Chapter Comparative Advantage and the Gains from Trade Copyright © 2011 Pearson Addison-Wesley All rights reserved Introduction: The Gains from Trade • The improvement in national welfare is known as the gains from trade Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-2 Adam Smith • 1776, Adam Smith published An Inquiry into the Nature and Causes of the Wealth of Nations – Attacked mercantilism—it dominated economic thought in the 1700s – Proved wrong that trade was a zero sum game • that the gain of one nation from trade was the loss of another – Voluntary exchange (trade) is a positive sum game — both nations gain Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-3 Implications of Adam Smith’s Theory • Specialization is important • Key to wealth creation is access to international markets – Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-4 Adam Smith and Trade Barriers • Highly critical of trade barriers • Trade barriers decrease - Specialization - Technological progress - Wealth creation • Widely accepted by modern economists Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-5 A Simple Model of Production and Trade • Referred to as the Ricardian model, named after economist David Ricardo • Assumptions – Markets are competitive: Firms are price takers – Static world: Technology is constant and there are no learning effects – Labor is perfectly mobile: It can easily move back and forth between industries Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-6 Absolute Productivity Advantage and the Gains from Trade – Productivity: The amount of output obtained from a unit of input – Labor productivity: (units of output) / (hours worked) – Absolute productivity advantage: Country that produces more of a certain good per hour worked Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-7 TABLE 3.1 Output per Hour Worked Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-8 Absolute and Comparative Productivity Advantage Contrasted • Benefits from trade have nothing to with country’s absolute advantage • Comparative productivity advantage (or comparative advantage): Country has lower opportunity costs of producing a good than its trading partners • Comparative advantage allows a country that lacks absolute advantage to sell its products abroad Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-9 Production Possibilities Curve (PPC) • A production possibilities curve (PPC) shows the tradeoffs a country faces when choosing between two goods Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-10 The Price Line or Trade Line • Autarky: The complete absence of trade; all nations can only consume the goods they produce at home Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-11 Case Study – Comparative Advantage in Single Natural Resource – Comparative advantage in crude largely depends on endowment – Oil is valuable resource, so develop oil industry – Becomes difficult to develop other economic activities – Only Saudi Arabia, Kuwait and United Arab Emirates (UAE) are high income Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-12 Case Study – Comparative Advantage in Single Natural Resource – Resource Curse: negative economic effects when country has single, valuable resource – Difficult to develop diversified, educated work force – National income greatly impacted when price of dominant commodity changes – Can lead to political strife Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-13 Table 3.2 Ten Largest Oil Reserves Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-14 Domestic Prices and the Trade Price • If trade price is loaves/ton: – – – – Nothing changes for US Canada will also specialize in steel and trade for bread Nobody is producing bread Shortage of bread, surplus of steel: bread price increases and steel price falls – World price falls to less than Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-15 TABLE 3.3 Output per Hour Worked Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-16 Table 3.4 Indicators of the Korean Economy Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-17 Changing Comparative Advantage • Since 1960, real per capita income in Republic of Korea grew 5.6% • After Korean War, grew economy by limiting imports and concentrate on import substitutes • In 1960, removed import barriers and promoted export oriented industries • Evolved from simple goods and few skills to capital goods with more skills and capital • Now high income country capable of exporting technologically advanced goods Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-18 Changing Comparative Advantage • Comparative advantage can change and can increase incomes and product development, but need: – Development of education and research – Organizational changes – To raise financial capital Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-19 Comparative Advantage and “Competitiveness” • Comparative advantage = competitive advantage when the prices of both inputs and outputs are an accurate indication of their relative scarcity • Comparative advantage ≠ competitive advantage when the markets fail to correctly value the price of inputs and outputs -Imbalances result from government policies, such as subsidies or protection Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-20 Economic Restructuring • Economic restructuring: Changes in the economy that may require some industries to grow and others to shrink or disappear – Often due to increased foreign competition – If there’s a net gain from trade, economic gains from winners exceed losses of losers – Increased foreign competition can create new problems Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-21 Economic Restructuring • Government can pass policies to make adjustment less painful – Increases support for free trade – Trade adjustment assistance (TAA) Provides extended unemployment benefits, and worker retraining Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-22 Table 3.5 Low-Cost and High-Cost Cotton Producers Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-23 Table 3.5 (continued) Low-Cost and High-Cost Cotton Producers Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-24 ... barriers decrease - Specialization - Technological progress - Wealth creation • Widely accepted by modern economists Copyright © 2011 Pearson Addison-Wesley All rights reserved 3-5 A Simple Model... Since 1960, real per capita income in Republic of Korea grew 5.6% • After Korean War, grew economy by limiting imports and concentrate on import substitutes • In 1960, removed import barriers and