comparative advantage

Comparative Advantage

Overheads

The Logic of Free Trade

Self-sufficiency is nice but …

Advantages of doing things ourselves

Good information about quality

Will not have any transactions costs

Don’t need to depend on others and their foibles

Can customize the product

Can coordinate production and consumption

Can keep information secret

Don’t have to worry about enforcing any contracts

Don’t have to worry about being exploited

Disadvantages of doing things ourselves

May not be able to achieve any economies of scale

May not have necessary knowledge, skill or intelligence for task

May have limited experience for some tasks

May have to keep continually changing tasks

Principle of specialization and exchange

Specialization and exchange enable us to enjoy greater production and higher living standardsthan would otherwise be possible.

As a result, all economies have been characterized by high degrees of specialization and exchange.

The principle of specialization and exchange applies not just to individuals, but to groups of individuals, such as those living within the boundaries that define cities, counties, states or nations.

International Trade -

International trade is trade between nations

Exports are goods and services that areproduced domestically, but sold abroad.

Imports are goods and services that areproduced abroad, but consumed domestically.

Absolute and comparative advantage

An individual producer has an absolute advantage in the production of a product if he has the ability to produce the good or service using fewer resources than other producers use.

Similarly a country has an absolute advantagein the production of a product if it has the abilityto produce the good or service using fewer resourcesthan other countries use.

An individual producer has a comparative advantagecomparative advantage in the production of a product if she has the ability to produce the good or service at a lower opportunity costlower opportunity costthan other producers.

Comparative advantage

Similarly, a country has a country has a comparative advantagecomparative advantage in the production of a product if it has the ability to produce the good or service at a lower opportunity costlower opportunity cost than other countries.

How to measure comparative advantage

We measure the opportunity costopportunity cost of a good,not by the resources used to produce it,but rather by the otherother goods goodswhose production must be sacrificedsacrificed.

Mutually Beneficial Trade

Mutually beneficial trade between any two countries

is possible whenever one country is relatively betterone country is relatively betterat producing a good than the other is at producing the good.

Being relatively betterrelatively better means having the ability

to produce a good at a lower opportunity costlower opportunity cost — that is, at a lower sacrifice of other goods foregone.

Measuring Productivity

We often measure productivity in terms ofoutput per unit of input (or other resource)

a. labor time or hours

b. land

c. expenditure or cost

Labor time example

Load of wash Vacuum a room

Labor requirement data for White House cleaning

Bill .80 hours .40 hours

Hillary .75 hours .25 hours

This data is input per unit of output

Convert requirement data to output per unit of input data

Take the reciprocal of the requirement data

Loads per hour Rooms per hourBill 1 / .80 = 1.25 loads 1 / .40 = 2.5 rooms

Hillary 1 / .75 = 1.333 loads 1 / .25 = 4 rooms

hoursload

loadshour

Mexico

U.S.

Corn (bu) Peanuts (lbs)

$2.50

$4.00

$0.25

$0.50

Corn and peanut exampleCost requirement data

$ per output

Convert requirement data to output per unit of input data

Take the reciprocal of the requirement data

Bushels of corn per $ Pounds of peanuts per $

U.S. 1 / 2.50 = 0.40 bu. 1 / .25 = 4 lbs.

Mexico 1 / 4.00 = 0.25 bu. 1 / .50 = 2 lbs (1/4)

Mexico

U.S.

Corn (bu) Peanuts (lbs)

0.40 bu

0.25 bu

4 lbs

2 lbs

Corn and peanut example

Output per $

How to determine who has the comparative advantage in what

2. Make an opportunity cost table (agents by goods)

1. Determine the output per per unit of input for each agent

5. The country with the lower opportunity cost has a comparative advantage in the production of each good

3. For each good (column) choose a unit of exchange

4. Determine the opportunity cost of each good in termsof the unit of exchange by dividing the production ofthe unit of exchange by the production of the other good

