Trade Theory

Introducing Absolute and Comparative Advantage

Absolute Advantage

The

capacity of one economy to produce a good or service with fewer resources than another

Some starting assumptions:

Only

2 countries (United States and Canada) Only 2 goods (shirts and shoes) Both countries can make both products. If they spend half of their working hours on each product they can produce the following:

Table A No Specialization
Shoes United States Canada 100 80 Shirts 75 100

United States has an absolute advantage in producing shoes. Canada has an absolute advantage in producing shirts.

Questions about Table A

What would be the total production of shoes and shirts without specialization and trade? b) How many units of each good would the United States have? c) How many units of each good would Canada have?
a)
Shoes Shirts

United States

100

75

Canada

80

100

What if each country specialized?

The United States would produce only? Canada would produce only.?

Table A
Shoes United States Canada 100 80 Shirts 75 100 United States

Table B
Shoes Shirts

Canada

Table B With Specialization

Shoes United States Canada 200 0 Shirts 0 200

Questions about Table B

How did specialization affect world production? e) How did specialization affect the standard of living in the United States? In Canada?
d)
Shoes Shirts

United States

200

Canada

200

Summary
The

world now has more of both shoes and shirts. The United States can trade 100 units of shoes for 100 units of shirts and both countries will benefit. What if a country has an absolute advantage in the production of both products though? Would trade still occur?

Table C
Shoes United States Canada 100 80 Shirts 80 75

The United States has an absolute advantage in both shoe and shirt production. Should it engage in trade?

Questions about Table C

What would the total world production be without specialization and trade? g) How many units of each good would the United States have? h) How many units of each good would Canada have?
f)
Shoes Shirts

United States

100

80

Canada

80

75

Which product would the US specialize in if it were to trade?

Look

to the opportunity costs.

US Opportunity Costs
Shoes United States 100 Shirts 80

Give up 100 shoes to get 80 shirts (or 100/80 = 1.25 shoes per shirt) Give up 80 shirts to get 100 shoes (or 80/100 = 0.8 shirts per shoe)

Canada Opportunity Costs

Shoes Canada 80 Shirts 75

Give up 80 shoes to get 75 shirts (or 80/75 = 1.06 shoes per shirt) Give up 75 shirts to get 80 shoes (or 75/80 = 0.94 shirts per shoe)

Opportunity Cost Summary

United States Give up 100 shoes to get 80 shirts (or 100/80 = 1.25 shoes per shirt) Give up 80 shirts to get 100 shoes (or 80/100 = 0.8 shirts per shoe) Canada Give up 80 shoes to get 75 shirts (or 80/75 = 1.06 shoes per shirt) Give up 75 shirts to get 80 shoes (or 75/80 = 0.94 shirts per shoe) Who should specialize in shoes and who shirts?

Comparative Advantage
United

States should produce shoes because it costs them only 0.8 shirts per shoe compared to Canadas cost of 0.94 shirts per shoe. Canada should produce shirts because it costs them only 1.06 shoes per shirt compared to the United States cost of 1.25 shoes per shirt

Comparative Advantage
The capacity of an economy to produce a good or service with comparatively fewer resources than another (e.g. having a lower opportunity cost)
The

United States is said to have a comparative advantage in shoes. Canada is said to have a comparative advantage in shirts.

Table D With Specialization

Shoes United States Canada 200 0 Shirts 0 150

Questions about Table D

Shoes Shirts

i)

How did specialization affect world production?

United States

200

Canada

150

How do we know whether the world is better off then?

j)

What if the United States made 8 units of shirts. How would this change the total production?

Table E With Partial Specialization

Shoes
United States Canada 190 0

Shirts
8 150

So the world is better off with specialization. What about the United States? Is it really benefiting?

Questions about Table E

k)

What if Canada traded 75 units of shirts to the United States for 90 units of shoes? How would that change Table E?

Shoes

Shirts

United States

190

Canada

150

Table F Specialization With Trade

Shoes United States Canada 100 90 Shirts 83 75

Compare Table C to Table F

Before Trade
Shoes Shirts

After Trade
Shoes Shirts

United States

100

80

United States

100

83

Canada

80

75

Canada

90

75

Terms of Trade
The rate at which a countrys exports are exchanged for their imports So the US will benefit from trade with Canada. How many shirts would the US insist on getting and how many shoes would they give up? Need to look at opportunity costs again.

US Opportunity Costs

Give up 100 shoes to get 80 shirts (or 100/80 = 1.25 shoes per shirt) Give up 80 shirts to get 100 shoes (or 80/100 = 0.8 shirts per shoe)

The US would be willing to give anywhere from 0 to 1.25 shoes per shirt.
They want to get at least 0.8 shirts per shoe.

Canada Opportunity Costs

Give up 80 shoes to get 75 shirts (or 80/75 = 1.06 shoes per shirt) Give up 75 shirts to get 80 shoes (or 75/80 = 0.94 shirts per shoe) Canada would be willing to give anywhere from 0 to 0.94 shirts per shoe. They want to get at least 1.06 shoes per shirt.

