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 CHAPTER Foundations of Modern Trad

2 Theory:
Comparative Advantage

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Chapter Outline (1 of 2)

• Historical Development of Modern Trade

Theory
• Production Possibilities Schedules
• Trading Under Constant Cost Conditions
• Dynamic Gains from Trade
• Changing Comparative Advantage
• The Impact of Trade on Jobs
• Wooster, Ohio, Bears the Brunt of Globalization

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 Chapter Outline (2 of 2)

● Comparative Advantage Extended to Many

Products & Countries
● Exit Barriers
● Empirical Evidence on Comparative Advantage
● Comparative Advantage & Global Supply Chains

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Historical Development of
Modern Trade Theory (1 of 7)

• The Mercantilists, 1500-1800

– Promoted a favorable trade balance by
encouraging exports and discouraging
imports
• Sought rise in domestic output and
employment
• Advocated government regulation of trade
(tariffs, quotas, other commercial policies)
– Held static view of world economy

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 Historical Development of
Modern Trade Theory (2 of 7)
● Criticisms of Mercantilism
• David Hume’s price-specie-flow doctrine
• A favorable trade balance is possible only in short
run
• Adam Smith, The Wealth of Nations (1776)
• World’s wealth is not a fixed quantity
• International trade increases general level of
productivity within a country as well as increases
world output

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 Historical Development of
Modern Trade Theory (3 of 7)
● Why Nations Trade? Absolute Advantage
• Assumption:
• Production costs differ among nations due to
different productivities of factor inputs
• Absolute Cost Advantage
• Countries that use less labor to produce one unit of
output
• Labor theory of value – assumes that within a
nation, labor is the only factor of production

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 Historical Development of
Modern Trade Theory (4 of 7)
● Principle of Absolute Advantage
• Consider two-nation, two-product world
• Each nation produces a good absolutely more
efficiently than its trading partner
• With trade and specialization
– Countries export goods – if have absolute cost
advantage
– Countries import goods – if have absolute cost
disadvantage

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 TABLE

2.1
A Case of
Absolute
Advantag
e…

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 Historical Development of
Modern Trade Theory (5 of 7)
● Principle of Comparative Advantage
• Emphasizes relative cost differences based on
opportunity costs; the basis for trade
• Trade is possible even if a nation has an absolute cost
disadvantage in production of both goods
• The more efficient nation
• Specializes and exports goods in which it is
relatively more efficient or where its absolute
advantage is greatest
• The less efficient nation
• Specializes and exports the good in which it is
relatively less inefficient or where its absolute
disadvantage is least
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 TABLE

2.2
Examples
of
Comparati
ve
Advantag
e…

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 Historical Development of
Modern Trade Theory (6 of 7)
● Principle of Comparative Advantage Simplified
model; assumptions:
• 1. World consists of 2 nations and 2 goods.
• 2. Labor, fully employed & homogenous, is sole input.
• 3. Labor can move freely only within nation.
• 4. Technology fixed for both nations; all firms within
nation utilize common production methods.
• 5. Costs proportional to amount of labor used and do
not vary with level of production.
• 6. Perfect competition prevails in all markets; firms are
price takers; products are identical.

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 Historical Development of
Modern Trade Theory (7 of 7)
● Principle of Comparative Advantage Simplified
model; assumptions:
• 7. Free trade occurs between nations; no barriers.
• 8. Transportation costs zero, so consumers don’t care
whether domestically produced or imported.
• 9. Firms make production decisions attempting to
maximize profits; consumers maximize satisfaction.
• 10. No money illusion; consumers and firms take
account of all prices in their decisions.
• 11. Trade is balanced (exports pay for imports),
implying no money flows between nations.