Output per unit of input data

Example Computation

3. Rooms is unit of exchange for wash Wash is unit of exchange for rooms

5. Bill has the comparative advantage in washing

5a. Hillary has the comparative advantage in room cleaning

4. Fill in comparative advantage table (unit of exchange per unit of good)

Hillary

Bill

Loads Rooms

1.25 2.5

1.33 4 Hillary

Bill

Loads Rooms

2 r

3 r

1/2 l

1/3 l

Example Computation

3. Peanuts is unit of exchange for corn Corn is unit of exchange for peanuts


Mexico

USA

Corn Peanuts

0.40 4

0.25 2 Mexico

USA

Corn Peanuts

10 p

8 p

1/10 c

1/8 c

40.40

10 20.25

8

Example Computation

3. Peanuts is unit of exchange for corn Corn is unit of exchange for peanuts

5. Mexico has the comparative advantage in corn

5a. USA has the comparative advantage in peanuts


Mexico

USA

Corn Peanuts

0.40 4

0.25 2 Mexico

USA

Corn Peanuts

10 p

8 p

1/10 c

1/8 c

Using input per unit of output data

Determining comparative advantage

Using cost per unit of output data

Output per unit of input data

We want the most possible

Input (cost) per unit of output data

We want the least possible

Most output per unit of input

Least input per unit of output

What does Bill give up to do a load of wash?What does Bill give up to do a load of wash?

Bill gives up 2 rooms to do a load of washBill gives up 2 rooms to do a load of wash

1 load of wash costs two rooms1 load of wash costs two rooms

0.8 0.4

0.75 0.25Hillary

Bill

Wash Rooms

Hours per task

Washing takes twice the resources of roomsWashing takes twice the resources of rooms

Hillary

Bill

1 Load 1 Room

Opportunity Cost of:

2 rooms

What about Hillary?What about Hillary?

Hillary gives up 3 rooms to do a load of washHillary gives up 3 rooms to do a load of wash

1 load of wash costs three rooms1 load of wash costs three rooms

0.8 0.4

0.75 0.25Hillary

Bill

Wash Rooms

Hours per task

Washing takes 3 times the resources of roomsWashing takes 3 times the resources of rooms

Hillary

Bill

1 Load 1 Room


2 rooms

3 rooms

Who has the lowest opportunity cost for washing?

Hillary

Bill

1 Load 1 Room

2 rooms

3 rooms

Bill has a comparative advantage in washingBill has a comparative advantage in washing

What does Bill give up to vacuum a room?What does Bill give up to vacuum a room?

Bill gives up 1/2 load of wash to vacuum a roomBill gives up 1/2 load of wash to vacuum a room

1 room costs ½ load of wash 1 room costs ½ load of wash

0.8 0.4

0.75 0.25Hillary

Bill

Loads Rooms

Hours per task

Vacuuming takes ½ as long as washingVacuuming takes ½ as long as washing

Hillary

Bill

1 Load 1 Room


2 rooms

3 rooms

½ load

What does Hillary give up to vacuum a room?What does Hillary give up to vacuum a room?

Hillary gives up 1/3 load of wash to vacuum a roomHillary gives up 1/3 load of wash to vacuum a room

1 room costs 1/3 load of wash 1 room costs 1/3 load of wash

0.8 0.4

0.75 0.25Hillary

Bill

Wash Rooms

Hours per task

Vacuuming takes 1/3 as long as washingVacuuming takes 1/3 as long as washing

Hillary

Bill

1 Load 1 Room


2 rooms

3 rooms

½ load

1/3 load

Bill has a comparative advantage in washingBill has a comparative advantage in washing

Hillary has a comparative advantage in vacuumingHillary has a comparative advantage in vacuuming

How to determine who has the comparative advantage in what

2. Make an opportunity cost table (agents by goods)

1. Determine the input per per unit of output for each agent

5. The country with the lower opportunity cost has a comparative advantage in the production of each good

3. For each good (column) choose a unit of exchange

4. Determine the opportunity cost of each good in termsof the unit of exchange by dividing the input use of each goodby the input use of the unit of exchange

Input per unit of output data

Example Computation

3. Peanuts is unit of exchange for cornCorn is unit of exchange for fish

5. Mexico has the comparative advantage in corn production

5a. U.S. has the comparative advantage in peanut production

4. Fill in comparative advantage table (unit of good per unit of exchange)

2.50 0.25

4.00 0.50Mexico

U.S.

