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Title: Aim: How does evaluation of comparative and absolute advantage help explain why nations trade?


1
Aim How does evaluation of comparative and
absolute advantage help explain why nations trade?
2
Why do nations trade?
  • You could saythat globalization, driven not by
    human goodness but by the profit motive, has done
    far more good for far more people than all the
    foreign aid and soft loans ever provided by
    well-intentioned governments and international
    agencies.
  • Paul Krugman, The Magic Mountain, New York
    Times, January 23, 2001

3
Adam Smith, The Wealth of Nations(often called
the Father of Modern Economics)
  • It is the maxim of every prudent master of a
    family, never to attempt to make at home what it
    will cost him more to make than to buy. The
    taylor does not attempt to make his own shoes,
    but buys them of the shoemaker. The shoemaker
    does not attempt to make his own clothes, but
    employs a taylor. The farmer attempts to make
    neither the one nor the other
  • What is prudence in the conduct of every
    private family, can scarce be folly in that of a
    great kingdom. If a foreign country can supply
    us with a commodity cheaper than we can make it,
    better buy it of them with some part of the
    produce of our own industry. (Book IV, Section
    ii, 12)

4
Why do nations trade?
  • Nearly all economic theories suggest that the
    benefits of international trade far exceed the
    costs.
  • Specialization and international trade increase
    the productivity of a nations resources and
    allow for greater total output than would
    otherwise be possible.
  • McConnell and Brue,
    16th edition

5
Important Terms to Know
  • Specialization Division of labor into specific
    tasks and roles intended to increase the
    productivity of workers.
  • Globalization Name for the process of
    increasing the connectivity and interdependence
    of the world's markets and businesses.
  • Imports Goods and services purchased from other
    countries
  • Exports Goods and services sold to other
    countries

6
Absolute Advantage
  • Individual exists when a person can produce
    more of a certain good/service than someone else
    in the same amount of time (or can produce a good
    using the least amount of resources.)
  • National exists when a country can produce more
    of a good/service than another country can in the
    same time period.

7
Is Absolute Advantage the only basis for
trading?What if a person or a nation has an
absolute advantage in producing everything.would
there still be a reason to specialize and trade?
8
Comparative Advantage
  • A person or a nation has a comparative advantage
    in the production of a product when it can
    produce the product at a lower domestic
    opportunity cost than can a trading partner.

9
Comparative advantage as the basis for trade is
one of the most important ideas in economics and
also one of the least intuitive.
10
Comparative Advantage
  • Comparative advantage is the basis for all trade
    between individuals, regions, and nations.
  • A person or nation will specialize in the
    production of a product for which it has a lower
    opportunity cost and trade to obtain those
    products for which its opportunity cost is
    higher.

11
Specialization and Trade
  • Gains from trade are based on comparative
    advantage, not absolute advantage
  • Specialization and trade increase productivity
    within a nation and increase a nations output
    and standard of living.
  • Everyone can benefit when people trade with one
    another. Not only can people enjoy a greater
    quantity of goods and services, but they can also
    enjoy a greater variety of goods.

12
Bake Cakes Make Pizza
Ms. Gray 2 cakes/hr. 6 pizzas/hr.
Mr. Pinson 4 cakes/hr. 8 pizzas/hr.
Who has the absolute advantage in producing
cakes? Mr. Pinson Who has the absolute advantage
in producing pizza? Mr. Pinson Would Mr. Pinson
be better off if he specializes and trades?
13
Mr. Pinson should specialize and trade if he has
a comparative advantage (lower opportunity
cost) in the production of one of the products.
Bake Cakes Make Pizza
Ms. Gray 2 cakes/hr. (1c 3p) 6 pizzas/hr. (1p 1/3c)
Mr. Pinson 4 cakes/hr. (1c 2p) 8 pizzas/hr. (1p 1/2c)
Mr. Pinson has a lower opportunity cost in
producing cakes therefore, he should specialize
in the production of cakes. Ms. Gray has a lower
opportunity cost in producing pizza therefore,
she should specialize in the production of pizza.
14
Terms of trade
Bake Cakes Pinson will specialize in cakes. Make Pizza Gray will specialize in pizzas.
Ms. Gray 1c 3p For one cake, Gray would be willing to pay anything up to 3 pizzas. 1p 1/3c For one pizza, Gray will want more than 1/3 cakes.
Mr. Pinson 1c 2p For one cake, Pinson will want more than 2 pizzas. 1p 1/2c For one pizza, Pinson would be willing to pay anything up to ½ cake.
15
How to Handle a Comparative Advantage Problem on
the AP Exam
  • 1. The question will have information about two
    nations producing two of the same products. This
    information will be given to you in a Production
    Possibilities table or on a Production
    Possibilities curve or maybe a word problem form.
  • 2. Ask what type of problem Output or input?

