Chapter 3: Comparative Advantage and the Gains from Trade
Class Notes: these count for 1% of your total grade
1. Define the following
Mercantilism: refers to the economic system that arose in Western Europe in the 1500s, stressing
the need for nations to run trade surpluses to obtain revenues for armies and national
construction projects. Mercantilist thinking included the key mistake that trade was a zero sum
activity, the belief that one nation’s gain is another nation’s loss
Absolute productivity advantage: A country has an absolute productivity advantage (or absolute
advantage) in a good if its labor productivity is higher. This means the country is able to produce
more output with an hour of labor than its trading partner can.
Production possibilities curve: The PPC shows the trade-offs a country faces when it chooses its
combination of output. It illustrates the maximum amount of output possible, given the available
supply of inputs. Any point lying on the PPC is considered an efficient point of production,
utilizing existing resources fully
Autarky is the complete absence of foreign trade; it represents total self-sufficiency of a national
economy
2. An opportunity cost ratio reveals what for a nation?
An opportunity cost ratio reveals the trade-off a country faces internally when shifting
production between two goods. This ratio is essentially the relative price of one good in terms of
the other. Specifically, the opportunity cost ratio is equivalent to the slope of the PPC at a
specific point of production. If no trade takes place, the relative price of a good must equal its
opportunity cost in production
3. How do we determine a trade price for two countries when they have an absolute or
comparative advantage?
For two countries to gain from trade, the price at which they exchange goods (the world price or
trade price) must fall somewhere between their two domestic opportunity costs (pre-trade
relative prices).
If the trade price settles within this range, both countries benefit from the exchange. If the world
price were outside this range, economic forces would cause it to move back:
- If the trade price were too high for a good (above the opportunity cost of both countries),
both countries would specialize in producing that good, leading to a surplus of that good
and a shortage of the other, causing the price to fall
- If the trade price were too low (below the opportunity cost of both countries), no one
would produce it, leading to a shortage, causing the price to rise
4. For the two countries above, how can you determine who has the absolute advantage in
each good?
Let compare mximum output of 2 country:
Goods Country 1 Country 2
Tacos 50 30
Pizza 30 60
So country 1 has absolute advantage in Tacos and country 2 has absolute advantage in Pizza
5. For the two countries above, how can you determine (and who has each) the comparative
advantage for each good?
Let calculate opportunities cost for each good:
Goods Opportunity cost of country 1 Opportunity cost of country 2
Tacos 0.6 pizza 2 pizza
Pizza 1.67 tacos 0.5 tacos
So country 1 has comparative advantage in tacos and country 2 has comparative advantage in
pizza
6. If each country devotes half their labor to each good, how much will each country
produce of each good?
b = 50/2 = 25 tacos _____
b’= 30/2 = 15 tacos _____
c = 30/2 = 15 pizza_____
c’= 60/2 = 30 pizza_____
7. What is the opportunity cost for country 1 when it comes to making tacos?
1 tacos = 0.6 pizza
8. What is the opportunity cost for country 2 when it comes to making tacos?
1 tacos = 1.67 pizza
9. If each country were to specialize in their comparative advantage they would produce
Country 1 ___tacos_____
Country 2 ____Pizza____
10. What is a reasonable terms of trade for each country (hint: it lies in-between their
opportunity cost ratios)?
We have:
Country 1’s opportunity cost is 0.6 pizza
Country 2’s opportunity cost is 2 pizza
So the mutually beneficial range: 1 tacos trade for between 0.6 and 2 pizza