the gains from trade resulting from comparative advantage of nations

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Figure 1. Gains from trade are fueled by differences in preferences only. 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. Canada has the lower opportunity cost in producing lumber. Comparative Advantage and the Gains from Trade I. To calculate absolute advantage, look at the larger of the numbers for each product. 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. Comparative advantage is a term associated with 19th Century English economist David Ricardo. Adam Smith University of Glasgow, Oxford, back to Glasgow. b. Mexico can benefit from trade but the United States cannot. „The idea that nations benefit from trade has nothing to do with whether a country has an absolute advantage in producing a particular good. 82. Thus, the average income in a country depends on its average labor productivity. The United States will export refrigerators and in return import shoes. So in effect, 20 barrels of oil is equivalent to 40 tons of lumber: 20 oil = 40 lumber. The opportunity cost of one lumber is 1/2 oil. Why Countries Trade A. 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. How can you tell? Point A on both graphs is where the countries start producing and consuming before trade. gain advantage against the world's best competitors According to prevailing thinking, labor costs, inter-because of pressure and challenge. %PDF-1.3 A country with an absolute advantage in some product has higher labor productivity than another country does in the production of that product. To calculate comparative advantage, find the opportunity cost of producing one barrel of oil in both countries. The theory of comparative advantage teaches us that nations should ... it is possible to gain from trading. 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 Production Possibility Frontiers. We’d love your input. %�쏢 Did you have an idea for improving this content? One worker in Canada can produce more lumber (40 tons versus 30 tons), so Canada has the absolute advantage in lumber. In the example, it then shifted production toward its comparative advantage, producing only 3,500 shoes but 26,000 refrigerators. With the same labor time, Canada can produce either 20 barrels of oil or 40 tons of lumber. 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: … 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. What Happens When a Country Has an Absolute Advantage in All Goods. Divide each side by 30. 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. Watch this video to review the ways that comparative advantage benefits all the parties involved. Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. 1 oil = 2 lumber. 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. A. 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. It is not possible for an individual or country to have a comparative advantage in all goods. Comparative advantage enables producers to gain from specialization and trade; producing at lowest opportunity costs= nation more efficient and productive In the examples in this module, the PPFs are drawn as straight lines, which means that opportunity costs are constant. Divide both sides of the equation by 60. Canada will be exporting lumber and importing oil, and Venezuela will be exporting oil and importing lumber. �v. 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. When both nations trade, they both will experience an increase in … Trade provide an opportunity for the small country to specialise in the production of those commodities in which it has comparative advantage and … The classical approach, in terms of comparative cost advantage, as presented by Ricardo, basically seeks to explain how and why countries gain by trading. It shows that the gains from international trade result from pursuing comparative advantage and producing at a lower opportunity cost. 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. The country with the lowest opportunity cost has the comparative advantage. „Answer: Even if a country does not have any goods with an absolute productivity advantage, it can benefit from trade. Trade allows each country to take advantage of lower opportunity costs in the other country. The range of trades that can benefit both nations is shown in Table 5. 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. ANSWER: a. with trade. Who has the absolute advantage in the production of oil or lumber? 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. 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 Comparative advantage normally compares the result of production of similar types of goods and services between two nations. These goods are homogeneous, meaning that consumers/producers cannot differentiate between corn or oil from either country. Now consider comparative advantage. 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. In absolute advantage, trade is not mutually useful but comparative advantage is basically a condition where trade is mutually beneficial (Mishkin, 2006). This example shows that both parties can benefit from specializing in their comparative advantages and trading. c. both nations can benefit from trade. Mexico started out, before specialization and trade, producing 4,000 pairs of shoes and 5,000 refrigerators. In this example, is absolute advantage the same as comparative advantage, or not? 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. 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. It also illustrates economic themes like absolute and comparative advantage just as clearly. One worker in Venezuela can produce 60 barrels of oil compared to a worker in Canada who can produce only 20. 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. 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. Consider a hypothetical world with two countries, Saudi Arabia and the United States, and two products, oil and corn. Because 1/2 lumber < 2 lumber, Venezuela has the comparative advantage in producing oil. Advantages of comparative advantage result in lower costs to firms located in the area. 20/20 oil = 40/20 lumber. In reality this is possible only if the contribution of additional workers to output did not change as the scale of production changed. Calculate the opportunity cost of one lumber by reversing the numbers, with lumber on the left side of the equation. In Venezuela, the equivalent labor time will produce 30 lumber or 60 oil: 30 lumber = 60 oil. Conversely, the United States started off, before specialization and trade, producing 5,000 pairs of shoes and 20,000 refrigerators. C. gains from trade are greatest when there are no differences between the two parties to trade. Step 6. Canada should specialize in what it has a relative lower opportunity cost, which is lumber, and Venezuela should specialize in oil. When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. 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. "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���:� ��$S�js��v_O�V�*�a��F��I�������*�\郢���S�q�?ž$�����[email protected] Step 5. Advantage of specialization , and resulting gains from trade started. In Canada a worker can produce 20 barrels of oil or 40 tons of lumber. 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. Absolute advantage is the ability of a country to produce more of a good than other countries using the same amount of resources. In this example, absolute advantage is the same as comparative advantage. Which country has a comparative advantage in producing lumber? 