Chapter 10 International Trade I --- The Law of Comparative Advantage

© Pilot Publishing Company Ltd. 2005

Chapter 10 International Trade I ---The Law of Comparative

Advantage


• The law of comparative advantage

• Distribution of gains from trade

• Graphical illustration of international trade

• International trade – Reasons and hindrance

• Advanced Materials 10.1 : Graphical illustration of international trade – Increasing production cost

Contents:


The Law of Comparative Advantage


Necessary conditions for international trade

Factors of production cannot be moved across national boundaries but goods can. Why?

Production costs of the trading parties are different. Why?

Protectionist measures are not prohibitive. Why?

The transportation and the transaction costs involved do not exhaust the gains from trade. Why?


A country is said to have an absolute advantage over another country in the production of a good if it can produce a larger amount of the good than the other country with the same amount of resources.

Absolute advantage


Two countries are said to have a reciprocal absolute advantage over each other if each country has an absolute advantage over the other in producing one of the two goods.

Reciprocal absolute advantage


The principle

Given that two countries have a reciprocal absolute advantage over each other, if each specializes in producing the good in which it has an absolute advantage, then the world’s total output will increase.


Case I

*1 unit of resources (a combination of labour, capital, and land)

Which country has an absolute advantage in the production of food?

Food Clothing

Output of 1 unit of resources*

Country A 10 8

Country B 3 10

Country A

Which country has an absolute advantage in the production of clothing? Country B


Specialization leads to increase in world’s output

If now country A shifts 1 unit of resources from the production of clothing to the production of food.

And country B shifts 1 unit of resources from the production of food to the production of clothing.

Country A 10 8

Country B 3 10

World’s total output

Food Clothing

+10 -8

-3 +10

+7 +2


Case II

*1 unit of resources ( a combination of labour, capital, and land)

Which country has an absolute advantage in the production of food?

Food Clothing

Country A

Output of 1 unit of resources*

Country A 100 80

Country B 3 10

Which country has an absolute advantage in the production of clothing? Country A


Comparative advantage

A country is said to have a comparative advantage over another country in the production of a good if it can produce the good at a lower opportunity cost than the other country.


The law of comparative advantage or the law of comparative cost states that if each country specializes in the production of the good in which it has a comparative adv. (or a lower production cost), the world’s total output will increase.

The law of comparative advantage


Production cost of 1F Production cost of 1C

Country A

Country B

0.80C100

80C F25.1

80

F100

F30.010

F3C33.3

3

C10

Output of 1 unit of resources

Country A 100F 80C

Country B 3F 10C


Country A +1.0F -0.8C

Country B -0.3F +1.0C

World’s total output +0.7F +0.2C

Food Clothing

If country A produces one more unit of food

while country B produces one more unit of clothing

Specialization leads to an increase in world’s output


Absolute advantage versus comparative advantage

1. Abs. adv. and comp. adv. are unrelated.

Abs. adv. compares productivity of the two countries (the amount of output obtained per unit of resources). Comp. adv. compares production costs of the two countries (the amount of another good forgone per unit of output).

However, if two countries have a reciprocal absolute advantage over each other, each will have a comparative advantage in the production of the good that it has an absolute advantage.


2. It is possible for a country to have an absolute advantage in the production of all goods, but it is impossible for the country to have a comparative advantage in all production.

3. It is the comparative advantage (not the absolute advantage) that determines the allocation of resources and the direction of trade.

However, comparative advantage does not determine the volume of trade, the terms of trade or the balance of trade.


