International

Economics
Chapter 2: Comparative Advantages
Agenda
• Introduction and expectation
• Main content
• Question and Answer

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 Category
.I. Historical Development of Modern Trade Theory
II. Production Possibilities Schedule
III. Trading under Constant-cost Condition
IV. Dynamic Gain From Trade
V. Changing Comparative Advantage
VI. Trading Under Increasing Cost
VII. The Impact Of Trade On jobs
VIII. Wooster, Ohio Bears the Brunt of Globalization
IX. Comparative Advantage Extended to many Products And Countries
X. Exit Barriers
XI. Empirical Evidence On Comparative Advantage
XII. The Case Of Free Trade
XIII. Comparative Advantages and Global Supply Chains

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I. Historical Development of Modern Trade Theory
Mercantilism: in 16th-18th century
- Believe that international wealth is fixed → countries can
not gain mutual benefits for trading → wrong

Absolute Advantage:
- Adam Smith
- The advantages of a nation that can make it produce more
quantity compared to others using the same amount of
resources.
- A nation will import good it have absolute disadvantages and
export good it have absolute advantages
- Labor theory of value: cost or price of a good within nation
depends on the amount of labor required to produce

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I. Historical Development of Modern Trade Theory
Comparative advantage.
- David Ricardo
- Based on advantage principle.
- Comparative is an economic term that refers to an
economy's ability to produce goods and services at a
lower opportunity cost than that of trade partners.

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II. Production Possibilities Schedules
• Ricardo and Adam Smith tradition theory:
- labor is the only factor input.
• Modern trade theory: using a production possibilities
schedule to provides a more generalized theory of
comparative advantage.
• Production possibilities schedule : the maximum output
possible for each nation when considering all factors input
including land, labor, capital, entrepreneurship used in their
most efficient manner.
• Illustrating the concept of comparative cost in its slope is
called marginal rate of transformation (MRT).
• MRT expresses how much a country must give up of one
product to get one additional unit of a different product
through trade. This can be thought of as an opportunity cost
of tradeoff.

.
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III. Trading Under Constant-Cost Condition
Basis for Trade and Direction of Trade

• The relative cost of producing an additional auto

United States: 0.5 bushels
Canada: 2 bushels
• Relative costs is different mutually favorable specialization and trade.

→ the United States specializing in and exporting autos and Canada

specializing in and exporting wheat.
Production Gains from Specialization:
U.S changes to produce only automobiles, the output increases from
40 to 120.
Canada focus on only wheat, increases production from 80 to 160.

→ number of wheat and automobiles produced globally increased.

III. Trading Under Constant-Cost Condition

Basis for Trade and Direction of Trade

• The relative cost of producing an additional auto

United States: 0.5 bushels
Canada: 2 bushels
• Relative costs is different mutually favorable specialization and trade.

→ the United States specializing in and exporting autos and Canada

specializing in and exporting wheat.
III. Trading Under Constant-Cost Condition

Production Gains from Specialization:

U.S changes to produce only automobiles, the output increases from
40 to 120.
Canada focuses on only wheat, increases production from 80 to 160.

→ number of wheat and automobiles produced globally increased.

III. Trading Under Constant-Cost Condition

Consumption gains from Trade

• Consumption gains: Post-trade consumption
points outside a nation's production
possibilities schedule.

• Terms of trade: The relative prices at which

two products are traded in the marketplace.

• Trading possibilities line: A line representing

the equilibrium terms-of-trade ratio
III. Trading Under Constant-Cost Condition

Distributing the gains from trade

• The domestic cost ratios set the outer limits for the
equilibrium terms of trade

• A country would not accept any terms of trade less than its
domestic cost-ratio line

→ no-trade boundary

• The area bounded by the cost ratios of the two trading

countries is the region of mutually beneficial trade
 III. Trading Under Constant-Cost Condition
Equilibrium Terms of Trade
• Theory of reciprocal demand: the actual terms of trade is determined by the relative strength of each country's
demand for the other country's product

• If two nations of approximately the same size and with similar taste patterns participate in international trade, the
gains from trade will be shared about equally between them.

• However, if one nation is significantly larger than the other, the larger nation attains fewer gains from trade while
the smaller nation attains most of the gains from trade (importance of being unimportant)
‹#›
IV. Dynamic Gains from Trade

• Different from static gain

• Dynamic gains flow from increased input and income
→ more savings and investments
→higher rate of economic growth.
• Countries that are more open to international trade,
grow faster than closed economies.
• Effect of trade on growth is not the same for all countries.
• Example: the gains tend to be less for a large country
such as the United States than for a small country such as
Belgium.
V. Changing Comparative Advantage
The countries can change or shift their comparative
advantage.
Graph 2.3 Analysis
If productivity in the Japanese computer industry grows
faster than it does in the U.S. computer industry,
the opportunity cost of each computer produced in the
United States increases relative to the opportunity cost of
the Japanese.
United States: comparative advantage shifts from
computers to autos.
=> producers are under constant pressure to hone their
skills and reinvent themselves to compete in more
profitable areas
VI. Trading Under Increasing-Cost Conditions
• Reality usually don’t have constant-cost condition

• the law of increasing costs “once all factors of production (land, labor,
capital) are at maximum output and efficiency, producing more
will cost more than average”

• Increasing opportunity costs give rise to a production possibilities schedule

that appears bowed outward from the diagram's origin.