16
  • Determine which nation or person has the absolute
    advantage in producing each of the two goods or
    services.
  • Determine which nation or person has the
    comparative advantage in producing each of the
    two goods or services.
  • For each nation, determine the opportunity cost
    of producing one unit of each good.
  • Identify the nation that has the lowest
    opportunity cost of producing one unit of each
    good. That nation has the comparative advantage.

17
  • Determine the terms of trade. Each country
  • will specialize in the production of the
    good in which it has the comparative advantage
    and will export that good. It will import the
    other good. The terms of trade will be whatever
    is mutually beneficial to the two countries.
    (They will want to be better off after trade than
    before trade.)
  • If the country exports Good A, it will want more
    of Good B than it would get before
    specialization.
  • If the country imports Good A, it will want to
    pay less in terms of Good B than it would have to
    pay before specialization and trade.

18
Hanks PPF
Toms PPF
Q of Coconuts
Q of Coconuts
30
20
9
8
6
28
40
10
Q of Fish
Q of Fish
19
Will the Castaways Gain From Trade?
Coconuts Fish
Tom
Hank
20
Will the Castaways Gain From Trade?
Coconuts Fish
Tom 1 C 1 1/3 F 1 F ¾ C
Hank 1 C ½ F 1 F 2 C
Tom has the lower opportunity cost in fishing and
Hank has the lower opportunity cost gathering
coconuts. Therefore, Tom should specialize in
fishing and Hank should specialize in gathering
coconuts.
21
Hanks PPF
Toms PPF
Q of Coconuts
Q of Coconuts
30
20
11
9
9
8
6
9
28
40
10
31
Q of Fish
Q of Fish
After specialization and trade, Tom and Hank can
consume outside their PPCs.
22
United States
Brazil
Coffee
Coffee
45 40 35 30 25 20 15 10 5
45 40 35 30 25 20 15 10 5


















5 10 15 20 25 30
35 40 45
5 10 15 20 25 30
35 40 45
Wheat
Wheat
23
Will the U.S. and Brazil Gain From Trade?
Coffee Wheat
U.S
Brazil
24
Benefits from Specialization and Trade
  • Specialization and trade increase productivity
    and the standard of living within a nation.
  • Because of specialization and trade, there will
    be a larger global output of goods and services.
  • Everyone can benefit when people trade with one
    another. Not only can people enjoy a greater
    quantity of goods and services, but they can also
    enjoy a greater variety of goods.

25
  • So.if economists all agree that free trade is
    such a great idea, why do so many people have
    problems with the idea?

26
Costs of Specialization and Trade
  • Domestic jobs are lost.
  • Domestic income is lost.
  • National security.
  • Nations dumping goods trying to drive out
    domestic competition.
  • Other nations dont treat their workers fairly.

27
Barriers to Trade
  • Tariffs a tax on imports
  • Quotas a restriction on the amount of imports

28
Trade Agreements
Trade agreements regulate international trade
between two or more nations. An agreement may
cover all imports and exports, certain categories
of goods, or a single category. The United States
is currently engaged in some 320 trade agreements
with various nations.
  • General Agreements on Tariffs and Trade (GATT)
  • North American Free Trade Agreement (NAFTA)
  • World Trade Organization

29
  • Corn Sunscreen
  • Mexico 300 150
  • France 200 150
  • 1. Type of problem (output or input)?
  • 2. Which nation has the absolute advantage in
    producing corn? Sunscreen?
  • Which nation has the comparative advantage in the
    production of each good? (What is the
    opportunity cost for each nation of producing one
    unit of corn and sunscreen ?)
  • What would be a favorable term of trade?

30
  • Wheat Cloth
  • United States 1 hour 2 hours
  • Canada 3 hours 4 hours
  • What type of problem is this? (output/input)
  • Who has the absolute advantage in producing
    wheat? In producing cloth?
  • Who has the lowest opportunity cost producing
    wheat? In producing cloth?
  • Favorable terms of trade?

31
Alpha
Beta
Guns
Guns
300
400
100
200
Butter
Butter
Significance of guns and butter?
32
  • Labor Hours Needed to
  • Produce a Unit of
  • Wheat Cloth
  • Portugal 10 20
  • England 20 60

33
In order to produce one ton of output, Mexico and
the USA must use the following amount of
resources (in acres of land).
Soybeans Avocados
Mexico 16 8
USA 8 6
34
Given a fixed amount of resources, Mexico and the
USA can choose between the following alternatives.
Soybeans Avocados
Mexico 15 60
USA 30 90
35
Chapter 6 Table 6.5
36
  • Mankiw, question 4, page 60
  • Pat and Kris are roommates. They spend most
    of their time studying (of course), but they
    leave some time for their favorite activities
    making pizza and brewing root beer. Pat takes 4
    hours to brew a gallon of root beer and 2 hours
    to make a pizza. Kris takes 6 hours to brew a
    gallon of root beer and 4 hours to make a pizza.
  • What is each roommates opportunity cost of
    making a pizza? Who has the comparative
    advantage in making pizza?

37
Root beer (hours to make) Pizza (hours to make)
Kris 16 8
Pat 4 2
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