Corn Peanuts

Mexico

U.S.

Corn Peanuts

10 p

8 p

1/10 c

1/8 c

Time for a break and review

Specialization and Gains from Trade

If individuals/countries specializeaccording to their comparative advantage,

a more efficient use of given resources occurs.

As a result, the output of at least one good rises,As a result, the output of at least one good rises,without decreasing that of any other good.without decreasing that of any other good.

The rate of substitution between outputs

Opportunity costHillary

Bill

Loads Rooms

2 rooms

3 rooms

½ load

1/3 load

If Bill cleans 1 less room, he washes 1/2 more load of laundry.If Bill cleans 1 less room, he washes 1/2 more load of laundry.

If Bill cleans 2 less rooms, he washes 1 more load of laundry.If Bill cleans 2 less rooms, he washes 1 more load of laundry.

(1 less room) x (½ load per room) = ½ more loads of laundry(1 less room) x (½ load per room) = ½ more loads of laundry

(2 less rooms) x (½ load per room) = 1 more loads of laundry(2 less rooms) x (½ load per room) = 1 more loads of laundry


If Bill does 1 more load of laundry, he cleans 2 less rooms.

If Bill does 2 more loads of laundry, he cleans 4 less rooms.If Bill does 2 more loads of laundry, he cleans 4 less rooms.

(1 more load) x (2 rooms per load) = 2 less rooms(1 more load) x (2 rooms per load) = 2 less rooms

(2 more loads) x (2 rooms per load) = 4 less rooms(2 more loads) x (2 rooms per load) = 4 less rooms


Bill

Loads Rooms

2 rooms

3 rooms

½ load

1/3 load


If Hillary does 1 more load of laundry, she cleans 3 less rooms

(1 more load) x (3 rooms per load) = 3 less rooms(1 more load) x (3 rooms per load) = 3 less rooms

If Hillary cleans 2 more rooms, she washes 2/3 less loads of laundryIf Hillary cleans 2 more rooms, she washes 2/3 less loads of laundry

(2 more rooms) x (1/3 load per room) = 2/3 more loads of laundry(2 more rooms) x (1/3 load per room) = 2/3 more loads of laundry


Bill

Loads Rooms

2 rooms

3 rooms

½ load

1/3 load

Now adjust tasks and see what happens


Bill

Loads Rooms

2 rooms

3 rooms

½ load

1/3 load

Bill does 2 more loads of laundry and Hillary does 2 less loads

(2 more loads) x (2 rooms per load) = 4 less rooms (Bill)(2 more loads) x (2 rooms per load) = 4 less rooms (Bill)

(2 less loads) x (3 rooms per load) = 6 more rooms (Hillary)(2 less loads) x (3 rooms per load) = 6 more rooms (Hillary)

Net impact is 2 more rooms vacuumedNet impact is 2 more rooms vacuumed

Now adjust tasks and see what happens

Opportunity costMexico

U.S.

Corn Peanuts

US grows 1,000 less bu corn and Mexico grows 1,000 more bu corn

(1,000 less bu corn) x (10 lbs per bu) = 10,000 more lbs of peanuts(1,000 less bu corn) x (10 lbs per bu) = 10,000 more lbs of peanuts

(1,000 more bu) x (8 lbs per bushel) = 8,000 less lbs of peanuts(1,000 more bu) x (8 lbs per bushel) = 8,000 less lbs of peanuts

Net impact is 2,000 more lbs of peanutsNet impact is 2,000 more lbs of peanuts

10 p

8 p

1/10 c

1/8 c

Another example


U.S.