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 TABLE

2.3
Compara
tive
Advantag
e when
U.S. has
Absolute
Advantag
e…
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Production Possibilities
Schedules (1 of 2)

• Production possibilities schedule

– Various alternative combinations of goods a
nation can produce when all factors of
production are employed to maximum
efficiency
– Maximum output possibilities of a nation, given
resource constraints, level of technology

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 Production Possibilities Schedules (2 of 2)

● Marginal rate of transformation (MRT)

• The amount of a good a nation must sacrifice
to obtain an additional unit of another good
• Rate of sacrifice = opportunity cost of a product
• MRT equals the absolute value of slope of
production possibilities schedule

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Trading Under
Constant-Cost Conditions
(1 of 10)
• Constant opportunity costs
– Straight line production possibilities schedules
– Factors of production perfect substitutes, and
all units of a factor are of same quality
• Autarky
– Absence of trade
• Specialization and trade result in production
gains

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 TABLE

2.4
Gains
from
Specializ
ation &
Trade…

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 TABLE

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 Trading Under
Constant-Cost Conditions (2 of 10)
● Consumption Gains from Trade
• Consumption gains for both countries
• Consumption points:
• Beyond domestic production possibilities schedules,
so countries consume more of both goods
● Terms of Trade
• Rate at which country’s export product is
traded for other country’s export product
• Defines relative prices of the two products

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 Trading Under
Constant-Cost Conditions (3 of 10)
● Domestic rate of transformation
• Domestic terms of trade
• Slope of production possibilities schedule
• Relative prices at which the two commodities can be
exchanged at home
● Terms of Trade for exports
• For country to consume beyond production
possibilities schedule, international terms of
trade must be more favorable than domestic
terms of trade

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 Trading Under
Constant-Cost Conditions (4 of 10)
● Trading possibilities line
• International terms of trade for both countries
● Trade triangle for a country
• Exports – along horizontal axis
• Imports – along vertical axis
• Terms of trade equal to slope
● Complete specialization
• Produces only one product

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 Trading Under
Constant-Cost Conditions (5 of 10)
● Domestic cost ratio
• Negatively sloped production possibilities
schedule
• Transforms into a positively sloped cost-ratio line
• Sets outer limits for equilibrium terms of
trade
• Constitutes the no-trade boundary
● Region of mutually beneficial trade bounded by
cost ratios of the two countries

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 FIGURE

2.2
Equilibri
um
Terms-of-
Trade
Limits

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 Trading Under
Constant-Cost Conditions (6 of 10)
● Equilibrium Terms of Trade
● Theory of Reciprocal Demand
• Within outer limits of the terms of trade, actual
terms of trade determined by relative strength
of each country’s demand for other country’s
product
• Production costs determine outer limits of terms of
trade
• Reciprocal demand determines what actual terms of
trade will be within those limits

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 Trading Under
Constant-Cost Conditions (7 of 10)
● Theory of Reciprocal Demand
• Best applies when both nations are of equal
economic size, so that their demand has
noticeable effect on market price
• If two nations are of unequal economic size
• Relative demand strength of smaller nation is
dwarfed by that of larger nation
– Domestic exchange ratio of larger nation will prevail
– Small nation can export as much of the commodity
as it desires

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 Trading Under
Constant-Cost Conditions (8 of 10)
● Importance of Being Unimportant
• For two nations of approximately same size
engaged in international trade, gains from
trade will be shared equally between them
• If one nation is significantly larger
• Larger nation – fewer gains from trade
• Smaller nation – most of the gains from trade
• Larger nation may continue to produce comparative-
disadvantage good because smaller nation cannot
meet all demand

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 Trading Under
Constant-Cost Conditions (9 of 10)
● Terms-of-Trade estimates
• Commodity terms of trade (a.k.a. barter
terms of trade)
• Measure of the international exchange ratio
• Measures the relation between the prices a nation
gets for its exports and the prices it pays for its
imports

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 Trading Under
Constant-Cost Conditions (10 of 10)
● Improvement in a nation’s terms of trade
• Rise in export prices relative to import prices
• A smaller quantity of export goods sold abroad
to obtain a given quantity of imports
● Deterioration in a nation’s terms of trade
• Rise in import relative to export prices
• Given quantity of imports requires sacrifice of
greater quantity of exports

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 TABLE

2.5
Commod
ity Terms
of Trade,
2013…

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Dynamic Gains from Trade
(1 of 2)

• Dynamic gains from international trade

– Effect of trade on country’s growth rate and volume
of additional resources made available to, or
utilized by, trading country
– Dwarf static gains from trade

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 Dynamic Gains from Trade (2 of 2)

