Chapter 3 Comparative Advantage

Link to syllabus

Questionable example on page 36

Adam Smith (1723-1790): The Wealth of Nations 1776

Scottish Philosopher.In a free market society,individuals, acting out of their ownself interest, will be guided, as if byan invisible hand, to make sociallybeneficial economic decisions.

Also: benefits of free trade, criticism ofmercantilism.Smith mistakenly focused on Absolute Advantage, not Comparative Advantage.

David Ricardo. 1772-1823

Born in London; father was a stockbroker.In addition to major contributions inEconomics, he was a member of the BritishParliament, a businessman and financier.Said to have become interested in economicsat the age of 27, after reading Adam Smith,while on vacation.

Was friends with James Mill, Bentham, Malthus, and other classical economists.

Ricardian example of comparative advantage. Page 36

1.5

0.67

It’s not clear to mt why Pugel makes the numbers for the US the same in the two tables on pages 36 and 37, while the numbers for the Rest ofthe World are different .

It is the case that the discussion in the text on page 36 refers to the numbers as they appear in the table on page 36. So perhaps this isnot a case of typographical errors, but poor selection of an example.

Ricardian example of comparative advantage. Page 37

Notation: let aW be the labor hours to produce one unit of wheat, and aC be labor hours for one unit of cloth (4 and 2 in the US in this example). ‘W/C’ means units of wheat to get a unit of cloth: 2W/C is two units of wheat for one unit of cloth, PC / PW = 2.If labor is the only cost and it is paid ‘wage’, then the price (or cost) of producing one unit of wheat, PW , is equal to ‘wage’ x aW, and similarly PC = ‘wage’ x aC.

Thus, PC / PW = aC / aW . In other words, the (relative) price of a good is higher if the country is (relatively) inefficient in the production of the good.

Pre-trade Prices in Ricardian example p. 38

Assume:

Figure 3.1 page 41Gains from trade: constant cost case

(From next chapter’s Figure 4.1 p. 51). Production Possibilities with Increasing Costs.

With increasing costs, free trade will generally not lead to complete specialization.

Figure 2.3 Page 25 Effects of trade on production, consumption and price

Absolute Advantage Does Matter p. 43

Handouts

Description of argument of comparative advantage

Numerical example of comparative advantage

Chapter 3 p. 45. Question #8

Solution:

P. 45 #8 Country V (Labor=30) Country MR (Labor =20)

Pre-Trade Post-Trade Pre-Trade Post-Trade

wine chees wine chees wine Chees wine cheese

Labor input/unit Q

15 10 same 10 4 same

Labor allocation 15 15 30 0 8 12 0 20

Production 1.0 1.5 2 0 0.8 3 0 5

Net Imports -- -- -1 2 -- -- 1 -2

Consumption 1.0 1.5 1 2 0.8 3 1 3

Percentage changes

w: 100*(1-1)/1 = 0c: 100*(2-1.5)/1.5 = 33

w: 100*(1-0.8)/0.8 = 25c: 100*(3-3)/3 = 0

The pre-trade relative price of wine in terms of cheese in V is 15/10=1.5; in MR it is 10/4 =2.5, so V has comparative advantage in wine, and will export it. The post-trade relative price of wine in both V and MR is 2; the book’s phrase is that ‘1/2 bottle of wine is worth 1 kilo of cheese ‘

Exam Question #5, Fall 2010

Consider now a Ricardian world composed of two countries, (Input/Q) Spain (S) and Chile (C ), and two goods, food (f) and games (g). Spain ChileSuppose the labor input per unit of output for these Food 20 25 activities is as indicated in the accompanying table. Games 50 75

Which country has absolute advantage in which good? Why?Which country has comparative advantage in which good? Why?What are the limits to the free trade relative price of Food? What will happen to the relative price of food in Spain, if both countries agree to free trade?Assume that Chile has 150 workers. Draw a production possibility curve for Chile,

Pre-trade PF/PG is 20/50 in Spain, and 25/75 in Chile, so Chile has comp adv in Food.

Limits to free trade price of food are .25 and .4

With free trade, the price of food in Spain will fall