INTERNATIONAL TRADE

at the end of the lesson you should be able to:

•explain meaning of absolute advantage

•explain meaning of comparative advantage

•distinguish between absolute and comparative advantage

•calculate opp.cost ratio

•identify absolute advantage and comparative advantage graphically

•explain gains from trade using the theory of comparative advantage

Assumptions:• 2 model country : X and Y• 2 goods produced wheat and cloth • There are no barriers to trade (no tariffs etc), no transportation cost• Perfect mobility of resources: of one industry can be switched into another without any loss of efficiency • Constant returns to scale (i.e. doubling the inputs in each country leads to a doubling of total output) • Both countries have equal resources which are divided equally between the 2 industries - X & Y has 1000 workers each in wheat and cloth industry

Theory of absolute

advantage

absolute advantage

• A country is said to have absolute advantage in the production of a good when it can produce the good more efficiently than other countries. Either it produces more by using the same resources or uses fewer resources to produce the same quantity as others i.e. produces it cheaper

Production before specialisation

Country Wheat in tonnes

Cloth in metres

X 10,000 5,000

Y 5,000 10,000

World output

15,000 15,000

absolute advantage

• X has absolute advantage in ______ and therefore specialises in _____ production

• Y has absolute advantage in ______ and therefore specialises in _____ production

Production after specialisation

Country Wheat in tonnes

Cloth in metres

X 20,000 ?

Y ? ?

World output ? ?

Production before specialisation

Country Wheat in tonnes Cloth in metresX 20,000 -

Y - 20,000

World output 20,000 20,000

Total Gain ? ?

Production after specialisation

Country Wheat in tonnes Cloth in metres

X 20,000 -

Y - 20,000

World output 20,000 20,000

Total Gain 5000 5000

Theory of Comparative advantage

comparative advantage

• Comparative advantage exists when a country has a margin of superiority in the production of a good or service i.e. where the opportunity cost of production is lower.

Production before specialisation

Country Wheat in tonnes

Cloth in metres

X 10,000 5,000

Y 4,000 4,000

World output

14,000 9,000

comparative advantage

•

XY

20,000 X

8,000 10,000

Y8,000

0

wheat

cloth

opportunity cost of production

Country Opportunity cost of 1 wheat

Opportunity cost of 1 cloth

X *give up = 5000 get 10,000

Y

*For input method, o.c = __get__

give up

Country Opportunity cost of 1

wheat

Opportunity cost of 1

clothX 0.5 2

Y 1 1

opportunity cost of production

O.C of wheat production

• to produce 1 wheat , X gives up 0.5 cloth

• to produce 1 wheat , Y gives up 1 cloth

O.C of wheat production

• Since ___ produces wheat at a less opportunity cost, it has a ________ advantage in wheat, it specialises in _____

O.C of cloth production

• to produce 1 cloth , X gives up __ wheat

• to produce 1 cloth, Y gives up __ wheat

O.C of wheat production

• Since ___ produces cloth at a less opportunity cost, it has a ________ advantage in cloth, it specialises in _____

Production after specialisation

Country Wheat in tonnes

Cloth in metres

X ? ?

Y ? ?

World output

? ?

Domestic O.C ratios Wheat : Cloth X = 2W : 1C Y = 1W : 1C* Terms of exchange or exchange

ratio should lie between the two o.c. ratios

• assume exchange ratio = 1.5W: 1C• means X exchanges1.5w for 1c• Y exchanges 1c for 1.5w

Gains from trade • Before specialisation,

X gives up 2 wheat to get 1 cloth • After specialisation,

X gives up 1.5 wheat to get1 cloth

• X gains by giving up less than before.

win-win situation• Before specialisation, Y

gets 1 wheat for 1 cloth

• After specialisation, Y gets 1.5 wheat for 1 cloth

• Y gains by getting more than before.

• Specialisation and tradetherefore allows an

• economy to consume beyond its PPC

Consumption Possibility Curve