Q10.4:

For each of the following typical cases, determine

(a) which country has an absolute advantage in the production of

(i) food (ii) clothing

(b) which country has a comparative advantage in the production of

(i) food (ii) clothing


Case 1: Output of 1 unit of resources

Country A Country B

Food 8 10

Clothing 2 6

Case 2: Output of 1 unit of resources

Food Clothing

Country A 8 10

Country B 2 6


Case 3:Amount of resources for producing

1 unit of output

Food Clothing

Country A 8 10

Country B 2 6

Case 4:Production cost of 1 unit of output

Food Clothing

Country A $8 $10

Country B £2 £6


Calculation of production costs

1. Given the amount of good X and good Y produced per unit of resources (marginal products), i.e., MPX and MPY:

Production cost of 1X is

Production cost of 1Y is

Y good of units MP

MP

X

Y

X good of units MP

MP

Y

X



2. Given the amount of resources required to produce one unit of good X and good Y (real marginal costs in terms of resources), i.e., MCX and MCY:



Y good of units MC

MC

Y

X

X good of units MC

MC

X

Y



3. Given the amount of money required to produce one unit of good X and good Y (nominal marginal costs in terms of money), i.e., MCX and MCY:



Y good of units MC

MC

Y

X

X good of units MC

MC

X

Y


Distribution of Gains from Trade


Principle

Specialization raises the world’s total output, while trade distributes the output among trading parties.

The world price (or exchange ratio or terms of trade) of a good is determined by its D & S in the world market.

From the trading of a good, a country gains the difference between its production cost of the good and the good’s world price.


Country A 8 lab 10 lab

Country B 10 lab 3 lab

Food Clothing

Amount of labour required to produce a unit of food and clothing in country A and country B

Illustration



Country A

Country B

0.80Clab 10

lab 8

0.30Flab 10

lab 33.33C

lab 3

lab 10

Calculation of gains from trade

Given exchange ratio: 1F=1C

World price of 1F (=1C) > Country A’s production cost of 1F (=0.8C) Country A exports foodCountry A exports foodCountry A exports foodCountry A exports food

From each unit of food exported, country A gains 0.2C (=1C-0.8C).

1.25Flab 8

lab 10



Country A

Country B

0.80Clab 10

lab 8

0.30Flab 10

lab 33.33C

lab 3

lab 10

Calculation of gains from trade

Given exchange ratio: 1F=1C

World price of 1F (=1C) < Country B’s production cost of 1F (=3.33C) Country B imports food

From each unit of food imported, country B gains 2.33C (=3.33C-1C).

1.25Flab 8

lab 10


Terms of trade

Terms of trade (TOT) is the ratio of a country’s export price (PX) to its import price (PM).

M

X

P

PTOT=


Implications of the terms of trade

An improvement (or deterioration) in the terms of trade reflects an increase (decrease) in the gain from trade per unit of export.

A change in the terms of trade has no implication on the amount of trade, the total gain from trade or the balance of trade. Why?

TOT It measures the amount of import that a country can exchange with a unit of its export


Terms of trade index

The terms of trade index= the unit value index for total exports the unit value index for imports measured in the same base period

The unit value index for total exports (or imports) is the weighted average of the export prices (or the import prices). where the weight of a good is equal to the proportion of its value in the total value of exports (or the total value of imports).


Q10.6 How will the terms of trade of Hong Kong be affectedunder the following situations?

(a) A rise in the price of foodstuff imported from the mainland.(b) An improvement in the labour productivity in Hong Kong.(c) A rise in the exchange value of Japanese yen.


Graphical Illustration of International Trade


A. Illustration with two separate diagrams – constant production cost

Given information:

- Production possibility curves of countries A & B

- Indifference maps of countries A & B

- A price line with its slope representing the world price (or the exchange ratio or the terms of trade) of good X in terms of good Y


1. The situation without trade (the autarkic situation)

- Without trade, a country is self-sufficient. It can consume what it can produce only, i.e., its production possibility curve (PPC) = its consumption possibility curve (CPC).

- To maximize social welfare, the country’s consumption optimum (CO) is the tangency point of its PPC and the highest indifference curve achievable, which is also its production optimum (PO) under self-sufficiency.


