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Chapter 10 International Trade I --- The Law of Comparative Advantage. Contents:. The law of comparative advantage Distribution of gains from trade Graphical illustration of international trade International trade – Reasons and hindrance

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

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Chapter 10 international trade i the law of comparative advantage

Chapter 10

International Trade I ---

The Law of Comparative Advantage


Contents

Contents:

  • 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


The law of comparative advantage

The Law of Comparative Advantage


Chapter 10 international trade i 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?

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

  • Protectionist measures are not prohibitive. Why?


Chapter 10 international trade i the law of comparative advantage

Absolute advantage

  • 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.


Chapter 10 international trade i the law of comparative advantage

Reciprocal 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.


Chapter 10 international trade i the law of comparative 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.


Chapter 10 international trade i the law of comparative advantage

Clothing

Case I

Food

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

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

Country A

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

Country B


Chapter 10 international trade i the law of comparative advantage

Specialization leads to increase in world’s output

  • If nowcountry A shifts 1 unit of resources from the production of clothingto the production of food.

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

Food

Clothing

+10  -8

-3  +10

+7 +2


Chapter 10 international trade i the law of comparative advantage

Case II

Food

Clothing

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

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

Country A

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

Country A


Chapter 10 international trade i the law of comparative advantage

Comparative advantage

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


Chapter 10 international trade i the law of comparative advantage

The law of comparative advantage

  • 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.


Chapter 10 international trade i the law of comparative advantage

Specialization leads to an increase in world’s output

  • If country A produces one more unit of food

  • whilecountry B produces one more unit of clothing

Clothing

Food


Chapter 10 international trade i the law of comparative advantage

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.


Chapter 10 international trade i the law of comparative 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 advantagedoes not determinethe volume of trade, theterms of tradeorthe balance of trade.


Chapter 10 international trade i the law of comparative advantage

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


Calculation of production costs

Calculation of production costs

  • 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


Calculation of production costs1

Calculation of production costs

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:

Production cost of 1X is

Production cost of 1Y is


Calculation of production costs2

Calculation of production costs

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:

Production cost of 1X is

Production cost of 1Y is


Distribution of gains from trade

Distribution of Gains from Trade


Chapter 10 international trade i the law of comparative advantage

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.


Chapter 10 international trade i the law of comparative advantage

Illustration

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

Food

Clothing


Chapter 10 international trade i the law of comparative advantage

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 food

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


Chapter 10 international trade i the law of comparative advantage

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).


Chapter 10 international trade i the law of comparative advantage

TOT=

Terms of trade

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


Chapter 10 international trade i the law of comparative advantage

Implications of the terms of trade

  • TOT

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

  • Animprovement (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 implicationon theamount of trade, the total gain from trade orthe balance of trade. Why?


Chapter 10 international trade i the law of comparative advantage

Terms of trade index

The terms of trade index

=the unit value indexfor total exports

the unit value index for imports

measured in the same base period

  • The unit value indexfor 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).


Chapter 10 international trade i the law of comparative advantage

Q10.6

How will the terms of trade of Hong Kong be affected

under 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

Graphical Illustration of International Trade


Chapter 10 international trade i the law of comparative advantage

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


Chapter 10 international trade i the law of comparative advantage

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.


Chapter 10 international trade i the law of comparative advantage

1F

1 600

Slope = Cost of 1F

= 1 600C/2 000 = 0.8C

COA0

POA0

2 000

Country A: The situation without trade

Clothing

PPCA0

= CPCA0

Food

0


Chapter 10 international trade i the law of comparative advantage

1F

1 500

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

COB0

POB0

450

Country B

Clothing

PPCB0

= CPCB0

0

Food


Chapter 10 international trade i the law of comparative advantage

2. The situation with trade

  • 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.

  • 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.

  • 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).


Chapter 10 international trade i the law of comparative advantage

  • 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.


Chapter 10 international trade i the law of comparative advantage

Complete specialization

POA

Country A

Clothing

---- Possible consumption possibility curves

2 000

---- Outermost consumption possibility curve

1 600

PPCA

Food

0

2 000


Chapter 10 international trade i the law of comparative advantage

Complete specialization

POB

Country B

Clothing

1 500

---- Possible consumption possibility curves

PPCB

---- Outermost consumption possibility curve

0

Food

450

1 500


Chapter 10 international trade i the law of comparative advantage

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.


Chapter 10 international trade i the law of comparative advantage

CPCA

COA

1 000

Import

POA

Export

1 000

Graphical illustration

Clothing

Country A

2 000

1 600

PPCA

Food

0

2 000


Chapter 10 international trade i the law of comparative advantage

POB

Export

COB

500

Import

CPCB

1 000

Graphical illustration

Clothing

Country B

1 500

PPCB

0

Food

450

1 500


Chapter 10 international trade i the law of comparative advantage

COA=COB

0

PPCB

1 000

POA=POB

C

1 000

F

Illustration with a composite diagram – Constant production cost

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

Countries A & B

Clothing

2 000

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

1 600

PPCA

2 000

0

Food


Chapter 10 international trade i the law of comparative advantage

Advanced Material 10.1

Graphical Illustration of International Trade

– Increasing Production Cost


Chapter 10 international trade i the law of comparative advantage

COA0

COB0

MCB0

POA0

POB0

MCA0

By production possibility curve and indifference curve

Without trade (the autarkic situation)

Clothing

Clothing

Country A

Country B


Chapter 10 international trade i the law of comparative advantage

COA1

Import of country A

POA1

Export of country A

With trade

Clothing

Country A

ICA1 > ICA0


Chapter 10 international trade i the law of comparative advantage

POB1

Export of country B

COB1

Import of country B

Clothing

Country B

ICB1> ICB0


International trade reasons and hindrance

International Trade --- Reasons and Hindrance


Chapter 10 international trade i the law of comparative advantage

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


Chapter 10 international trade i the law of comparative advantage

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

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.


Chapter 10 international trade i the law of comparative advantage

Correcting Misconceptions:

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.


Chapter 10 international trade i the law of comparative advantage

Correcting Misconceptions:

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.


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