Comparative Advantage:

1
Comparative Advantage

• The Classical Theory of Trade

2
Assumptions of the Classical Model

• A 2-country, 2-commodity world
• Perfect competition
• No transportation costs
• Factors mobile internally, immobile
  internationally
• Constant costs of production
• Fixed technology for each country

3
More Assumptions of the Classical Model

• All resources are fully employed (everyone who
  wants to work has a job)
• The labor theory of value holds that is, all
  goods can be valued according to how much labor
  they embody.

4
Labor Theory of Value

• Let
• ax labor time to produce 1 X in country A
• ay labor time to produce 1 Y in country A
• bx labor time to produce 1 X in country B
• by labor time to produce 1 Y in country B

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Labor Theory of Value

• PxA ax ? wA
• PyA ay ? wA
• PxB bx ? wB
• PyB by ? wB

• PxA/PyA ax/ay
• PxB/PyB bx/by

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Comparative Advantage Defined

• Country A has a comparative advantage in good X
  if
• (Px/Py)A lt (Px/Py)B OR if
• ax/ay lt bx/by OR if
• ax/bx lt ay/by
• If country A has a comparative advantage in good
  X, then country B must have a comparative
  advantage in good Y

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Comparative Advantage An Example
8
Comparative Advantage

• The U.S. (country A) has a comparative advantage
  in good corn (good X) because ax/ay lt bx/by (1/5
  lt 3/6), OR because ax/bx lt ay/by (1/3 lt 5/6)
• Mexico (country B) must therefore have a
  comparative advantage in blankets (good Y)

9
Comparative Advantage

• Alternatively, simply look at the autarky price
  ratios (APRs)

10
Comparative Advantage An Example
11
Comparative Advantage

• Since the U.S.s APR for corn is lower than
  Mexicos (1/5 lt 1/2), the U.S. must have a
  comparative advantage in corn
• Since Mexicos APR for blankets is lower than the
  U.S.s (2 lt 5), Mexico must have a comparative
  advantage in blankets

12
Efficiency and Production Possibilities

• The Production Possibilities Frontier (PPF) is
  the set of all combinations of corn and blankets
  that a country is capable of producing, given
  available technology and resources, and assuming
  full employment
• Suppose in our example the U.S. has 1000 hours of
  labor available and Mexico has 1800

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U.S. Production Possibilities
Corn
1000
C
A
500
E
200
100
Blankets
14
Slope of the PPF

• rise over run
• for this example, -5

15
U.S. Production Possibilities
Corn
1000
Slope rise/run -1000/200 -5
A
500
200
100
Blankets
16
Slope of the PPF

• rise over run
• for this example, -5
• Notice the slope (in absolute value) is the APR
  of the good on the horizontal axis
• Therefore, the slope is the opportunity cost of
  the good on the horizontal axis
• marginal rate of transformation

17
Mexicos Production Possibilities
Corn
600
Slope -2, or the opportunity cost of blankets
300
Blankets
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Classical Model The Gains from Trade

• Suppose that in autarky, the U.S. is at point A,
  producing and consuming 500 corn and 100 blankets

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U.S. Production Possibilities
Corn
1000
A
500
200
100
Blankets
20
Classical Model The Gains from Trade

• Suppose that in autarky, Mexico is at point B,
  producing and consuming 300 corn and 150 blankets

21
Mexicos Production Possibilities
Corn
600
B
300
150
300
Blankets
22
Classical Model The Gains from Trade

• Suppose now that the U.S. and Mexico agree to
  trade at an exchange rate of 1B 3.33C (or, 1C
  .3B)
• Suppose further that the U.S. specializes in
  corn. How many units of corn could the U.S.
  produce? 1000.
• If Mexico specializes in blanket manufacture, how
  many blankets could be made? 300.

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The Gains from Trade U.S.

• If the U.S. wants to continue to consume 500C,
  they will now have 500C to trade for blankets
• If the exchange rate is 1B 3.33C (or, 1C
  .3B), how many blankets can the U.S. get in
  exchange for 500C?
• 150
• Therefore, the U.S. can move outside its PPF (to
  point C) by trading!

24
U.S. Production Possibilities
Corn
1000
A
C
500
200
100
150
Blankets
25
The Gains from Trade Mexico

• If Mexico wants to continue to consume 150B, they
  will now have 150B to trade for corn
• If the exchange rate is 1B 3.33C (or, 1C
  .3B), how much corn can Mexico get in exchange
  for 150B?
• 500
• Therefore, Mexico can also move outside its PPF
  (to point D) by trading!

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Mexicos Production Possibilities
Corn
600
D
500
B
300
150
300
Blankets
27
Comparative Advantage Intuitively

• CA tells us why nations trade
• CA also tells why we trade with each other
• In the extreme, self-sufficiency is the road to
  poverty (both individually and nationally)

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The Limits to Mutually Advantageous Trade

• Exchange rate must be at least as great as
  Mexicos APR
• Exchange rate must be no greater than the
  U.S.s APR
• Bottom line we still dont know how the terms of
  trade will be determined, but they must be
  between the countries APRs if trade is to be
  mutually beneficial

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How Trade Affects Domestic Prices in the U.S.

• In the U.S., the corn price will rise (it was 1C
  0.2B, now it is 1C 0.3B)
• This increase is necessary to increase national
  production of corn
• The blanket price will fall (it was 1B 5C, now
  it is 1B 3.33C)
• Good for consumers, especially bad for blanket
  manufacturers

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How Trade Affects Domestic Prices in Mexico

• The blanket price will rise (it was 1B 2C, now
  it is 1B 3.33C)
• This increase is necessary to increase national
  production of blankets
• The corn price will fall (it was 1C 0.5B, now
  it is 1C 0.3B)
• Good for consumers, especially bad for corn
  farmers

31
The Gains from Trade the Consumption
Possibilities Frontier (CPF)

• The CPF is a collection of points that represent
  combinations of corn and blankets that a country
  can consume if it trades

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U.S. Consumption Possibilities
Corn
PPF
1000
A
B
500
CPF
F
200
100
150
300
Blankets
33
The Gains from Trade the Consumption
Possibilities Frontier (CPF)

• The CPF is a collection of points that represent
  combinations of corn and blankets that a country
  can consume if it trades
• The CPFs slope is the same as the terms of trade
  (stated in terms of the horizontal axis good)
• The CPF pivots around the production point
• If trade is to the benefit of a country, the CPF
  lies outside the PPF

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Mexicos Consumption Possibilities
H
1000
Corn
PPF
600
D
500
300
B
CPF
150
300
Blankets
35
The Limits of Mutually Advantageous Trade,
Continued

• What if the terms of trade were not 1B3.33C, but
  instead 1B5C?
• For the U.S., the PPF and the CPF would be the
  same line, so the U.S. would be indifferent to
  trade

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U.S. CPF and PPF
Corn
1000
A
500
CPF and PPF slope -5
200
100
Blankets
37
The Limits of Mutually Advantageous Trade,
Continued

• What if the terms of trade were not 1B3.33C, but
  instead 1B5C?
• For Mexico, the CPF would be even farther outside
  its PPF, so Mexico would gain even more from
  trading

38
Mexicos Consumption Possibilities
H
1000
Corn
PPF
CPF2 slope -5
600
D
500
CPF1 slope -3.33
300
B
150
300
Blankets
39
The CPF and Small Countries

• The nearer are the terms of trade to a countrys
  APR, the less that country stands to gain from
  trade
• The farther away the terms of trade are from a
  countrys APR, the more that country stands to
  gain from trade
• Moral small countries stand to gain a lot from
  trade, large countries gain less