Clothing

Food PPCA0

Slope = Cost of 1F = 1 600C/2 000 = 0.8C

1F1 600

2 0000

Country A: The situation without trade

COA0

POA0

= CPCA0


Clothing

Food 0

Country B

450

1 500

PPCB0

Slope = Cost of 1F = 1 500C/450 = 3.33C

1F

COB0

POB0

= CPCB0


2. The situation with trade

The slope of a PPC shows the marginal production cost of good X in terms of good Y. On the other hand, its inverse shows the marginal production cost of good Y in terms of good X.

From the PPCs, the amount of output of the two countries can be compared. However, without information on their amount of resources endowed, absolute advantage cannot be determined.

As PPCA has a gentler slope than PPCB, country A has a lower cost in producing good X (food) while country B has a comparative advantage in producing good Y (clothing).


The world price is determined by demand & supply at which Qd of the importing country equals Qs of the exporting country.

With the existence of international market, a country can sell what it produces to buy what it wants to consume. This can be represented by a movement along the price line passing through the PO.

To maximize wealth, the new PO is the point through which the outermost price line passes.

The outermost price line is the new CPC.

To maximize social welfare, the CO is the point at which the new CPC touches the highest indifference curve achievable.


Clothing

Food

PPCA

1 600

2 0000

2 000

Country A

---- Possible consumption possibility curves

POA

Complete specialization

---- Outermost consumption possibility curve


Clothing

Food 0450

1 500

1 500

PPCB

Country B

---- Possible consumption possibility curves

POB

Complete specialization

---- Outermost consumption possibility curve


Amount of trade

If PO > CO, the excess amount of the good is exported. On the other hand, if PO < CO, the insufficient amount is imported.

Country A’s export is country B’s import and vice versa.


Clothing

Food

PPCA

1 600

2 0000

Country A2 000

1 000

1 000

CPCA

Graphical illustration

COA

POAExport

Import


Clothing

Food 0

Country B

450

1 500

1 500P

PC

B

500

1 000

Export

ImportCPCB

POB

COB

Graphical illustration


Clothing

Food

PPCA

1 600

2 000

2 000

0 1 000

1 000

C

F

0

PPCB

COA=COB

POA=POB

Illustration with a composite diagram – Constant production cost

C: Export of country B = Import of country A = 1 000 units of clothing

F: Export of country A = Import of country B = 1 000 units of food

Countries A & B


Advanced Material 10.1

Graphical Illustration of International Trade

– Increasing Production Cost


MCA0

MCB0

By production possibility curve and indifference curve

Without trade (the autarkic situation)

Country A Country B

COA0

POA0

COB0

POB0

Clothing Clothing


With trade

POA1Export of

country A

Import of country A

COA1

Country A

ICA1 > ICA0

Clothing


Country B

Export of country B

Import of country B

POB1

COB1

ICB1 > ICB0

Clothing


International Trade --- Reasons and Hindrance


Reasons for international trade

1. Incapable of being self-sufficient

2. Difference in production costs

3. Economies of scale and learning by doing

4. A wider range of goods and services

5. Improvement in technology and productivity

6. Suppression of domestic monopoly

7. Price stability

8. Intangible benefits


Hindrance to international trade

1. Transportation cost

2. Protectionism

3. Lack of a mutually acceptable exchange ratio

4. International tension

5. Internal instability

6. Fluctuations in exchange rate


Correcting Misconceptions:

1. If a country has an absolute advantage in the production of good X, it will also have a comparative advantage in its production.

2. It is possible for a developed country to have an absolute advantage as well as a comparative advantage over a developing country in the production of all goods.


3. Comparative advantage determines the direction of trade, the terms of trade, the amount of trade as well as the balance of trade.

4. The terms of trade is the ratio of a country’s amount of import to its amount of export.

5. The terms of trade determines the gain from trade, the amount of trade as well as the balance of trade.



6. If the terms of trade of a country becomes more favourable, the country will be better off.

7. Trade enables a country to produce and consume beyond its production possibility curve.

8. Difference in opportunity cost is both the necessary and sufficient conditions for international trade.


Documents

Chapter 10 International Trade I --- The Law of Comparative Advantage