the gains from trade resulting from comparative advantage of nations

The production possibilities curve model is useful for showing gains from trade based on comparative advantage. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. %�쏢 Let’s say that, in the situation before trade, each nation prefers to produce a combination of shoes and refrigerators that is shown at point A. Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. Comparative Advantage in Production: Nations like individuals maximise their poten­tial well-being and consumption by producing goods and services that they are especially well- suited to produce. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil. 1776: Wealth of Nations published. The country with the lowest opportunity cost has the comparative advantage. The comparative advantage model is simplistic and may not … Which country has a comparative advantage in producing lumber? Point B is where they end up after trade. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20. This revision video takes students through a worked example of comparative advantage and the potential gains from specialisation and trade at a mutually beneficial terms of trade between two countries. If labor in Mexico is less productive than labor in the United States in all areas of production, a. neither nation can benefit from trade. These goods are homogeneous, meaning that consumers and producers cannot differentiate between shoes from Mexico and shoes from the U.S.; nor can they differentiate between Mexican or American refrigerators.From Table 1, we can see that it takes four U.S. workers to produce 1,000 pairs of shoes, but it takes five Mexican workers to do so. x��XKo�6��W�(0�᛽mQ�-����޵��w��#A�F��g�7v��QV��i�|����C+�V�_&.vM�ݞ�����C��i�������S߂R�g��1v�ZE0�2�����?�����y�lAZI'\�kL�oZ[C40��y���7��*��k)e����4�/����S����� Bk.���FgŨ ��R� �k˻�reD�Jhߨx)�i��-��]�k�p�;�R�!�nן(�������p�[�50�ww�� �/>�'RHkc����J(���>V�:��2@ג\�^���A]��ϯ1��4L����%q �WQgn��m]����? The classical economists utilized three methods in dealing with the question of the gains from trade: (1) the doctrine of comparative costs; (2) the increase in income as a criterion of gain; and (3) the terms of trade as an index of the gains from trade and its distribution. Why Countries Trade A. One lumber has an opportunity cost of two oil. comparative advantage in a single primary commodity comparative advantage can lead countries to specialize in exporting primary goods and raw materials that TRAP THEM IN LOW-WAGE ECONOMICES BUT competitive advantage attempts to correct for this issue by stressing maximizing scale of economies in goods and services that garner premium prices It answers the question, “How many inputs do I need to produce shoes in Mexico?” Comparative advantage asks this same question slightly differently. So, the comparative advantage of the United States, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexico’s comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes. But, it does not indicate that trade will necessarily occur because trade barriers and/or transportation costs may prevent it. According to the mercantilists: A) Only one nation can gain from trade, and it is at the expense of other nations. Owning to small size, the scope of gains from specialisation and exchange are limited whereas large country has scope for both. It is not possible for an individual or country to have a comparative advantage in all goods. Did you have an idea for improving this content? But Country A has a comparative advantage in the production of good X. These goods are homogeneous, meaning that consumers and producers cannot differentiate between shoes from Mexico and shoes from the U.S.; nor can they differentiate between Mexican or American refrigerators. For example, the United States transfers six workers away from shoes and toward producing refrigerators. Absolute advantage simply compares the productivity of a worker between countries. The reduction of shoe production by 1,500 pairs in the United States is more than offset by the gain of 2,000 pairs of shoes in Mexico, while the reduction of 2,500 refrigerators in Mexico is more than offset by the additional 6,000 refrigerators produced in the United States. The mercantilists contended that because one nation’s gains from trade come the expense of its trading partners, not all nations could simultaneously realize gains from trade. Then, in the numerical example given, Mexico shifted production toward its comparative advantage and produced 6,000 pairs of shoes but only 2,500 refrigerators. How Trade Makes Nations “Better Off” (continued) •The important concept is that trade occurs because of differences in prices in the two countries before trade •Consumers end up being able to consume more goods and services than the resources of the country could produce • Comparative Advantage leads to gains in trade, but why In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. In absolute advantage, trade is not mutually useful but comparative advantage is basically a condition where trade is mutually beneficial (Mishkin, 2006). The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to explain how and why countries gain by trading. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. Table 3 shows the output of each good for each country and the total output for the two countries. Increased saving and investment resulting in economic growth c. Increased competition resulting in lower prices and wider range of output d. Increasing comparative advantage leading to specialization ANS: D PTS: 1 DIF: Moderate NAT: BPROG: … Consider the example of trade in two goods, shoes and refrigerators, between the United States and Mexico. 5 0 obj To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. If a country has an absolute advantage in producing both goods, it has higher labor productivity in both and its workers will earn higher incomes than those in the other country. When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe production–when labor is transferred from producing the latter to producing the former (see Figure 1). Canada should specialize in what it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. If the 40 workers in the United States are making refrigerators, and each worker can produce 1,000 refrigerators, then a total of 40,000 refrigerators will be produced. Trade allows each country to take advantage of lower opportunity costs in the other country. How can you tell? Gains from trade may also refer to net benefits to a country from lowering barriers to trade such as tariffs on imports. A) Adam Smith B) Alfred Marshall C) David Ricardo D) David Hume Answer: C Page: 28 16. „The idea that nations benefit from trade has nothing to do with whether a country has an absolute advantage in producing a particular good. Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. The United States can produce 1,000 shoes with four-fifths as many workers as Mexico (four versus five), but it can produce 1,000 refrigerators with only one-quarter as many workers (one versus four). In this example, absolute advantage is the same as comparative advantage. ANSWER: a. with trade. For example, as Table 2 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1,000 shoes, a total of 10,000 shoes will be produced. The theory of comparative advantage explains why countries trade: they have different comparative advantages. Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. b. Mexico can benefit from trade but the United States cannot. To calculate absolute advantage, look at the larger of the numbers for each product. {�h-��О('0~k��D��x�;�d��tހV*p+��nPpL�{������DG:�q�:�PY��\mc��Kg���^χ����1d��2���=@%Q:�=2���t��]�=���%�qB�#�[�?�^��7V�� �:�훹kk&��c2�ّU]�퍐NM�Ϣ+c�/�z+eqk��������Ƣb���*5or%Ә]��%z�dA�\����P� �r�%L�O%�*"�j^��eL1���aH���v�=��b�XN��s%[L�D�j��� �C=�X�}%R ���k.��quC�M�U4��#*�,)�Sn�* In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). Ricardo considered what goods and services countries should produce, and suggested that they should specialise by allocating their scarce resources to produce goods and services for which they have a comparative cost advantage. Watch this video to review the ways that comparative advantage benefits all the parties involved. They can then trade … So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. A. stream If both of them focus on producing the goods with lower opportunity costs, their combined output will increase and all of them will be better off. Recall from earlier readings that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers. In what product should Venezuela specialize? The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. (One should not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. “The Father of Economics” 1723-1790 2. For example, a trade where the U.S. exports 4,000 refrigerators to Mexico in exchange for 1,800 pairs of shoes would benefit both sides, in the sense that both countries would be able to consume more of both goods than in a world without trade. Benefits of specialization is the reason a person typically focuses on the production of only one good or services. International trade - International trade - Simplified theory of comparative advantage: For clarity of exposition, the theory of comparative advantage is usually first outlined as though only two countries and only two commodities were involved, although the principles are by no means limited to such cases. Gains from trade are fueled by differences in preferences only. Countries are better off if they specialize in producing the goods for which they have a comparative advantage. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. „Answer: Even if a country does not have any goods with an absolute productivity advantage, it can benefit from trade. B. Gains from trade with comparative advantage country Gains from Trade with Comparative Advantage:  Country should specialize in the production of those goods in which it is relatively more productive... even if it has absolute advantage in all goods it produces. 