Corn Peanuts

US grows 10,000 less corn and Mexico grows 100,000 less peanuts

(10,000 less bu corn) x (10 lbs per bu) = 100,000 more lbs of peanuts(10,000 less bu corn) x (10 lbs per bu) = 100,000 more lbs of peanuts

(100,000 less lbs) x (1/8 bushels per pound) = 12,500 more corn(100,000 less lbs) x (1/8 bushels per pound) = 12,500 more corn

Net impact is 2,500 more bushels of cornNet impact is 2,500 more bushels of corn

10 p

8 p

1/10 c

1/8 c

A third example


U.S.

Corn Peanuts

US grows 4,000 more corn and Mexico grows 40,000 more peanuts

(4,000 more bu corn) x (10 lbs per bu) = 40,000 less lbs of peanuts(4,000 more bu corn) x (10 lbs per bu) = 40,000 less lbs of peanuts

(40,000 more lbs) x (1/8 bushel per pound) = 5,000 less corn(40,000 more lbs) x (1/8 bushel per pound) = 5,000 less corn

Net impact is 1,000 less bushels of cornNet impact is 1,000 less bushels of corn

10 p

8 p

1/10 c

1/8 c

Oops!!Oops!!

Helpful note on finding tradeoffs

1 bu corn10 lbs peanuts

3,000 bu cornz lbs peanuts

z lbs peanuts 1 bu corn10 lbs peanuts

3,000 bu corn

The tradeoff in the US is 1 bushel corn for 10 pounds of peanuts

Suppose we produce 3,000 less bushels of corn in the US

How much will peanuts rise?

z lbs peanuts 3,000 bu corn 10 lbspeanuts1 bushel corn

z lbs peanuts 30,000 lbspeanuts

Helpful note on finding tradeoffs

1 bu corn8 lbs peanuts

x bu corn30,000 lbs peanuts

x bu corn 1 bu corn8 lbs peanuts

30,000 lbs peanuts

The tradeoff in the Mexico is 1 bushel corn for 8 pounds of peanuts

Suppose we want 30,000 less lbs of peanuts

How much will corn rise?

x bu corn 3,750 bu corn

If countries specialize according to their comparative advantage,

a more efficient use of given resources occurs.

The world output of at least one good rises,without decreasing that of any other good.

With the opening of trade, there will be anet increase in world output.

Gains from trade

Therefore, international trade flows can be arrangedso that no country would have less of anything, while each country would some of the gain in total output.

Mexico

U.S.

Corn Peanuts

World

Production Gain

U.S.

Mexico

Corn

Corn

Peanuts

Peanuts

Loss from exports (-)

Gain from imports (+)

Mexico

U.S.

Corn Peanuts

Opportunity cost

10 p

8 p1/10 c

1/8 c

- 100 + 1000

+ 100 - 800

+ 0 + 200

- 100

+ 1000

+ 100- 800

US imports 100 corn and exports 900 peanuts

+ 100

-900

-100

+900

+0

+100

+0

+100

900/100 = 9 so the US is trading 9 for 1

Mexico

U.S.

Corn Peanuts

World

Production Gain

U.S.

Mexico

Corn

Corn

Peanuts

Peanuts



Mexico

U.S.

Corn Peanuts

Opportunity cost

10 p

8 p1/10 c

1/8 c

- 10 + 100

+ 12 - 96

+ 2 + 4

- 10

+ 100

+ 12- 96


+ 11

-98

-11

+98

+1

+2

+1

+2

98/11 = 8.909 the US is trading 8.909 for 1

Mexico

U.S.

Corn Peanuts

World

Production Gain

U.S.

Mexico

Corn

Corn

Peanuts

Peanuts



Mexico

U.S.

Corn Peanuts

Opportunity cost

10 p

8 p1/10 c

1/8 c

- 40 + 400

+ 45 - 360

+ 5 + 40

- 40

+ 400

+ 45- 360


+ 45

-360

-45

+360

+5

+40

+0

+0

360/45 = 8 so the US is trading 8 for 1

As long as the opportunity costs differ,specialization and trade can be beneficial to all involved.