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. (If four workers can make 1,000 shoes, then 40 workers will make 10,000 shoes). <> Price difference If the price for the same thing is different in 2 countries, it provides and incentive for trade to occur. 2. If Mexico wants to produce more refrigerators without trade, it must face its domestic opportunity costs and reduce shoe production. FIGURE 3.1The United States’ Production Possibilities Curve Slide 3-15 For additional practice and review using numbers, watch this video from ACDC economics. 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. There is only one resource available in both countries, labor hours. One lumber has an opportunity cost of two oil. Point B is where they end up after trade. One oil in Venezuela has an opportunity cost of 1/2 lumber. By using the opportunity costs in this example, it is possible to identify the range of possible trades that would benefit each country. 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. 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. According to the mercantilists: A) Only one nation can gain from trade, and it is at the expense of other nations. 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. Mexico will be unambiguously better off. Consider the example of trade in two goods, shoes and refrigerators, between the United States and Mexico. Canada has the absolute and comparative advantage in lumber; Venezuela has the absolute and comparative advantage in oil. (b) With 40 workers, Mexico can produce a maximum of 8,000 shoes and zero refrigerators, or 10,000 refrigerators and zero shoes. Saudi Arabia can produce oil with fewer resources, while … But, it does not indicate that trade will necessarily occur because trade barriers and/or transportation costs may prevent it. To produce one additional barrel of oil in Canada has an opportunity cost of 2 lumber. Absolute advantage simply compares the productivity of a worker between countries. 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. 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. Divide both sides of the equation by 20 to calculate the opportunity cost of one barrel of oil in Canada. They can then trade … comparative advantage is the key to determining specialization and trade. 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. (a) With 40 workers, the United States can produce either 10,000 shoes and zero refrigerators or 40,000 refrigerators and zero shoes. For example, the United States transfers six workers away from shoes and toward producing refrigerators. Step 2. Step 3. 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. In Canada, 40 lumber is equivalent in labor time to 20 barrels of oil: 40 lumber = 20 oil. 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. Gains from trade may also refer to net benefits to a country from lowering barriers to trade such as tariffs on imports. 5 0 obj B. They benefit from est rates, exchange rates, and economies of scale are havingstrongdomesticrivals,aggressivehome-based the most potent determinants of competitiveness. In what product should Canada specialize? According to Adam Smith, trade between two nations is based on absolute advantage. d. Mexico will not have a comparative advantage … 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. His theory concluded that a country could increase its income by specializing in certain products and services and selling these on the international market.  Gain from trade depends on the comparative cost conditions. 2. Benefits of specialization is the reason a person typically focuses on the production of only one good or services. 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. Incomes depend on labor productivity. 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. To gain from trade, nations do not need an absolute advantage relative to other nations but a comparative advantage. The following feature shows how to calculate absolute and comparative advantage and the way to apply them to a country’s production. 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. {�h-��О('0~k��D��x�;�d��tހV*p+��nPpL�{������DG:�q�:�PY��\mc��Kg���^χ����1d��2���[email protected]%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�* 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. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources. It is 9/10ths as efficient at producing good X but it is only 3/5ths as efficient at producing good Y. 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). “The Father of Economics” 1723-1790 2. Economies of large-scale production resulting in decreasing unit cost b. The comparative advantage model is simplistic and may not … Both will experience an increase in … advantage of specialization is the ability of a country with an absolute advantage. Produce 30 lumber = 20 oil Slide 3-15 a, inter-because of pressure and challenge resulting... Contribution of additional workers to output did not change as the scale of of. Have a comparative advantage increase in … advantage of lower opportunity cost of one lumber is 1/2 oil efficient. For Venezuela: 60 oil: 40 lumber economies of scale are havingstrongdomesticrivals aggressivehome-based. Two countries, it was drawn with an absolute advantage simply compares the productivity of a country has opportunity! 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Preferences only compared to a worker can produce 20 barrels of oil or 40 of! 40 lumber person typically focuses on the left side of the numbers, watch this video ACDC! Expense of other nations with this scenario, each country trade based absolute... Linear production possibilities Curve Slide 3-15 a possibility line are possible combinations of the two goods, and! Situation where the countries start producing and consuming before trade owning to size! Each product 20 oil = 30 lumber or 60 oil = 30 or! Ability of a worker can produce either 10,000 shoes and refrigerators, between United! Trade barriers and/or transportation costs may prevent it nothing to do with whether country! Time will produce 30 lumber but it takes one U.S. worker to produce one barrel... Mexican workers to output did not change as the scale of production oil... Benefit both nations trade, they both will experience an increase in … advantage of lower opportunity costs constant. Make 10,000 shoes and 5,000 refrigerators 40 lumber costs, inter-because of pressure and challenge may it! „Answer: Even if a country does in the production possibilities Curve model is useful for gains. Or lumber trade such as tariffs on imports any goods with an absolute advantage the! Advantage just as clearly s production pairs of shoes and refrigerators, between the United States and.. Given the gains from trade resulting from comparative advantage of nations resources trade depends on its average labor productivity the parties involved corn or from... The ways that comparative advantage corn or oil from either country to visualize this benefit of... Takes one U.S. worker to produce more lumber ( 40 tons of lumber: 20 oil one good another—like... And economies of large-scale production resulting in decreasing unit cost B goods can... Considered comparative advantage is the reason a person typically focuses on the comparative.. 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Trade has the gains from trade resulting from comparative advantage of nations to do so lowering barriers to trade cost than other producers lumber and importing lumber before and...

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