AGEC 340 – International Economic DevelopmentCourse slides for week 12 (Mar. 30-Apr. 1)

Globalization and Comparative Advantage*

Can free trade really make us richer?

* If you are following the textbook, this is chapter 16

So far…we’ve explained prices and quantities in terms of market equilibrium between supply and demand

Price($/lb)

Quantity (thousands of tons/yr)

1.25

10

1.00

15

0.75

17

D

S

…but usually trade is available, so our price is determined by equilibrium with trade

Price($/lb)

1.25

10

1.00

0.75

17

Price($/lb)

1.25

10

1.00

0.75

17

Imports = 7Exports = 7

D

S

D

S

For exported goods For imported goods

…and governments often restrict trade, so our price is determined by trade and policy

Price($/lb)

1.25

10

1.00

0.75

17

Price($/lb)

1.25

10

1.00

0.75

17

Imports = 7Exports = 7

D

S

D

S

For exported goods For imported goods

1.15Tax on exporting($0.10/lb)

Tax on importing($0.10/lb)

0.85

In terms of economic surplus, adjusting to foreign prices creates gains from trade

Price($/lb)

1.25

10

1.00

0.75

17

Price($/lb)

1.25

10

1.00

0.75

17

Imports = 7Exports = 7

D

S

D

S

For exported goods For imported goods

In terms of economic surplus, a trade restriction cuts some of the gains from trade

Price($/lb)

1.25

10

1.00

0.75

17

Price($/lb)

1.25

10

1.00

0.75

17

Imports = 7Exports = 7

D

S

D

S

For exported goods For imported goods

1.15Tax on exporting($0.10/lb)

Tax on importing($0.10/lb)

0.85

The textbook describes another way to look at

comparative advantage…

Your textbook, page 318

To see this view of comparative advantage,let’s start by looking first at what it is not

• Comparative advantage is not “absolute advantage”– Absolute advantage would be

a lower cost per unit of output in terms of the quantity of inputs used

ex.: more bushels/acre, so fewer acres/bushelex.: more units/hour, so fewer hours/unit

in terms of the money cost of inputsex.: lower cost of landex.: lower cost of labor

– Comparative advantage is a lower cost relative to other options

To understand comparative advantage, it’s helpful to use a familiar example

• In US agriculture, why do Indiana & Kansas grow what we grow? These two states are roughly similar, but Kansas has less rain & lower yields:

Approximate crop yields, Indiana and Kansas (bu/acre)IN KS

Corn 130 75Wheat 55 50

• Who and what has an absolute advantage? …and who actually grows what? why?

To predict what farmers will grow, we can use a PPF diagram for a typical acre in each state.

Assuming all other costs per acre are equal:Q ofcorn

(bu/ac)

Q of wheat (bu/ac)55

Indiana

130we can draw the line straight if there’s no interaction between the two crops

Q ofcorn

(bu/ac)

55

Indiana

130

Q ofcorn

(bu/ac)

Q of wheat (bu/ac)

Kansas

50

75

Kansas has lower yields of both crops,but which crop do farmers grow?

As always, economists expect they’ll grow whichever maximizes profit

Q ofcorn

(bu/ac)

55

Indiana

130

Q of wheat (bu/ac)

Kansas

50

75

We need to know prices, to get the slope of the iso-revenue lines, e.g. : at recent prices

Pwheat/Pcorn = -4/2.5 = -1.6Q ofcorn

(bu/ac)

55

Indiana

130

Q of wheat (bu/ac)

Kansas

50

75

Q ofcorn

(bu/ac)

55

Indiana

130

Q of wheat (bu/ac)

Kansas

slope ofKansas PPF = -75/50 = -1.5

slope of isorev. lines:Pwheat/Pcorn=-4/2.5=-1.6

slope ofIndiana PPF = -130/55 = -2.36

50

75

The iso-revenue line is flatter than the Indiana PPF, and

steeper than the Kansas PPF

Q ofcorn

(bu/ac)

55

Indiana

130

Q of wheat (bu/ac)

Kansas

slope ofKansas PPF = -75/50 = -1.5

slope of isorev. lines:Pwheat/Pcorn=-4/2.5=-1.6

slope ofIndiana PPF = -130/55 = -2.36

50

75

This helps explain why Indiana specializes in corn while Kansas specializes in wheat.

Q ofcorn

(bu/ac)

55

Indiana

130

Q of wheat (bu/ac)

Kansas

slope ofKansas PPF = -75/50 = -1.5

slope of isorev. lines:Pwheat/Pcorn=-4/2.5=-1.6

slope ofIndiana PPF = -130/55 = -2.36

50

75

Growing the “wrong” crop in each place would simply give lower revenue in that place.

This is exactly the same idea as was shown in supply-demand diagrams

•

cc c

Imports = Qd-QsExports = Qs-Qd

D

S

D

SIndiana exports corn…. ...and imports wheat

QsQs QdQd

PcornPwheat

To conclude, we can sat that Indiana grows corn and Kansas grows wheat, simply because it’s in each state’s comparative advantage to grow what they grow best, compared to their own alternatives.

The same idea is why any country (or any individual person) is often better off specializing in something to trade with others. Self-sufficiency may sound good, but it’s often very costly!

So...

• What sectors do different countries have a comparative advantage?– the US?–other industrialized countries?–very poor countries

So...

• What sectors do different countries want to have a comparative advantage?– the US?–other industrialized countries?–very poor countries

So, what trade patterns do we see?Is the pattern of comparative advantage fixed?

Our textbook data:

In conclusion…

• Countries (and regions) can reach their highest possible level of real income through open trade with the rest of the world.

• What they trade depends on their comparative advantage, by exporting what is relatively cheap for them to sell, and importing what is relatively valuable;

• The pattern of comparative advantage changes over time, and depends on local technologies, resources and consumer preferences.