● Dynamic gains from international trade

include:
• More efficient use of an economy’s resources
• Higher output and income
• More saving, more investment
• Higher rate of economic growth
• Higher productivity
• Economies of large-scale production
• Increased competition

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Changing Comparative
Advantage

• Patterns of comparative advantage change over

time
– Productivity increases
• Production possibilities schedule changes
• More output can be produced with same amount of
resources
– Producers must hone skills to compete in more
profitable areas

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 FIGURE

2.3
Changin
g
Compara
tive
Advantag
e

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Trading Under
Increasing-Cost Conditions
(1 of 5)
• Increasing opportunity costs
– Concave production possibilities schedule
• Bowed outward from the diagram’s origin
– Inputs are imperfect substitutes for one another
– MRT rises along slope of production
possibilities schedule

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 FIGURE

2.4
Producti
on
Possibilit
ies
Schedule
…

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 Trading Under
Increasing-Cost Conditions (2 of 5)
● Increasing-Cost Trading Case
• One country specializes, producing one good;
other country specializes in producing the other
good
• Process of specialization continues in both
nations until
• Relative cost of one good is identical in both nations
• One country’s exports of one good equal other
country’s imports of the good
• Domestic rates of transformation are same

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 FIGURE

2.5

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 Trading Under
Increasing-Cost Conditions (3 of 5)

● Production Gains
• More of each good is being produced
● Consumption gains
• Both countries consume more of at least
one good
● Trade Triangle
• Denotes country’s exports, imports, and
terms of trade
• Same for both countries
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service or otherwise on a password-
 TABLE

2.6
Increasin
g…

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 Trading Under
Increasing-Cost Conditions (4 of 5)
● Partial Specialization
• Each country specializes only partially in
production of good in which it has comparative
advantage
• Arises from increasing costs: mechanism that
forces costs in two trading nations to converge,
at which point basis for further specialization
ceases to exist
• Counties then likely to produce some of each
good

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 Trading Under
Increasing-Cost Conditions (5 of 5)
● Reasons for Partial Specialization
• Not all goods and services are traded
internationally
• Differing tastes for products
• Most products are differentiated

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The Impact of Trade on
Jobs

• The extent to which an economy is open

– Influences mix of jobs within an economy
– Can cause dislocation in certain areas or
industries
– Has little effect on the overall level of
employment

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 FIGURE

2.6

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Wooster, Ohio Bears
the Brunt of Globalization

– Rubbermaid, based in Wooster, Ohio, was an

industry leader and solid corporate citizen.
– In 1995, resin prices skyrocketed; when the firm
tried to raise its prices to compensate, Walmart
ceased carrying its products, broke relations, &
turned to foreign producers with lower labor costs.
– Profits plunged 30%; closed 9 manufacturing
plants; laid off 10% of workforce.
– In 1999, firm purchased by Newell Corp, known for
cost-cutting; 1,000 jobs left Wooster.

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Comparative Advantage Extended
to Many Products & Countries
(1 of 2)

• More than two products

– Comparative advantage ranks goods by
degree of comparative cost
– Each country exports product(s) in which it has
greatest comparative advantage
– Each country imports product(s) in which it has
greatest comparative disadvantage
– Cutoff point between exports & imports
depends on relative strength of international
demand

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 Comparative Advantage Extended
to Many Products & Countries (2 of 2)
● More than two countries
• Multilateral trading relations
• Bilateral balance should not pertain to any two
trading partners
• Trade surplus with trading partners that buy
many products it supplies at low cost
• Trade deficit with trading partners that are low-
cost suppliers of goods it imports intensively

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 FIGURE

2.8

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Exit Barriers (1 of 2)

• In an open trading system

– Resources channeled from low productivity to high
productivity uses
– Competition forces high cost plants to exit, leaving
low cost plants to operate in long run
• Exit barriers hinder market adjustments that
would occur through comparative advantage

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 Exit Barriers (2 of 2)

● Exit barriers in U.S. steel industry caused by:

• Relatively fixed cost of union-negotiated wages
& benefits
• Antiquated plants with no other use; contract
termination fines; environmental problems
● Exit barriers associated with:
• Overcapacity (caused by imports, reduced
demand, productivity-improving technology)

