618 PART • Information, Market Failure, and the Role of Government ratio P1F/P1C, producers will not produce the combination of food and clothing at B Because the producer wants to produce F1 units of food, while consumers want to buy F2, there will be an excess demand for food Correspondingly, because consumers wish to buy C2 units of clothing while producers wish to sell C1, there will be an excess supply of clothing Prices in the market will then adjust: The price of food will rise and that of clothing will fall As price ratio PF/PC increases, the price line will move along the production frontier An equilibrium results when the price ratio is PF*/PC* at C In equilibrium, there is no way to make a consumer better off without making another consumer worse off Hence, this equilibrium is Pareto efficient Moreover, producers want to sell F* units of food and C* units of clothing; consumers want to buy the same amounts At this equilibrium, the MRT and the MRS are equal again; therefore, the competitive equilibrium is output efficient 16.5 The Gains from Free Trade Clearly there are gains from international trade in an exchange economy We have seen that two persons or two countries can benefit by trading to reach a point on the contract curve However, there are additional gains from trade when the economies of two countries differ so that one country has a comparative advantage in producing one good while the other has a comparative advantage in producing another Comparative Advantage • comparative advantage Situation in which Country has an advantage over Country in producing a good because the cost of producing the good in 1, relative to the cost of producing other goods in 1, is lower than the cost of producing the good in 2, relative to the cost of producing other goods in • absolute advantage Situation in which Country has an advantage over Country in producing a good because the cost of producing the good in is lower than the cost of producing it in Country has a comparative advantage over Country in producing a good if the cost of producing that good, relative to the cost of producing other goods in 1, is lower than the cost of producing the good in 2, relative to the cost of producing other goods in 2.5 Note that comparative advantage is not the same as absolute advantage A country has an absolute advantage in producing a good if its cost is lower than the cost in another country A comparative advantage, on the other hand, implies that a country’s cost, relative to the costs of other goods it produces, is lower than the other country’s When each of two countries has a comparative advantage, they are better off producing what they are best at and purchasing the rest To see this, suppose that the first country, Holland, has an absolute advantage in producing both cheese and wine A worker there can produce a pound of cheese in hour and a gallon of wine in hours In Italy, on the other hand, it takes a worker hours TABLE 16.3 HOURS OF LABOR REQUIRED TO PRODUCE CHEESE AND WINE CHEESE (1 LB) WINE (1 GAL) Holland Italy Formally, if there are goods, x and y, and countries, i and j, we say that country i has a comparaaix ajx tive advantage in the production of good x if i j where aix is the cost of producing good x in ay ay country i