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Chapter Three Why Everybody Trades: Comparative Advantage and Factor Proportions

International Economics by: Thomas Pugel

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I. ADAM SMITHs THEORY OF ABSOLUTE ADVANTAGE Adam Smith compared the nations to households. The Absolute Advantage theory of Adam Smith uses labor to determine and measure the value of trade products. The benefits of free trade are displayed in the efficiency of global production by allowing each country exploit its absolute advantage in producing some products. The theory says that at least one country is better off with trade, and this countrys gain is not at the expense of the other country. Trading countries gain by splitting the benefits of global production. Labor productivity the number of units of output that a worker can produce in one hour. Example: If our country can produce some set of goods at lower cost than a foreign country, and if the foreign country can produce some other set of goods at a lower cost than we can produce them, then clearly it would be best for us to trade our relatively cheaper goods for their relatively cheaper goods. In this way both countries may gain from trade. (Steven Suranovic)

Country Philippines Vietnam

Sacks of rice produced per day 20 16

No. of farmers 4 4

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II. RICARDOs THEORY OF COMPARATIVE ADVANTAGE

The law of comparative advantage refers to the ability of an individual, firm, or a country to produce a particular good or service at a lower opportunity cost than another product or service. It is the ability to produce a product with the highest relative efficiency given all the other products that could be produced. It can be contrasted with absolute advantage which refers to the ability of a party to produce a particular good at a lower absolute cost than another. Comparative advantage explains how trade can create value for both parties even when one can produce all goods with fewer resources than the other. The net benefits of such an outcome are called gains from trade. It is the main concept of the pure theory of international trade. The key word here is comparative, meaning relative and not necessarily absolute. Even if one country is absolutely more productive at producing everything and the other country is absolutely less productive, they can gain by trading with each other as long as their relative advantages in making different goods are different. Each of these countries can benefit from trade by exporting products in which it has greatest relative advantage. Example: Using wheat and cloth in the US and the rest of the world: US Productivity: Yard of cloth per labor hour Bushels of wheat per labor hour Labor Hours to make: 1 Yard of cloth 1 Bushels of wheat 0.25 0.5 4.0 2.0 < < > > Rest of the World 1.0 0.67 1.0 1.5

In this illustration, one country has inferior productivity in both goods. The US has absolute disadvantages in both good. What products (if any) will the US export or import? Can trade bring net national gains to both countries?

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Each country will have to produce both products to meet local demands for the two products. What will the product prices be in each country? Without trade, the prices of the two products within each country will be determined by conditions within each country. We must try to ignore money for as long as it takes. Instead we will use the relative price - the ratio of one product price to another product price. By using this in the example and with no trade, 4 hours of labor in the US could produce either 2 bushels of wheat or 1 yard of cloth. The price of 1 yard of cloth is then 2 bushels of wheat in the US. The opportunity cost in this is the 2 bushels of wheat in producing cloth in the US. While in the rest of the world, 1 hour of labor could produce 1 yard of cloth or 2/3 of wheat. The price of cloth is .67 bushels of wheat in the rest of the world. US With no international trade: Price of cloth Price of wheat 2.0 bushel/yard 0.5 yard/bushel Rest of the World 0.67 bushel/yard 1.5 yard/bushel

Let trade be possible between the US and the rest of the world. Somebody will notice the different national prices for each goods and will try to profit from this difference. As long as prices differ in two places, there is way to profit through arbitrage - buying at the low price in one place and selling at the high price in the other place. If a person acquires cloth in the rest of the world, giving up 0.67 bushel of wheat for each yard and then ships it to the US and sells it there for 2.0 bushel per yard. Then he can make an arbitrage profit of 1.33 bushel of wheat each yard of cloth that he exports from the rest of the world. And so with wheat, selling it to the rest of the world. The opening of profitable international trade will start pushing the two separate national price ratios toward a new worldwide equilibrium. As people remove cloth from the rest of the world and exporting it, cloth become more expensive relative to wheat in the res of the world.

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VI. PRODUCTION AND CONSUMPTION TOGETHER a. With no trade

With no trade, a country must be self-sufficient and must find the combination of domestically produced wheat and cloth that will maximize community well-being.

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b. With trade INDIFFERENCE CURVES

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PRODUCTION POSSIBILITY CURVE

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DEMAND CURVE

SUPPLY CURVE

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VII. THE GAINS FROM TRADE There is a gain in trade if we view more consumption as desirable. The idea in trade gain is when a country receives a higher price for its exports, relative to the price it pays for its imports. There is a term we call terms of trade wherein the price the country receives from foreign buyers for its export products is relative to the price the country pays foreign sellers for its imported products.

VIII. TRADE AFFECTS PRODUCTION AND CONSUMPTION

The opening has two types of implications for production. First, within each country output expands for the product in which the country has a comparative advantage - more wheat in the US and more cloth in the rest of the world. Second, the shift from no trade to free trade results in more efficient world production as each country expands output of the product in which it is initially the low-cost producer.

IX. WHAT DETERMINES TRADE PATTERN

The immediate basis for the pattern of international trade that we see here is that relative product prices would differ between the two countries if there was no trade. But why would products prices differ with no trade? They can differ because: - Production Condition differ. - Consumption Condition differ. - Some combination of these two differences. In the US basis to import cloth could be that the US has a high demand for cloth, perhaps due to harsh climate or fashion consciousness. Production-side differences can be a basis for the international trade pattern when the relative shapes of the PPC differ. The second reason that the relative shapes of the PPC can differ is more subtle but has become the basis for the orthodox modern theory of comparative advantage. The H-O theory based on (1) differences across countries in the availability of factor resources and (2) differences across products in the use of these factors in producing the products.

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X. THE HECKSCHER-OHLIN (H-O) THEORY : FACTOR PROPORTIONS ARE KEY

A capital-abundant country will export the capital-intensive good, while the labor-abundant country will export the labor-intensive good. The critical assumption on the H-O model is that the two countries are identical, except for the difference in resource endowments. This also implies that the aggregate preferences are the same. The relative abundant in capital will cause the capital-abundant to produce the capital-intensive good cheaper than the labor-abundance country and vice versa. When the countries are not trading" - the price of capital-intensive good in capital-abundant country will be bid down relative to the price of the good in the other country. - the price of labor-intensive good in labor-abundant country will be bid down relative to the price of the good in the other country. Once trade is allowed, profit-seeking firms will move their products to the markets that have higher price. As a result - the capital-abundant country will export the capital-intensive good. - the labor-abundant country will export the labor-intensive good. The H-O explanation of trade patterns begins with a specific hunch as to why products might differ between countries before they open trade. If cloth costs 2 bushels a yard in the US and less than a bushel a yard elsewhere, it must be primarily because the US has relatively less of the factors that cloth uses intensively, and relatively more of the factors that wheat uses intensively, than does the rest of the world. Let land be the factor that wheat uses more intensively and labor be the factor that cloth uses more intensively. Therefore, the H-O theory predicts that the US exports wheat and imports cloth because wheat is land-intensive and cloth is labor-intensive. Under this conditions with no international trade, lande should rent more cheaply in the US than elsewhere, and labor should command higher wage rate in the US than elsewhere. The cheapness of land cuts costs more in wheat farming than in cloth making. And the theory predicts, it is the difference in relative factor and the pattern of factor intensities that make the US export wheat instead of cloth.

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