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Comparative Advantage and International Trade. Why do we trade? How do we trade?. Comparative Advantage. Difference in opportunity costs leads to the notion of comparative advantage. Definition:. A person has a comparative advantage in an activity if she can

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comparative advantage and international trade

Comparative Advantage and International Trade

Why do we trade?

How do we trade?

comparative advantage
Comparative Advantage
  • Difference in opportunity costs leads to the notion of comparative advantage


A person has a comparative advantage in an activity if she can

perform that activity for a lower cost than any other person.

This applies to nations, firms, economies, etc. and the activity is usually production.

Thus, in our case, Plant_____has a comparative advantage in the production of cars and Plant ____ has a comparative advantage in the production of SUVs.

comp adv and specialization
Comp Adv. And Specialization
  • If production is efficient, then comparative advantage leads to specialization in production


Adam Smith’s pin factory

Assembly-line at auto plant

Nations: Nepal vs. United States

  • Specialization leads to greater quantities produced
  • Specialization can be seen in the PPF as well.
specialization and trade
Specialization and Trade
  • If we specialize ----- we must rely on others to produce the “other good”
  • Continuing our car/SUV example, consider the two plants now as two countries (e.g. Canada (Plant B) and United States (Plant A)
  • So, the US specializes in cars, Canada in SUVs.
specialization and trade ii
Specialization and Trade II









If each country produces according to its comparative advantage, they

produce at the corners of their PPFs

Total World Production = 200 cars and 100 SUVs – There is a gain

from trade

specialization and trade iii
Specialization and Trade III
  • We are still producing on each PPF, but now have the ability to CONSUME outside the PPF of each country.
  • But, how are we able to get the goods that the other country produces?
  • DEFINITION The terms of trade tell us the rate at which a country can trade domestic products for imported products.
terms of trade
Terms of Trade
  • For trade to take place, we need to find a ratio of cars/SUVs that makes both countries better off. This occurs when each country is able to obtain the non-specialized good more cheaply than if it produced it.

Where does this ratio fall?

In between the opportunity costs for each country.

terms of trade ii
Terms of Trade II

Opp Cost: CARS SUVs

US 1/2 SUV 2 cars

Canada 1 SUV 1 car

The numbers above are the domestic opportunity costs to produce a

Car/SUV in each country.

What is an “international” opportunity cost (Terms of Trade) that

allows both countries to benefit? At what ratio can the US and

Canada trade cars/SUVs to lower their opportunity costs?

terms of trade iii
Terms of Trade III
  • Another example:
  • Japan - can produce 10 computers for every 1 tractor
  • China - can produce 4 tractors for every 1 computer

1) Who produces what good? Who has the comparative advantage

in tractors? In computers?

2) What would be a terms of trade that would benefit both


terms of trade iv
Terms of Trade IV


  • There can be more than 1 terms of trade that will benefit both countries.
  • Even if you have an absolute advantage, there can still be gains from trade - trade is determined by specialization and comparative advantage, NOT absolute advantage.
issues in trade policy
  • We have shown that “free trade” (no restrictions) leads to gains for all involved. Then why do we see restrictions of trade.
  • Trade restrictions --- not efficient from a production standpoint
  • Then why don’t we ever really seem to see free trade?
trade policy definitions
Trade Policy Definitions


1) Free trade is when there is no government intervention in trade.

2) Managed Trade(Protectionism) occurs when the government sets

policy that restricts the flow of trade between nations

(usually to protect domestic firms from foreign competition)

What are the forms of protection??

1) Tariffs

2) Non-tariff barriers

tariff and non tariff barriers
Tariff and Non-tariff Barriers


  • A tariff is a tax imposed by the government when an imported
  • good enters the country.

2) A non-tariff barrier is any other action that limits international


Examples of Non-tariff barriers:


2) VERs (Voluntary Export Restraints)

3) Others

b) Safety standards

a) Licensing agreements

c) Product quality standards

d) Environmental standards

why do trade barriers exist
Why Do Trade Barriers Exist?

2) Infant-industry protection

1) National Security

3) Dumping

4) Others

b) cheap foreign labor

a) Job protection

c) property rights protection

d) environmental regulation

e) political concerns/human rights

Are all of these legitimate reasons for trade protection?

Who governs trade policies outside of the individual governments??

Major Trade Accords


2) EU


4) WTO

5) Others