This remains true regardless of whether the parties involvedare nations, state, countries, or individuals.

It remains true even if one party holds an all-around absolute advantage or disadvantage.

Time for another breakTime for another break

Mexico

U.S.

Corn Peanuts

World

Production Gain

U.S.

Mexico

Corn

Corn

Peanuts

Peanuts



Mexico

U.S.

Corn Peanuts

Opportunity cost

10 p

8 p1/10 c

1/8 c

- 100 + 1000

+ 100 - 800

+ 0 + 200

- 100

+ 1000

+ 100- 800

The US is trading 100 bu corn for 900 lbs peanuts

+ 100

-900

-100

+900

+0

+100

+0

+100

Terms of trade

Terms of tradeThe U.S. is exporting 900 pounds of peanuts and importing 100 bushels of corn.

This exchange ratio is known as the terms of trade.

The US is exchanging 900 lbs peanuts for 100 bu corn

With different terms of trade, the benefitsof specialization and exchange would beapportioned in different manner.

The exchange ratio in this example is 9 to 1

More formally, the terms of tradeterms of trade is the ratio at which a country can trade

domestically produced productsfor foreign-produced products.

(900/100) = 9

Bounds on the terms of trade

What is the most the US will pay for a bushel of cornin terms of peanuts?

No more than what it can transform peanuts into corn domestically.


What is the least Mexico will take for a bushel of cornin terms of peanuts?

No more than what it can transform corn into peanuts domestically.

Corn and Peanuts

US

Country Opportunity Cost of a Bushel of Corn

1 bu. corn costs 10 lbs. of peanuts

Mexico 1 bu. corn costs 8 lbs. of peanuts

What if Mexico asks for 5 lbs of peanuts per bushel?

What if Mexico asks for 15 lbs of peanuts per bushel?

Will Mexico ask only 5 lbs of peanuts for a bushel of corn?

NO!!!


The U.S. will not trade peanuts for cornfor more than

10 pounds for 1 bushel

Mexico will not trade peanuts for corn at less than

8 pounds for 1 bushel

Another Little BreakAnother Little Break

Analysis of Comparative Advantage using PPF’sAnalysis of Comparative Advantage using PPF’s

Output Combinations of Peanuts & Corn - USOutput Combinations of Peanuts & Corn - US

PeanutsPeanuts CornCorn

00 10,00010,000100,000100,000 0 0

20,00020,000 8,000 8,000

40,00040,000 6,000 6,000

0100020003000400050006000700080009000

1000011000

0 20000 40000 60000 80000 100000 120000

Peanuts

Co

rn

PPF_US

This is a linear PPF which we can see by plotting it

We can find the slope of the PPF using two of the points

In particular, use the first two points in the set

CornCorn PeanutsPeanuts

10,00010,000 0 0 00 100,000 100,000

ΔcornΔpeanuts

(10,000 0)(0 100,000)

10,000 100,000

110

The implication is that the US gains 1 corn for 10 peanuts

0100020003000400050006000700080009000

1000011000

0 20000 40000 60000 80000 100000 120000

Peanuts

Co

rn

PPF_US

We can see this slope graphically

-20,000

2000

ΔcornΔpeanuts

2,000 20,000

110

The US produces 10,000 corn when it produces no peanuts

So the intercept in the line describing the PPF is 10,000

The equation for the PPF is then given by

corn = (- 1/10) peanuts + 10,000

Some example points

corn = (- 1/10) peanuts + 10,000

corn = (- 1/10) (20,000)(20,000) + 10,000

corn = - 2,000 + 10,000

corn = 8,000

corn = (- 1/10) (40,000)(40,000) + 10,000

corn = - 4,000 + 10,000

corn = 6,000

Given a change in peanuts we can get the change in corn

corn = slope * peanuts

8,000 8,000 20,000 20,000

6,0006,000 40,000 40,000


corn = (-1 / 10) * (40,000 - 20,000) corn = (-1 / 10) * (20,000)

corn = -2,000

corn peanuts

0100020003000400050006000700080009000

1000011000

0 20000 40000 60000 80000 100000 120000

Peanuts

Co

rn

PPF_US

Graphically

-40,000

4000

ΔcornΔpeanuts

4,000 40,000

110

Now consider MexicoNow consider Mexico

Output Combinations of Corn & Peanuts - MexicoOutput Combinations of Corn & Peanuts - Mexico


