Micro International Trade Essentials 1 WCC Absolute Advantage, Comparative Advantage, and Trade

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1 Micro International Trade Essentials 1 WCC Absolute Advantage, Comparative Advantage, and Trade Why do people trade? Generally speaking, we assume that all people pursue the same goal. They are out to maximize utility. Therefore, if people engage in trade, it must mean that they believe that trading brings them greater utility than not trading. After all, trading is voluntary. No one makes you trade. Since trade takes two parties, both sides must believe that the trade is beneficial. They both expect to be better off than if they do not trade. Since both parties benefit, it doesn t seem too much of a stretch to claim the following then, Trade is good. A corollary logically then follows, Anything that interferes with trade is bad. This may be a bit of a simplification, but it s a good philosophical starting point. How does trade increase utility? Occasionally, trade allows you access to a resource or good that you cannot produce or find domestically. More frequently, trade allows you to obtain goods at a lower cost, and when economists speak of cost, they mean opportunity cost. Basically trade lowers the opportunity cost of getting goods and services for both parties. So, essentially, trade is based on differences in opportunity cost. Determining the pattern of trade The pattern of trade simply refers to determining which country produces which goods. While it isn t a big jump for us to recognize that differences in opportunity cost will determine the pattern of trade, early economists took a long time to come to this realization. Two by two models are a good way of illustrating how OC determines the pattern of trade. They also illustrate how easy it is to misunderstand what drives trade. Two by two models Limit us to a world in which there are only two countries and two goods. The numbers in the table represent labor productivity, output/person/time period. Labor and resources cannot move back and forth between the countries. Only the goods can be traded. international trade essentials 1.doc 1 Revised on: 3/6/2018

2 Example 1 Poland and Argentina Consider the case of Poland and Argentina. Both countries are capable of producing vodka and beef. As it turns out, a worker in Poland can produce 400 bottles of vodka per year, while a worker on Argentina can produce only 240 bottles of vodka per year. Why? Perhaps the workers in Poland have better potatoes or better stills to work with. However, a worker in Poland can only produce 20 head of cattle per year, while a worker in Argentina can produce 80 head of cattle per year. Why? Perhaps this is due to Argentina having wide open spaces with plentiful grass, or a culture of vaquero skills that has been passed down from generation to generation. In any event, we would record this information in a table as follows. Poland Argentina Vodka 400 bottle 240 bottles Beef 20 head 80 head Tentative conclusions Poland is more efficient at producing vodka than Argentina. It can produce more vodka per person. Argentina is more efficient at producing beef than Poland. It can produce more beef per person than Poland. Adam Smith s position Smith developed the concept of absolute advantage. A producer has an absolute advantage in a good if it can produce that good more efficiently than another producer. Smith argued that the pattern of trade was determined by absolute advantage. He believed that countries should specialize in the good in which they have an absolute advantage and trade for the other good. Therefore, Poland should specialize in vodka and Argentina should specialize in beef. The two should then trade vodka for beef. This seems logical, but there is a problem. He is arguing that trade is based on efficiency, but we started this discussion by agreeing that trade is based on opportunity cost. Consider the following example. international trade essentials 1.doc 2 Revised on: 3/6/2018

3 Example 2 Niger and Mexico Consider the case of Mexico and Niger. Both countries can produce sisal and cotton. Sisal is a plant fiber used in making ropes. Cotton, of course, is used in making textiles, though it too can be used to make cotton twine. Niger Mexico Sisal 100 bales 200 bales Cotton 50 bales 175 bales Tentative conclusions Mexico is more efficient at producing both sisal and cotton. Therefore, Mexico has an absolute advantage in both goods. According to Smith then, no trade should take place as Niger has nothing to trade. Again though we should doubt this conclusion though, because we started this section by arguing that trade is based on OC not efficiency David Ricardo s position Ricardo developed the concept of comparative advantage. A producer has a comparative advantage in a good if it can produce that good at a lower OC than another producer. Ricardo argued that the pattern of trade was determined by comparative advantage. He believed that countries should specialize in the good in which they have an comparative advantage and trade for the other good. Sadly, this means we actually have to calculate the OC for each good in each country. OC of Cotton in Niger N = 100 bales of sisal = 2 bales of sisal 50 bales of cotton bale of cotton OC of Cotton in Mexico M = 200 bales of sisal = bales of sisal 175 bales of cotton bale of cotton OC of Sisal in Niger N = 50 bales of cotton = 0.5 bales of cotton 100 bales of sisal bale of sisal OC of Sisal in Mexico N = 175 bales of cotton = bales of cotton 200 bales of sisal bale of sisal international trade essentials 1.doc 3 Revised on: 3/6/2018

