Absolute and Comparative Advantage

You could saythat globalization, driven not by human goodness but by the profit motive, has done far more good for far more people than all the foreign aid and soft loans ever provided by well-intentioned governments and international agencies. Paul Krugman, 2008 Nobel Laureate in Economic Sciences*

The Mercantilists- Earliest Trade TheoriesWhat is wealth?How can precious metals be obtained?Extraction from naturally occurring stocksEarn precious metals through exports of goods and servicesSince payment for exports is made with precious metals, exporting causes precious metals to flow into a countrySimilarly, since payment for imports is also made with precious metals, importing causes precious metals to flow out of countryThe natural conclusion exports must exceed imports for a country to become wealthy!

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Are precious metals wealth?To the Mercantilists, yes.Modern measures of wealth are based on a countrys ability to produce the goods and services that improve quality of life.Hence, the Mercantilist conclusion is based a definition of wealth the differs significantly from modern notions of wealth.This distinction leads to very different conclusions about how to become a wealthy nation.2 - *

Absolute advantageBuilt on the ideas of Adam Smith (1770)Absolute advantage exists between nations when they differ in their ability to produce goods.More specifically, absolute advantage exists when one country is good at producing one item, while another country is good at producing another item.Same input => more outputSame output => less input

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Absolute Advantage: Production Conditions When Each Country Is More Efficient in the Production of One CommodityEU workers are more productive in producing machinesThe EU has an absolute advantage in machine production

Indian workers are more productive in producing clothIndia has an absolute advantage in cloth production

One Person Per Day of Labor ProducesCountryMachinesClothEU5 machines (or)10 sq. metersIndia2 machines (or)15 sq. meters

Assume TWO Persons per day, so that each product can be fully produced(and)(and)(and)This is a condition under Autarky: (The complete absence of trade). However, if each country produces to their absolute advantage below

(and)

Two Persons Per Day of Labor ProducesCountryMachinesClothEU5 machines10 sq. metersIndia2 machines15 sq. metersWorld Output7 machines25 sq. meters

Two Persons Per Day of Labor ProducesCountryMachinesClothEU10 machines 0 sq. metersIndia0 machines30 sq. metersWorld Output10 machines30 sq. meters

Specialization and trade advantage both countriesTherefore, the best policy is to allow producers and consumers in both countries unfettered access to goods from both countries to maximize the number of advantageous trades that can occur.In other words, laissez-faire.The policy of minimum government interference with economic activity.

What if one country is better at everything?The theory of comparative advantage provides this answer.*

David Ricardo: Principles of Political Economy (1817)

Extended free trade argument

Should import even if the country is more efficient in the products production than country from which it is buying.

Look to see how much more efficient. If only comparatively efficient, then import.

India - Opportunity Costs

1 Machine = 5 cloth 1 Cloth = 0.2 machineUS - Opportunity Costs

1 Machine = 3 cloth 1 Cloth = 0.33 machineU.S. has bigger Absolute Advantage in production of Machines

One Person Per Day of Labor ProducesCountryMachinesClothU.S.5 machines15 sq. metersIndia1 machine 5 sq. meters

The U.S. has a greater absolute advantage in producing machines than it does in producing cloth (5x more efficient in machines only 3x more efficient in cloth)Indias absolute disadvantage/opportunity cost is smaller in producing cloth than in producing machinesThus the U.S. has a comparative advantage in machines and India has a comparative advantage in cloth

Even though U.S. has an absolute advantage in both goods, India has a comparative advantage in cloth productionEven if U.S. has an absolute advantage in both goods, beneficial trade is possibleIf both countries specialize according to their comparative advantage, they both can gain from this specialization and trade

Since we are dealing with Opp. Costs, we will compare across 15 sq. meters of cloth.(per)Let us allow India to produce cloth up to the level that the U.S. can

One person Per Day of Labor ProducesCountryMachinesClothU.S.5 machines15 sq. metersIndia1 machine 5 sq. meters

One Person Per Day of Labor ProducesCountryMachinesClothU.S.5 machines-15 sq. metersIndia (3 days)-3 machines15 sq. metersWorld Output+2 machines0 cloth

Japan - Opportunity Costs

1 car = 1 steel1steel = 1 carMalaysia - Opportunity Costs

1 car = 2 steel1steel = 0.5 carDo you see any Absolute Advantages?Do you see any Comparative Advantages?

Output per hour of teamCountryCarsSteel (tons)Japan22Malaysia0.51

Let us allow Malaysia to produce steel up to the level that Japan can

One Person Per Day of Labor ProducesCountryCarsSteel (tons)Japan22Malaysia0.51

One Person Per Day of Labor ProducesCountryCarsSteel (tons)Japan2-2Malaysia (2 days)-12World Output+10

Laissez-faire still holdsGains need not be equalHours of work traded need not be equal but the advantage still existsTrade is based on the existence of relative not absolute production advantages*

Domestic jobs are lost.Domestic income is lost.National security.Nations dumping goods trying to drive out domestic competition.Other nations dont treat their workers fairly.

Factor EndowmentsSome countries have more capital => cheaper rent => comparative advantage in capital intensive productsSome countries have a larger labor force =>cheaper wage => comparative advantage in labor intensive products*

Economies of ScaleIncrease in production leads to lower average cost, and vice versaChoice of specialization is completely accidental*

How much can an arbitrager earn if he borrows 10,000$ to import one car into Cambodia and import rice into Japan? if he borrows 30,000$ to import 100 tonnes of rice into Cambodia and import one car into Japan?How do we find comparative advantage?*

US$Car (Toyota Corolla)Rice (100 tonnes)Cambodia20,00040,000Japan10,00030,000

CornSunscreenMexico 300 150

France 200 150

Type of problem (output or input)?: Which nation has the absolute advantage in producing corn? Sunscreen?Which nation has the comparative advantage in the production of each good? (What is the opportunity cost for each nation of producing one unit of corn and sunscreen ?)What would be a favorable term of trade?

WheatClothUnited States1 hour2 hoursCanada3 hours4 hours

What type of problem is this? (output/input)Who has the absolute advantage in producing wheat? In producing cloth?Who has the lowest opportunity cost producing wheat? In producing cloth?Favorable terms of trade?

AlphaBetaGunsGunsButterButter400 300200100Significance of guns and butter?

Labor Hours Needed toProduce a Unit of:

WheatCloth

Portugal 10 20

England 2060

SoybeansAvocadosMexico 16 8USA 8 6

SoybeansAvocadosMexico 15 60USA 30 90

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