8,0008,000 0 0 00 64,000 64,000

6,000 6,000 16,000 16,000

2,5002,500 44,000 44,000

3,0003,000 40,000 40,000

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

0 10000 20000 30000 40000 50000 60000 70000

Peanuts

Co

rn

The linear PPF

PPF_Mexico

6,00048,000

18

ΔcornΔpeanuts

(0 6,000)(64,000 16,000)

We can find the slope of the PPF using two of the points

In particular, use the second two points in the set


00 64,000 64,000 6,000 16,00016,000

The implication is that Mexico gains 1 corn for 8 peanuts

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

0 10000 20000 30000 40000 50000 60000 70000

Peanuts

Co

rnGraphically

PPF_Mexico

-20,000

2500

ΔcornΔpeanuts

2,500 20,000

18

5500

Mexico produces 8,000 corn when it produces no peanuts

So the intercept in the line describing the PPF is 8,000

The equation for the PPF is then given by

corn = (- 1/8) peanuts + 8,000

Given a change in peanuts we can get the change in corn

corn = slope * peanuts

6,000 6,000 16,000 16,000

2,5002,500 44,000 44,000


corn = (-1 / 8) * (16,000 - 44,000) corn = (-1 / 8) * (- 28,000)

corn = 3,500

corn peanuts

Production Possibility Frontier

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

11000

0 20000 40000 60000 80000 100000 120000

Peanuts

Co

rnCombine the diagrams

PPF_US

PPF_Mexico


0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

11000

0 20000 40000 60000 80000 100000 120000

Peanuts

Co

rn

PPF_US

PPF_Mexico

The US gets more peanuts for corn compared to Mexico.

16000

Now consider some initial production point for each country

CountryCountry CornCorn PeanutsPeanuts

MexicoMexico 3,0003,000 40,00040,000USUS 6,0006,000 40,00040,000

TotalTotal 9,0009,000 80,00080,000


15002000250030003500400045005000550060006500

36,000 38,000 40,000 42,000 44,000

Peanuts

Co

rn

PPC_Mexico

US Corn

Graphically we can see this point as follows

PPC_US

Mexico Corn

Now decrease US corn production by 1 unit


5998

5998.5

5999

5999.5

6000

6000.5

6001

6001.5

39,990 39,995 40,000 40,005 40,010 40,015 40,020

Peanuts

Cor

n

Initial CornLess Corn

PPF_US

peanuts = + 10

Now increase Mexican corn production by 1 unit


2999

3000

3001

3002

39,984 39,988 39,992 39,996 40,000 40,004

Peanuts

Co

rn

PPC_Mexico

Initial Corn

More Corn

peanuts = - 8

Initial SubsequentCorn Peanuts Corn Peanuts

MexicoU.S.

Total

3,000 40,0006,000 40,000

9,000 80,000

3,001 39,9925,999 40,010

9,000 80,002

Putting it all together

By growing one less bushel of corn in the U.S.and one more bushel in Mexico,there is a net gain of 2 pounds of peanuts.

What have we learned?