4 Result Mexico has a lower OC for producing cotton. Therefore, Mexico has a comparative advantage in producing cotton. Niger has a lower OC for producing sisal. Therefore, Niger has a comparative advantage in producing sisal. Ricardo would argue that Mexico should specialize in producing cotton, while Niger should specialize in producing only sisal. Notes on comparative advantage Comparative advantage is based on differences in OC, not efficiency. If one country has a comparative in one good, the other country must have a comparative advantage in the other good. While one country could theoretically have an absolute advantage in all goods, no country can have a comparative advantage in all goods. This means that all countries can benefit from trade based on comparative advantage, even if they are relatively unproductive. Proving Ricardo s thesis How do we prove that Ricardo s assertion is correct, and that trade should be based on comparative advantage? Remember that the goal of trade is to maximize utility. More stuff probably equals more utility. We can try to follow Smith s advice and then Ricardo s advice, and see which method gives us more stuff. Following Smith s advice Consider Niger and Mexico again, and assume each country has 10 workers. Since Mexico has an absolute advantage in both goods, Smith argued that no trade should take place. Each country will need to produce its own sisal and cotton. No specialization takes place. So assume each industry gets 5 workers in each country. Output Niger Mexico World Sisal 1,000 1, Cotton ,125 international trade essentials 1.doc 4 Revised on: 3/6/2018

5 Following Ricardo s advice Consider Niger and Mexico again, and assume each country has 10 workers. Since Mexico has a comparative advantage in cotton, it should specialize in cotton. Since Niger has a comparative advantage in sisal, it should specialize in sisal. Let s start this process by moving one worker from sisal to cotton in Mexico, and 3 workers from cotton to sisal in Niger. Output Niger Mexico World Sisal ,600 Cotton 100 1,050 1,150 Result No additional labor was used, but output of both goods increased when the countries started to specialize based on comparative advantage. Essentially, the size of the world pie has increased. That, however, isn t enough to ensure that both countries will benefit. Since the world pie is larger, both countries could get more stuff. However, we need to show that both countries actually do get a larger slice of pie. Production Possibilities Frontiers PPFs show the maximal combination of two goods a country can produce given its resources and technology. They are the best tool for demonstrating that both parties actually gain from trade. If a country does not trade, its production possibilities frontier (PPF) is also its consumption possibilities frontier (CPF). Our examples will assume that no specialization of inputs exists, therefore the PPFs are linear. Keep in mind that the steepness of the PPF measures the OC of the good on the horizontal axis. Example 3 Drawing a PPF for Cuba Assume that Cuba has 10 workers. Each worker can produce 32 cigars per day, or 8 gallons of rum per day. Multiplying the number of workers times their output per day gives us the maximum output of each good. These represent the intercepts. Since there is no specialization of inputs, the PPF is linear. If the Cuba does not trade with anyone else, then this PPF is also their CPF. What you produce is what you get to consume. international trade essentials 1.doc 5 Revised on: 3/6/2018

6 Cuba s PPF (and CPF, in the absence of trade) Cigars Rum Example 4 Illustrating that both countries gain from trade The table below captures labor productivity (output per worker per day) in the U.S. and China. Assume each country has 10 workers. U.S. China Tentative conclusions China has an absolute advantage in both goods. The OC of producing a TV is lower in the U.S. than in China. Therefore, the U.S. has a comparative advantage in. The OC of producing a computer is lower in China than in the U.S. Therefore, China has a comparative advantage in producing computers. Ricardo would argue that the U.S should specialize in, while China specializes in computers. Graphs 100 U.S. 400 China international trade essentials 1.doc 6 Revised on: 3/6/2018

7 Thoughts on these graphs Efficiency is a good thing, no doubt. The fact that China is more efficient at producing both goods means that their PPF sits farther out than ours. In the absence of trade, this means that they have a higher standard of living. There is more output per person available for consumption. Following Ricardo s advice However, let s try to follow Ricardo s advice and have the U.S. specializes in while China specializes in computers. The two will then swap for computers. If we do this, China produces at the vertical intercept on their PPF and we produce at the horizontal intercept on our PPF. To trade though, both countries have to agree on the terms of trade, the rate at which they will swap for computers. Let s assume that the terms of trade are 2 for 1 computer. TPF TPF 100 U.S. 400 China Results When countries specialize in producing one good, and then trade at these terms of trade, both trace out a trading possibilities frontier (TPF) that sits outside their PPF. Thus, both sides do get a larger slice of pie by following Ricardo s advice. Of course, other terms of trade will work too, as long as they fall between 4 = 1 computer and 1 TV = 1 computer. Essentially, the proposed terms of trade must lie between the autarky OC of production in each country. If the terms are outside that range, one country will refuse to trade. While both countries benefit, they do not necessarily benefit equally. A country will benefit more if it can get terms of trade closer to the slope of its trading partner s PPF. So, how much each country benefits depends on the terms of trade. international trade essentials 1.doc 7 Revised on: 3/6/2018

3. What proportion of international trade is based on absolute advantage?

3. What proportion of international trade is based on absolute advantage? File: Ch02; Chapter 2: The Law of Comparative Advantage Multiple Choice 1. The Mercantilists did not advocate: a. free trade b. stimulating the nation's exports c. restricting the nations' imports d. the