the gains from trade resulting from comparative advantage of nations

Comparative Advantage and the Gains from Trade I. In this example, absolute advantage is the same as comparative advantage. Step 5. FIGURE 3.1The United States’ Production Possibilities Curve Slide 3-15 2. Price difference If the price for the same thing is different in 2 countries, it provides and incentive for trade to occur. Consider the example of trade in two goods, shoes and refrigerators, between the United States and Mexico. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). Comparative advantage enables producers to gain from specialization and trade; producing at lowest opportunity costs= nation more efficient and productive The linear production possibilities frontier is a less realistic model, but a straight line simplifies calculations. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. According to Adam Smith, trade between two nations is based on absolute advantage. Which of these economists considered comparative advantage in production to be the basis for trade between nations? %PDF-1.3 Figure 1. Incomes depend on labor productivity. The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to explain how and why countries gain by trading. 2. A country that has an absolute advantage in producing all goods still stands to benefit from trade with other countries, since the basis of the gains for trade is comparative advantage, not absolute advantage. 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 our example above, for country A, every extra unit of good Y produced involves an … �v. There is only one resource available in both countries, labor hours. With the same labor time, Canada can produce either 20 barrels of oil or 40 tons of lumber. Efficient Employment of Resources: The direct dynamic gains from foreign trade are that comparative advantage leads to a more efficient employment of the productive resources of the world. Notice that when both countries shift production toward each of their comparative advantages (what they are relatively better at), their combined production of both goods rises, as shown in Table 4. The idea of comparative costs advantage is drawn in view of deficiencies observed by Ricardo in Adam Smith’s principles of absolute cost advantage in explaining territorial specialisation as a basis for international trade. 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. In the examples in this module, the PPFs are drawn as straight lines, which means that opportunity costs are constant. 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: … So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. Absolute advantage simply compares the productivity of a worker between countries. Mexico will be unambiguously better off. As a result, U.S. production of shoes decreases by 1,500 units (6/4 × 1,000), while its production of refrigerators increases by 6,000 (that is, 6/1 × 1,000). Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators. Now consider comparative advantage. 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). 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. Conversely, when the United States specializes in its comparative advantage of refrigerator production and trades for shoes produced in Mexico, international trade allows the United States to take advantage of the lower opportunity cost of shoe production in Mexico. Canada should specialize in what it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. 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 The United States will export refrigerators and in return import shoes. 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. 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. Calculate the same way for Venezuela: 60 oil = 30 lumber. To gain from trade, nations do not need an absolute advantage relative to other nations but a comparative advantage. Consider a situation where the United States and Mexico each have 40 workers. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. It is 9/10ths as efficient at producing good X but it is only 3/5ths as efficient at producing good Y. Watch this video to review the ways that comparative advantage benefits all the parties involved. Which country has a comparative advantage in the production of oil? Trade provide an opportunity for the small country to specialise in the production of those commodities in which it has comparative advantage and … In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. His theory concluded that a country could increase its income by specializing in certain products and services and selling these on the international market. In absolute advantage, trade is not mutually useful but comparative advantage is basically a condition where trade is mutually beneficial (Mishkin, 2006). gain advantage against the world's best competitors According to prevailing thinking, labor costs, inter-because of pressure and challenge. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. It answers the question, “How many inputs do I need to produce shoes in Mexico?” Comparative advantage asks this same question slightly differently. This shape illustrated that as inputs were transferred from producing one good to another—like from education to health services—there were increasing opportunity costs. Comparative advantage normally compares the result of production of similar types of goods and services between two nations. 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. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. c. both nations can benefit from trade. 