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Chapter 3
Comparative Advantage
and the Gains from Trade
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Learning Objectives
• Analyze numerical examples of absolute and comparative advantage.
• Define and state the differences between the concepts of absolute advantage,
• comparative advantage, and competitiveness.
• Discuss the economic and ethical considerations of economic restructuring caused by international trade.
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Introduction: The Gains from Trade
• The improvement in national welfare is known as the gains from trade
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Adam Smith and the Attack on Economic Nationalism
• In 1776, Adam Smith published the first modern statement of economic theory, An Inquiry into the Nature and Causes of the Wealth of Nations
– The Wealth of Nations attacked mercantilism—the system of nationalistic economics that dominated economic thought in the 1700s
– Smith proved wrong the belief that trade was a zero sum game—that the gain of one nation from trade was the loss of another
– Voluntary exchange (trade) is a positive sum game —both nations gain
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Implications of Adam Smith’s Theory
Access to foreign markets helps create wealth
– If no nation imports, every company will be limited by the size of its home country market
– Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs
– Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation
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Adam Smith and Trade Barriers
• Smith was highly critical of trade barriers
• Trade barriers decrease - Specialization- Technological progress- Wealth creation
• The modern view of trade shares Smith’s dislike for trade barriers
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A Simple Model of Production
and Trade• A basic model, often referred to as the
Ricardian model, named after economist David Ricardo
• Assumptions– Markets are competitive: Firms are price takers– Static world: Technology is constant and there are
no learning effects– Labor is perfectly mobile: It can easily move back
and forth between industries but perfectly immobile across national borders.
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TABLE 3.1 Assumptions of the Simple Ricardian Trade Model
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Absolute Productivity Advantage and the Gains from Trade
– Productivity: The amount of output obtained from a unit of input
– Labor productivity:(units of output) / (hours worked)
If two loaves of bread can be produced in 1 hour, productivity = (2 loaves) / (1 hour)
– Absolute productivity advantage: The advantage held by a country that produces more of a certain good per hour worked than another
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TABLE 3.2 Output per Hour Worked
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Relative Prices
• Without trade, the U.S. would forgo 0.67 loaves of bread for an additional ton of steel. This is the opportunity cost of steel, or the relative price of steel
• Why relative price? Because the price is not in monetary units but in units of the other good
-Relative price of steel is the inverse of the price of bread: if 0.67 loaves of bread is the price of a ton of steel in the U.S., then 1.5 tons of steel is the price of one loaf of bread
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The Consumption Possibilities Curve
• Autarky: The complete absence of trade; all nations can only consume the goods they produce at home
• Trade allows countries to raise their consumption
• Example:– If the opportunity cost of steel in Canada is 3 loaves of bread
per ton, and in the U.S. 0.67 loaves per ton, both countries can consume more by trading
– Gains from trade will occur if the price of steel settles somewhere between the opportunity costs in Canada and the U.S.
3.0 (loaves/ton) > WSP > 0.67 (loaves/ton)
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The Gains from Trade
• In sum, suppose the relative price of steel is 2 loaves of bread
– When the U.S. increases steel output by 1 ton, it gives up 0.67 loaves of bread output; however, it can now trade the steel for 2 loaves, leaving a net gain of 1.33 loaves (2 - 0.67 = 1.33)
– To meet U.S. demand for 2 more loaves of bread, Canada gives up 0.67 tons of steel output; however, it can now trade 2 loaves for 1 ton of steel, leaving a net gain of 0.33 tons (1 - 0.67 = 0.33)
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Domestic Prices and the Trade Price
• How do we make sure that the trade price settles within
– If the trade price was 4 loaves of bread, both countries would specialize in steel. However, the consequent bread shortage and steel glut would increase the price of bread and decrease the price of steel; once the price of bread fell to less than 3.0, Canadian producers would switch back to bread
– If trade price is closer to 0.67, gains are larger for Canada; if it is closer to 3.0, gains are larger for the U.S.; however, both would gain from trade when the price falls in this range
3.0(loaves/ton) > WSP > 0.67(loaves/ton) ?
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Absolute and Comparative Productivity Advantage Contrasted
Absolute productivity advantage is having a higher labor productivity. If each country has an absolute productivity advantage in one of the goods, both benefit by specializing in that good and trading it for the other good.
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Absolute and Comparative Productivity Advantage Contrasted (cont.)
Comparative productivity advantage is if a country’s opportunity costs of producing a good are lower than those of its trading partners. The concept is based on the idea that nations maximize their material well-being when they use their resources where they have their highest value.
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Comparative Productivity Advantage and the Gains from Trade
• Question: What happens if a country does not have an absolute productivity advantage in anything?
• Answer: Even if a country does not have any goods with an absolute productivity advantage, it can still benefit from trade
- The idea that nations benefit from trade has nothing to do with whether a country has an absolute advantage in producing a particular good
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TABLE 3.3 Output per Hour Worked
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Gains from Trade with No Absolute Advantage
• Japan has an absolute advantage in both cars (2>0.5) and steel (3>1), yet it can still gain from trade, as can Malaysia
• Once trade opens, the world price of cars will be between one and two tons of steel per car
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Comparative Advantage and “Competitiveness”
• Comparative advantage = competitive advantage when the prices of both inputs and outputs are an accurate indication of their relative scarcity
• Comparative advantage ≠ competitive advantage when the markets fail to correctly value the price of inputs and outputs
-Imbalances result from government policies, such as subsidies or protection
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Economic Restructuring
Economic restructuring: Changes in the economy that may require some industries to grow and others to shrink or disappear
– In the Ricardian model, trade opening moved labor from bread to steel production: restructuring improved U.S. overall economic welfare but made its bread industry disappear
– If trade results in net gain (in an increase of the consumption bundle), a country will be better off by trading; however, some sectors may still lose
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Economic Restructuring(cont.)
• Given that some lose due to economic restructuring, the government can seek to get the winners from trade and restructuring to compensate the losers
– Trade adjustment assistance (TAA) helps losers by providing extended unemployment benefits, worker retraining, and temporary tax on imports
– For example, the U.S. government created a special program for workers laid off because of NAFTA; in 1994, 17,000 workers qualified for the program