Now drop US corn production by 1000


USUS 6,0006,000 40,00040,000

corn = (-1 / 10) * peanuts

-1000 = (-1 / 10) * peanuts

-10000 = (-1 ) * peanuts

10000 = peanuts

Now increase Mexican corn production by 1000


corn = (-1 / 8) * peanuts

1000 = (-1 / 8 ) * peanuts

8000 = (-1 ) * peanuts

-8000 = peanuts

MexicoMexico 2,5002,500 44,00044,000

Corn stays the same

In the US, peanuts = 10000

Summarizing

In Mexico, peanuts = -8000

In Total, peanuts = 2000


MexicoMexico 4,0004,000 32,00032,000

USUS 5,0005,000 50,00050,000

TotalTotal 9,0009,000 82,00082,000

Total Production

TotalTotal 9,0009,000 80,00080,000

PreviouslyPreviously

Mexico

US

Total

3000 40000

Corn Peanuts

9,000 80,000

Corn Peanuts

2501 39992

5999 44010

9,000 80,002

Corn Peanuts

2502 39984

5998 44020

9,000 88,004

Corn Peanuts

8000 0

1000 90000

9,000 90000

Consider a variety of alternative production points

Corn stays the same, peanuts increase by 10,000Corn stays the same, peanuts increase by 10,000

6000 40000

Practice ProblemPractice ProblemOutput Combinations of Cotton and SugarOutput Combinations of Cotton and Sugar

CottonCotton SugarSugar

100,000100,000 0 0

00 25,00025,000

US Cuba


30,00030,000 0 0

00 15,00015,000

slope for US ΔcottonΔsugar

(100,000 0)(0 25,000)

4

slope for Cuba ΔcottonΔsugar

(30,000 0)(0 15,000)

2

Practice ProblemPractice ProblemInitial Outputs of Cotton and SugarInitial Outputs of Cotton and Sugar

60,00060,000 10,00010,000

US Cuba

CottonCotton SugarSugar CottonCotton SugarSugar

10,00010,000 10,00010,000

Final Outputs of Cotton and SugarFinal Outputs of Cotton and Sugar

?? 5,0005,000

US Cuba

CottonCotton SugarSugar CottonCotton SugarSugar

?? 15,00015,000

For the USΔcotton (slope) (Δsugar) ( 4)( 5,000) 20,000

For CubaΔcotton (slope) (Δsugar) ( 2)(5,000) 10,000

Outputs of Cotton and SugarOutputs of Cotton and Sugar


US Cuba


60,00060,000 10,00010,000 10,00010,000 10,00010,000Initial

Final 80,00080,000 5,0005,000 00 15,00015,000

Consumption beyond the frontier

Suppose terms of trade are 9 pounds of peanuts for 1 bushel of corn9 pounds of peanuts for 1 bushel of corn.

Any time the U.S. stops producing a bushel of corn, it gets 10 pounds of peanuts.

It can trade 9 of these for a bushel of corn and have1 left over to bring it outside the frontier.

Any time Mexico stops growing a pound of peanutsit can produce 1/8 of a bushel of corn.

It can trade this for 9 pounds of peanuts and be better off.

So if Mexico stops growing 8 pounds of peanuts, it will have a bushel of corn to trade.

Consumption beyond the frontier

If opportunity costs differ and countries specializeIf opportunity costs differ and countries specialize according to their comparative advantage,according to their comparative advantage,

As a result, both countries are better offAs a result, both countries are better off

they can consume combinations of goodsthey can consume combinations of goods that lie outsidethat lie outsidetheir production possibilities frontiers. their production possibilities frontiers.

Convert domestic currency into the foreign currency and then compare prices.

Turning potential gains into actual gains

Exchange rates will adjust so that trade occurs.

Buy at the lowest price and sell at the highest price.

Provisos

Costs of trading

Sizes of countries

Size of market

Market power

Increasing opportunity cost and a concave PPF

Barriers to trade

Sources of Comparative Advantage

Capital stock

Physical

Experience

Natural resources

Human

Objections to free trade

Alternative groups in society are madebetter and worse off

Exports

Good for domestic producers

Bad for domestic consumers

Good for domestic consumers

Imports

Bad for domestic producers

Compensation principle

With free trade the gainers can compensatethe losers such that everyone is better off

Barriers to trade

Tariffs

Quotas

Clever rules

The EndThe End

comparative advantage

Documents

greater production

goodswhose production

comparative advantagesimilarly

comparative advantagewe

lower opportunity costthan

lower sacrifice

roomlabor requirement

unit of input datatake