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Empirical Evidence on
Comparative Advantage
(1 of 2)
• Ricardian model
– Implies nations export goods in which their
labor productivity is relatively high
• Testing Ricardian model
– MacDougall, 1951
• Export patterns of 25 industries in the United States
and United Kingdom (1937) examined
• 20 industries fit predicted pattern
– Balassa and Stern
• Also supports Ricardo’s conclusions

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 Empirical Evidence on Comparative
Advantage (2 of 2)
● Testing Ricardian model (cont.)
• Stephen Golub
• Found that relative unit labor costs help explain
trade patterns of U.S. vis-à-vis United Kingdom,
Japan, Germany, Canada, and Australia
● Limits of Ricardian model
• Labor not the only factor input; production and
distribution costs also impact trade
• Differences in product quality impact trade as
well

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 FIGURE

2.9

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The Case for Free
Trade (1 of 2)
• Main arguments
– For world as whole, free trade results in higher
level of output and income than would occur in
absence of free trade
– Allows each individual nation to achieve higher
level of production and consumption than
would be achieved in isolation

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 The Case for Free Trade (2 of 2)

● Additional benefits of free trade:

• Deters monopoly
• Fosters innovation
• Yields wider range of product choice
• Reduces international political animosities
● However, trade sometimes harms particular
domestic industries and workers, prompting calls
for protections from imports

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Comparative Advantage
& Global Supply Chains
(1 of 7)
• Ricardian theory assumes production cannot
move to other nations
• Today, labor, technology, capital, ideas all shift
around globe
• Today, many goods supplied by global supply
chains, international production networks that
allow firms to move goods and services efficiently
across national borders

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 Comparative Advantage &
Global Supply Chains (2 of 7)
● Global supply chains use outsourcing
• Subcontracting work to another firm, or
• Purchasing components rather than
manufacturing them
● Advantages of outsourcing
• Reduced costs & increased competitiveness
• New exports, repatriated earnings
• Creation of new industries and products

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 Comparative Advantage &
Global Supply Chains (3 of 7)
● Outsourcing & U.S. Auto Industry
• Early 1900s, Ford Motor Model T: utilized just
700 parts
• Achieved gains of large-scale mass production
• Achieved gains of a high degree of specialization
within plant
• More sophisticated cars and competition
compelled Ford to outsource production
– Strategically important tasks & production kept
in-house; noncore tasks purchased from external
suppliers

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 Comparative Advantage &
Global Supply Chains (4 of 7)
● Outsourcing & U.S. Auto Industry
• Increasing numbers of parts and services now
considered noncore
• Today, about 70% of typical Ford vehicle comes
from parts, components, and services purchased
from external suppliers

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 Comparative Advantage &
Global Supply Chains (5 of 7)
● iPhone Economy & Global Supply Chain
• In early years, Apple outsourced little of its
production to foreign manufacturers
• Around 2000, Apple switched to foreign
manufacturing
• Drawn by Asia’s less expensive, semiskilled workers
and ease of maintaining supply chains for parts and
components
• Software & marketing remain in U.S.

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 Comparative Advantage &
Global Supply Chains (6 of 7)
● Outsourcing Backfires for Boeing 787 Dreamliner
• Japan, Italy, China & Australia all supplied sections
of Boeing 787, assembled in U.S.
• Boeing required foreign suppliers to share in cost
of developing plane; foreign suppliers invested
billions
• Strategy backfired when suppliers fell behind;
production delayed four+ years
• By giving up control of supply chain, Boeing lost
ability to oversee production

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 Comparative Advantage &
Global Supply Chains (7 of 7)
● Reshoring Production to U.S.
• Emphasis had been on cheaper labor cost but
wage gap narrowing
• Cost of shipping goods by ocean freight
increasing sharply; goods in transit for weeks
• Distance made it difficult to customize goods to
local markets; natural disasters, geopolitical
shocks disrupt supply chains
• Many firms now returning some production to
U.S.

Copyright ©2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website,accessible
publicly in whole orwebsite,
in part. in©redmal/E+/Getty
whole or in part. ©derrek/Getty
images Images