0.4) wheat units for each unit of cloth that you export from the rest of the world. (You could also explain the arbitrage as buying and exporting wheat from the United States.) 6. Using the information on the number of labor hours to make a unit of each product in each country, you can determine the relative price of cloth in each country with no trade. With no trade, the relative price of cloth is W/C (= 4/) in the United States, and it is 0

5 0.4 W/C (= 1/.5) in the rest of the world. With free trade the equilibrium world price of cloth must be in the range bounded by these two no-trade prices. So, yes, it is possible that the free-trade equilibrium relative price of cloth is 1.5 W/C (1.5 is greater than 0.4, and less than ). 7. a. Pugelovia has an absolute disadvantage in both goods. Its labor input per unit of output is higher for both goods, so its labor productivity (output per unit of input) is lower for both goods. b. Pugelovia has a comparative advantage in producing rice. Its relative disadvantage is lower (75/50 < 100/50). c. With no trade, the relative price of rice would be 75/100 = 0.75 unit of cloth per unit of rice. d. With free trade the equilibrium international price ratio will be greater than or equal to 0.75 cloth unit per rice unit and less than or equal to 1.0 cloth unit per rice unit (the notrade price ratio in the rest of the world). Pugelovia will export rice and import cloth. 8. a. Moonited Republic has an absolute advantage in wine it takes fewer labor hours to produce a bottle (10 < 15). Moonited Republic also has an absolute advantage in producing cheese it takes fewer labor hours to produce a kilo (4 < 10). b. Moonited Republic has a comparative advantage in cheese. The opportunity cost of producing a kilogram of cheese is 0.4 (= 4/10) bottles of wine in Moonited Republic, while the opportunity of a kilo of cheese in Vintland is 0.67 (= 10/15) bottles. Vintland has a comparative advantage in wine. The opportunity cost of a bottle of wine is 1.5 kilos of cheese in Vintland, while it is.5 kilos in Moonited Republic. c. Wine Vintland Wine Moonited Republic 1 N V 0.8 N M Cheese 3 5 Cheese d. When trade is opened, Moonited Republic exports cheese and Vintland exports wine. If the equilibrium free trade price ratio is 1/ bottle per kilo, Moonited Republic will specialize completely in producing cheese, and Vintland will specialize completely in producing wine. 1

6 e. With free trade Moonited Republic produces 5 (=0/4) million kilos of cheese. If it exports million kilos, then it consumes 3 million kilos. It consumes the 1 million bottles of wine that it imports. With free trade Vintland produces (=30/15) million bottles of wine. If it exports 1 million bottles, then it consumes 1 million bottles. It consumes the million kilos of cheese that it imports. Wine Vintland Wine Moonited Republic 1 N V T V 1 N M T M Cheese Cheese f. Each country gains from trade. Each is able to consume combined quantities of wine and cheese that are beyond its ability to produce domestically. The free trade consumption point is outside of the production possibility curve. 9. a. With no trade, the real wages in the United States are 1/ = 0.5 wheat unit per hour and 1/4 = 0.5 cloth unit per hour. The real wages in the rest of the world are 1/1.5 = 0.67 wheat unit per hour and 1/1 = 1.0 cloth unit per hour. The absolute advantages (higher labor productivities) in the rest of the world translate into higher real wages in the rest of the world. b. With free trade the United States completely specializes in producing wheat. The U.S. real wage with respect to wheat remains 0.5 wheat unit per hour. Cloth is obtained by trade at a price ratio of one, so the U.S. real wage with respect to cloth is 0.5 cloth unit per hour. The gains from trade for the United States are shown by the higher real wage with respect to cloth (0.5 > 0.5). As long as U.S. labor wants to buy some cloth, the United States gains from trade by gaining greater purchasing power over cloth. With free trade the rest of the world completely specializes in producing cloth. Its real wage with respect to cloth is unchanged at 1.0 cloth unit per hour. Its real wage with respect to wheat rises to 1.0 wheat unit per hour because it can trade for wheat at the price ratio of one. The rest of the world gains from greater purchasing power over wheat. c. The rest of the world still has the higher real wage. Absolute advantage matters higher labor productivity translates into higher real wages.

7 10. If the number of labor hours to make a bushel of wheat is reduced by half to 1 hour, this reinforces the U.S. comparative advantage in wheat. (In fact, the United States then has an absolute advantage in wheat.) The United States is still predicted to export wheat and import cloth. If, instead, the number of hours to make a yard of cloth is reduced by half to hours, this reduces the U.S. absolute disadvantage in cloth, but it does not change the pattern of comparative advantage. The relative price of cloth is now 1 (=/) bushel per yard in the United States with no trade, but this is still higher than the price of 0.67 bushel per yard in the rest of the world. The United States still has a comparative advantage in wheat, so the United States is still predicted to export wheat and import cloth. 11. For the United States (left side of Figure 3.1), the new trade line still begins at the production point S1, and it is steeper than the initial trade line shown in the figure. The intercept of the new trade line with the horizontal axis is 50/1. = 41.7 (rather than 50 for the initial trade line). The United States still gains from trade it can consume more than it can consume with no trade (at point S0 ). But the United States gains less when the world price is 1. W/C because the new trade line is inside of the initial trade line. The United States is not able to consume at the initial trade-enabled consumption point C. For the rest of the world (right side of Figure 3.1), the new trade line begins at the production point S1 and is steeper than the trade line shown in the figure. The intercept of the new trade line with the vertical axis is = 10 (rather than 100 for the initial trade line). The rest of the world gains from trade it can consume more than it can consume with no trade (at point S0). And the rest of the world gains more when the world price is 1. W/C, because the new trade line is outside of the initial trade line. The rest of the world is able to consume at points on the new trade line that allow more consumption of both goods than at the initial trade-enabled consumption point C. 1. a. The opportunity cost of producing a unit of product Z is units (= 8/4) of product V. b. With no trade the price of product Z in the country is V/Z. With free trade and the equilibrium world price of Z of 1.5 V/Z, the country will want to import product Z. So, the country will shift toward producing (and exporting) product V. c. Yes, it is possible. If the price 1.5 V/Z is an equilibrium world price for product Z, then the other country must want to export product Z (and import product V). With no trade the opportunity cost of producing product Z in the other country is 1 (= 6/6) V/Z. Because 1 V/Z is less than 1.5 V/Z, the other country will want to export product Z. More download links: International Economics 16th Edition Thomas Pugel Solutions international economics pugel 16th edition test bank pdf international economics pugel 16th edition pdf international economics thomas pugel 16th edition pdf 3

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