Terms of Trade
The US would be willing to give anywhere from 0 to 1.25 shoes per shirt. Canada wants to get at least 1.06 shoes per shirt.

Therefore the terms of trade will be between 1.06 and 1.25 shoes per shirt.

Terms of Trade
Canada would be willing to give anywhere from 0 to 0.94 shirts per shoe. The US wants to get at least 0.8 shirts per shoe.

Therefore the terms of trade will be between 0.8 and 0.94 shirts per shoe.

Practice in Economics Now

Page 383 #1 to 5 (add (#6) What would be the range of terms of trade?) Page 399 #6 (add (d) What would be the range of terms of trade?)

Page 383 #1
Steel (tonnes/1000 hours) Coal (tonnes/1000 hours)

Arcticona Tropicona

4 3

10 2

Arcticona has an absolute advantage in producing steel (4 is more than 3). Arcticona has an absolute advantage in producing coal (10 is more than 2).

Page 383 #2
Steel Arcticona 4 Coal 10

Give up 4 steel to get 10 coal (or 4/10 = 0.4 steel per coal) Give up 10 coal to get 4 steel (or 10/4 = 2.5 coal per steel)

Page 383 #2
Steel Tropicona 3 Coal 2

Give up 3 steel to get 2 coal (or 3/2 = 1.5 steel per coal) Give up 2 coal to get 3 steel (or 2/3 = 0.67 coal per steel)

Page 383 #3

Comparative Advantage
Arcticona

should produce coal because it costs them only 0.4 steel per coal compared to Tropiconas cost of 1.5 steel per coal. Tropicona should produce steel because it costs them only 0.67 coal per steel compared to the Arcticonas cost of 2.5 coal per steel

Page 383 #4 Table A No Specialization 4000 labour hours half of the labour is spent producing each product

Steel
Arcticona Tropicona Total 8 6 14

Coal
20 4 24

Page 383 #4 Table B Specialization 4000 labour hours Steel Arcticona Tropicona Total

Coal 40 0 40

0 12 12

Is there a benefit? 40 coal instead of 24 (almost double) 12 steel instead of 14 (a small drop). Want to be sure? What about partial specialization?

Page 383 #4 Table C Partial Specialization Steel Arcticona Tropicona Total

Is

Coal 30 0 30

4 12 16

there a benefit? 30 coal instead of 24; 16 steel instead of 14. Specialization meant more of both produced.

Page 383 #5
Tropicona Opportunity cost steel specialization

Give up 3 steel to get 2 coal (or 3/2 = 1.5 steel per coal) Domestically they would GAIN 4 coal by giving up 6 steel (trading 6 steel for 3 coal would therefore be unacceptable)

Arcticona (specialize in coal) Give up 4 steel to get 10 coal (or 4/10 = 0.4 steel per coal) Give up 10 coal to get 4 steel (or 10/4 = 2.5 coal per steel)
Arcticona would be willing to give anywhere from 0 to 2.5 coal per steel. They want to get at least 0.4 steel per coal.

Tropicona (specialize in steel) Give up 3 steel to get 2 coal (or 3/2 = 1.5 steel per coal) Give up 2 coal to get 3 steel (or 2/3 = 0.67 coal per steel)
Tropicona would be willing to give anywhere from 0 to 1.5 steel per coal. They want to get at least 0.67 coal per steel.

Terms of Trade
Arcticona

would be willing to give anywhere from 0 to 2.5 coal per steel. wants to get at least 0.67 coal

Tropicona

per steel.
Therefore

the terms of trade will be between 0.67 and 2.5 coal per steel.

Terms of Trade

Tropicona would be willing to give anywhere from 0 to 1.5 steel per coal. Arcticona wants to get at least 0.4 steel per coal. Therefore the terms of trade will be between 0.4 and 1.5 steel per coal. (note the question is asking whether Tropicona would accept an amount of 2 steel per coal outside the range)

Page 383 #6
Steel (tonnes) Coal (tonnes)

Arcticona Tropicona
Total

0 12
12
Steel (tonnes)

40 0
40
Coal (tonnes)

Arcticona Tropicona Total

4 12 16

30 0 30

Page 399 #6 (a)

Showshoes Running Shoes

Myopia Utopia

8 10

5 25

Utopia has an absolute advantage in producing showshoes and running shoes.

Page 399 #6 (b)

Comparative Advantage

Myopia should produce snowshoes because it costs them only 0.625 running shoes per snowshoe compared to Utopias cost of 2.5 running shoes per snowshoe. Utopia should produce running shoes because it costs them only 0.4 snowshoes per running shoe compared to the Myopias cost of 1.6 snowshoes per running shoe.

Terms of Trade
Myopia

would be willing to give anywhere from 0 to 1.6 snowshoes per running shoe. wants to get at least 0.4 snowshoe per running shoe. the terms of trade will be between 0.4 and 1.6 showshoes per running shoe.

Utopia

Therefore

Terms of Trade
Utopia

would be willing to give anywhere from 0 to 2.5 running shoes per snowshoe. wants to get at least 0.625 running shoes per snowshoe. the terms of trade will be between 0.625 and 2.5 running shoes per snowshoe.

Myopia

Therefore