82. According to the price-specie-flow doctrine, a trade-surplus nation would experi- ence gold outflows, a decrease in its money supply, and a fall in its price level. Thus, the average income in a country depends on its average labor productivity. Step 2. Comparative advantage is the ability of an​ individual, a​ firm, or a country to produce a good or service at a lower opportunity cost than competitors. For additional practice and review using numbers, watch this video from ACDC economics. The opportunity cost of one lumber is 1/2 oil. It is not possible for an individual or country to have a comparative advantage in all goods. They can then 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. 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. 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]����? By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. 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). One lumber has an opportunity cost of two oil. To calculate absolute advantage, look at the larger of the numbers for each product. 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. 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. (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. 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. What Happens When a Country Has an Absolute Advantage in All Goods. 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.  Gain from trade depends on the comparative cost conditions. 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. Divide each side of the equation by 40. Point B is where they end up after trade. Which country has a comparative advantage in producing lumber? 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. Table 3 shows the output of each good for each country and the total output for the two countries. 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. „Answer: Even if a country does not have any goods with an absolute productivity advantage, it can benefit from trade. 20/20 oil = 40/20 lumber. A) Adam Smith B) Alfred Marshall C) David Ricardo D) David Hume Answer: C Page: 28 16. Further assume that consumers in both countries desire both these goods. As a result, production of refrigerators in Mexico falls by 2,500 (10/4 × 1,000), but production of shoes increases by 2,000 pairs (10/5 × 1,000). Gains from trade are fueled by differences in preferences only. The dynamic gains from trade include all of the following except: a. In this example, is absolute advantage the same as comparative advantage, or not? Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. "JK�i�)�)���Qӊ;�ԓ|�Ln�,��,?2N���Iw`��l�^e�O��s�0�ȥ���r�O.�-�}����lF׮sS��R�M�+�L�{�%�6��`�[C�0ߣp��Go��z��_�o������N���:� ��$S�js��v_O�V�*�a��F��I�������*�\郢���S�q�?ž$�����Zw@. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. 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. 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. 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 Venezuela, a worker can produce 60 barrels of oil or 30 tons of lumber. They benefit from est rates, exchange rates, and economies of scale are havingstrongdomesticrivals,aggressivehome-based the most potent determinants of competitiveness. The production possibilities curve model is useful for showing gains from trade based on comparative advantage. How can you tell? 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. 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. Countries have a comparative advantage in production when they can produce a good or service at a lower opportunity cost than other producers. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. Advantages of comparative advantage result in lower costs to firms located in the area. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20. 1 oil = 2 lumber. Adam Smith University of Glasgow, Oxford, back to Glasgow. Benefits of specialization is the reason a person typically focuses on the production of only one good or services. Countries are better off if they specialize in producing the goods for which they have a comparative advantage. But Country A has a comparative advantage in the production of good X. Step 6. The range of trades that can benefit both nations is shown in Table 5. When both nations trade, they both will experience an increase in … Step 4. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber. If Mexico, instead, produces more shoes and then trades for refrigerators made in the United States, where the opportunity cost of producing refrigerators is lower, Mexico can in effect take advantage of the lower opportunity cost of refrigerators in the United States. Saudi Arabia can produce oil with fewer resources, while … One oil in Venezuela has an opportunity cost of 1/2 lumber. David Ricardo in 1817 first clearly stated and proved the principle of comparative advantage, termed a "fundamental analytical explanation" for the source of gains from trade. 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. The comparative advantage model is simplistic and may not … Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. The theory of comparative advantage teaches us that nations should ... it is possible to gain from trading. 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. <> ANSWER: a. with trade. XWY��FP�\����$X+<59�� ���sΐ�Ha��>�u���!�0Ƴ�P��p��Dz�S{�!U��݄���4�l�����M�݂�+�l���T���~@���aR�>/֘\,����pV��UŅ����ؽ2n�z�P 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. Advantage of specialization , and resulting gains from trade started. b. Mexico can benefit from trade but the United States cannot. C. gains from trade are greatest when there are no differences between the two parties to trade. Divide each side by 30. Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. According to the mercantilists: A) Only one nation can gain from trade, and it is at the expense of other nations. The concept of comparative advantage was first formulated by economist David Ricardo as an explanation of the benefits of international trade for countries. Owning to small size, the scope of gains from specialisation and exchange are limited whereas large country has scope for both. Trade allows each country to take advantage of lower opportunity costs in the other country. Why Countries Trade A. Did you have an idea for improving this content? %�쏢 A country with an absolute advantage in some product has higher labor productivity than another country does in the production of that product. 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. But, it does not indicate that trade will necessarily occur because trade barriers and/or transportation costs may prevent it. d. Mexico will not have a comparative advantage … The United States has an absolute advantage in producing both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators. Comparative advantage exists when a country has lower opportunity cost, i.e., it gives up less of one product to obtain more of another product. 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. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. The theory of comparative advantage explains why countries trade: they have different comparative advantages. The theory of comparative advantage was an expansion on the theory of absolute advantage, or Adam Smith's justification of free trade on the basis that a nation should produce what it is most efficient at producing; Ricardo's observation, however, is that "a country will profit by producing the product or commodity for which it enjoys a lower... opportunity cost, and then trading it for the ones other countries can produce at a lower relative internal opportunity cost" … Even though the United States has an absolute advantage in producing both refrigerators and shoes, it makes economic sense for it to specialize in the good for which it has a comparative advantage. „The idea that nations benefit from trade has nothing to do with whether a country has an absolute advantage in producing a particular good. 1752: Professor of Moral Philosophy (natural theology, ethics, jurisprudence, and ‘expediency’ [political economy]) 1759: Theory of Moral Sentiments 1766: returns to London, working on new book on political economy. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil. 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. 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. The country with the lowest opportunity cost has the comparative advantage. It also illustrates economic themes like absolute and comparative advantage just as clearly. Consider the example of trade in two goods, shoes and refrigerators, between the United States and Mexico. One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. In what product should Venezuela specialize? 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 Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. It takes one U.S. worker to produce 1,000 refrigerators, but it takes four Mexican workers to do so. 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. In suppliers, and demanding local customers. B. Comparative advantage is a term associated with 19th Century English economist David Ricardo. 1776: Wealth of Nations published. Comparative advantage describes the economic reality of the work gains from trade for individuals, firms, or nations, which arise from differences in their factor endowments or technological progress. 5 0 obj 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. Gains from trade are fueled by differences in opportunity costs of production only. Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. Absolute advantage is the ability of a country to produce more of a good than other countries using the same amount of resources. Economies of large-scale production resulting in decreasing unit cost b. When you first met the production possibility frontier (PPF) in an earlier module, it was drawn with an outward-bending shape. Gains from trade 1. T F 4. comparative advantage is the key to determining specialization and trade. Who has the absolute advantage in the production of oil or lumber? stream The advantages of specialization, and the resulting gains from trade, were the start-ing point for Adam Smith’s 1776 book The Wealth of Nations,which many regard as the beginning of economics as a discipline. 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. (One should not compare the monetary costs of production or even the resource costs (labor needed per unit of output) of production. Production Possibility Frontiers. Divide both sides of the equation by 60. 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. Gains from trade may also refer to net benefits to a country from lowering barriers to trade such as tariffs on imports. A. The following feature shows how to calculate absolute and comparative advantage and the way to apply them to a country’s production. Step 3. {�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 what product should Canada specialize? For example, the United States transfers six workers away from shoes and toward producing refrigerators. The production possibilities frontier is a useful tool to visualize this benefit. We’d love your input. Canada has the lower opportunity cost in producing lumber. “The Father of Economics” 1723-1790 2. This example shows that both parties can benefit from specializing in their comparative advantages and trading. In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. When a marginal unit of labor is transferred away from growing corn and toward producing oil, the decline in the quantity of corn and the increase in the quantity of oil is always the same. Point A on both graphs is where the countries start producing and consuming before trade. When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. 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