• MRT equals the production possibilities schedule's slope, it will also be

different for each point on the schedule.

• Graph analysis: As in figure 2.4, the MRT becomes steeper as we move from
A to B.
VI. Trading Under Increasing-Cost Conditions

1. Increasing Cost Trading Case

Analysis Graph
• Amount of autos and wheat
before < after specialization
2. Partial specialization
is the country that not only completely
produced 1 good that it has advantages but
also produce the other goods while focus in
the advantaged one

more of each consumption both consume

production gains good is gain from more at least
produced trade 1 good.
VII. The Impact of Trade on Jobs

Because:
Based on comparative advantage,
Trade tends to lead countries to specialize in producing
goods they hold comparative advantage.
So That
Trade influences the mix of jobs
Workers and capital shift away from industries which less
productive relative (compared to foreign producers) to
which they do better.

Conclusion
Increased trade can only cause dislocation in certain areas
or industries, but has little effect on the overall level of
employment.
VIII. Wooster, Ohio Bears the Brunt of Globalization
This is a specific example : A
manufacturer in Ohio making
• The increase in the cost for resin household items - Rubbermaid.
Cause

• the company was forced to raise prices of

their products.
• Retailers responded by seeking foreign
Action producers,

• Result: within 5 years, the company was

sold, and 1,000 people lost their jobs in
Result Wooster.
IX. Comparative Advantage Extended to
Many Products and Countries
1. More Than Two Products

• 2 countries produce many goods

• => Requires degree of comparative cost ranking.

• The ranking work based on the advantages and

disadvantages between 2 countries of each goods

• Demand and supply determine the cutoff point

production.

• For example, a rise in the demand for steel and

semiconductors, leads to rising production in the
Japanese steel and semiconductor industries.
IX. Comparative Advantage Extended to
Many Products and Countries
2. More Than Two Countries

• Multilateral trading relations.

• Case study: Figure 2.8 illustrates the process of multilateral

trade for the United States, Japan, and OPEC.

• Reality => more complex

• A country can suffer or gain:

• trade surpluses (exports exceed imports)
• trade deficits (imports exceed exports)
X. Exit Barriers
• Low-cost producers take a leading position in global markets ≠ high-cost
producers are forced out of business.

• Exit barriers are obstacles of a firm wanting to leave a given market or

industrial sector.

• These obstacles often cost the firm financially to leave the market and
may prohibit it doing so.

• If the barriers of exit are significant: a firm may be forced to continue

competing in a market, as the costs of leaving may be higher than
those incurred if they continue competing in the market.
XI. Empirical Evidence on Comparative Advantage

Theory: Ricardo's theory of comparative advantage implies

that each country will export goods for which its labor is
relatively productive compared with its trading partners.
Purpose and action: Applied the model to actual market
interactions to find out how markets generally respond.
Result: there is empirical support for the Ricardian model,
its limitations are also found.
These limitations include:
• Labor is not the only factor input
• Production and distribution costs
• Differences in product quality.
XII. The Case for Free Trade
Free trade: is a market situation in which trade in goods and services
between or within countries having:
• No restrictions by the government
• No tariffs
• No quotas
According to Ricardo:
Free trade results in a higher level of output and income than no trade;
it also allows each nation to obtain a higher level of production and
consumption.
Some of its benefits are:
• Increased competition deters monopoly
• More innovation,
• Wider range of product choices and harmony of nation interests.
XII. The Case for Free Trade
In Reality:
Trade may harm domestic industries and their workers. (especially developing countries)
Those industries might attempt to maintain their economic positions by convincing
governments to protect them from imports, perhaps through tariffs or other trade barriers.
.

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XIII. Comparative Advantage and Global Supply Chains

Global Supply Chain:

• Many industries separate production process into stages or tasks that
are undertaken by multiple countries and then transported across
national borders.
• Employ the practice of outsourcing (off shoring):
Hiring a party outside to perform services and create goods
rather than doing on their own to maximize the country
absolute advantages in making that.
• Example: Apple, Ford, Boeing and others.
XIII. Comparative Advantage and Global Supply Chains
Advantages and Disadvantages of Outsourcing

Advantages Disadvantages
Reduced costs Rely on many factors: politics,
Increased competitiveness countries supply chain, trading
New exports opportunities agreement
Productivity improvement Equalization of labor costs between
Create of new industries and new nations
jobs Cost of shipping goods
Utilize the skillful labor force Delays in time
Natural disasters
Geopolitical shocks

Reshoring Production
Although offshoring is good, lately this trend has been changing because of
the disadvantages.
Therefore, some production sectors start to bring the production of goods
back home called reshoring.
CASE STUDY: BOEING 787 Dreamliner

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