20/20 oil = 40/20 lumber. Comparative advantage enables producers to gain from specialization and trade; producing at lowest opportunity costs= nation more efficient and productive Figure 1. Economies of large-scale production resulting in decreasing unit cost b. Point A on both graphs is where the countries start producing and consuming before trade. Instead of comparing how many workers it takes to produce a good, it asks, “How much am I giving up to produce this good in this country?” Another way of looking at this is that comparative advantage identifies the good for which the producer’s absolute advantage is relatively larger, or where the producer’s absolute productivity disadvantage is relatively smaller. Further assume that consumers in both countries desire both these goods. Comparative advantage is a term associated with 19th Century English economist David Ricardo. One oil in Venezuela has an opportunity cost of 1/2 lumber. The following feature shows how to calculate absolute and comparative advantage and the way to apply them to a country’s production. Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. c. both nations can benefit from trade. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber. gain advantage against the world's best competitors According to prevailing thinking, labor costs, inter-because of pressure and challenge. Consider a situation where the United States and Mexico each have 40 workers. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Thus, comparative advantage is more important than absolute advantage in understanding which country should trade which product in order to maximize the standard of living in both countries. The range of trades that can benefit both nations is shown in Table 5. We’d love your input. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country. Step 2. When you first met the production possibility frontier (PPF) in an earlier module, it was drawn with an outward-bending shape. In this example, is absolute advantage the same as comparative advantage, or not? Trade provide an opportunity for the small country to specialise in the production of those commodities in which it has comparative advantage and … His theory concluded that a country could increase its income by specializing in certain products and services and selling these on the international market. They benefit from est rates, exchange rates, and economies of scale are havingstrongdomesticrivals,aggressivehome-based the most potent determinants of competitiveness. For additional practice and review using numbers, watch this video from ACDC economics. Production Possibilities and Comparative Advantage, Mutually Beneficial Trade with Comparative Advantage, How Opportunity Cost Sets the Boundaries of Trade, https://cnx.org/contents/vEmOH-_p@4.44:1p6taX-z@3/What-Happens-When-a-Country-Ha, https://www.youtube.com/watch?time_continue=408&v=4rUfoU04QJM, Calculate absolute and comparative advantage. XWY��FP�\����$X+<59�� ���sΐ�Ha��>�u���!�0Ƴ�P��p��Dz�S{�!U��݄���4�l�����M�݂�+�l���T���~@���aR�>/֘\,����pV��UŅ����ؽ2n�z�P Step 6. When one nation is more efficient than another in the production of one commodity but it less efficient than the other nation in producing a second commodity, then both nations can gain by each specializing in the production of the commodity of its absolute Thus, if Mexico can export no more than 2,000 pairs of shoes (giving up 2,000 pairs of shoes) in exchange for imports of at least 2,500 refrigerators (a gain of 2,500 refrigerators), it will be able to consume more of both goods than before trade. In the examples in this module, the PPFs are drawn as straight lines, which means that opportunity costs are constant. If the United States can export no more than 6,000 refrigerators in exchange for imports of at least 1,500 pairs of shoes, it will be able to consume more of both goods and will be unambiguously better off. Divide both sides of the equation by 60. Comparative advantage normally compares the result of production of similar types of goods and services between two nations. In our example above, for country A, every extra unit of good Y produced involves an … Continuing with this scenario, each country transfers some amount of labor toward its area of comparative advantage. SIZE OF THE COUNTRY AND GAINS FROM TRADE Gains from trade are relatively larger for a small country. comparative advantage is the key to determining specialization and trade. Gains from trade 1. If a country specializes production in the product in which it has a comparative advantage, it raises its average labor productivity and raises its average income. Which of these economists considered comparative advantage in production to be the basis for trade between nations? Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. This numerical example illustrates the remarkable insight of comparative advantage: even when one country has an absolute advantage in all goods and another country has an absolute disadvantage in all goods, both countries can still benefit from trade. The concept of comparative advantage suggests that as long as two countries (or individuals) have different opportunity costs for producing similar goods, they can profit from specialization and trade. Divide each side of the equation by 40. Calculate the same way for Venezuela: 60 oil = 30 lumber. 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