ENC 500 Saudi Electronic University Economics Discussion
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Select a country of your choice (other than Saudi Arabia) and discuss its comparative advantage. What are the sources and the challenges? What is the role of the government? What policies should the government implement to enhance the comparative advantage?Embed course material concepts, principles, and theories, which require supporting citations along with at least one scholarly, peer-reviewed reference in supporting your answer unless the discussion calls for more. Keep in mind that these scholarly references can be found in the Saudi Digital Library by conducting an advanced search specific to scholarly references.Use APA 7th edition and Saudi Electronic University academic writing standards.You are required to reply to at least two peer discussion question post answers to this weekly discussion question and/or your instructors response to your posting. These post replies need to be substantial and constructive in nature. They should add to the content of the post and evaluate/analyze that post answer. Normal course dialogue doesnt fulfill these two peer replies but is expected throughout the course. Answering all course questions is also required.
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INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 2:
Foundations of
Modern Trade
Theory:
Comparative
Advantage
© 2019 Cengage. All rights reserved.
2
Chapter Outline (1 of 2)
Historical Development of Modern Trade Theory
Production Possibilities Frontiers
Trading Under Constant-Cost Conditions
Dynamic Gains from Trade: Economic Growth
Changing Comparative Advantage
Trading under Increasing-Cost Conditions
The Impact of Trade on Jobs
© 2019 Cengage. All rights reserved.
3
Chapter Outline (2 of 2)
Wooster, Ohio, Bears the Brunt of Globalization
Comparative Advantage Extended to Many
Products & Countries
Factor Mobility, Exit Barriers, and Trade
Empirical Evidence on Comparative Advantage
The Case for Free Trade
Comparative Advantage & Global Supply Chains
© 2019 Cengage. All rights reserved.
4
Main Concepts
Basis for trade: why do nations export
and import certain products?
At what terms of trade are products
exchanged in world market?
Gains from international trade:
production & consumption
© 2019 Cengage. All rights reserved.
5
Historical Development of
Modern Trade Theory (1 of 11)
The Mercantilists, 15001800
Promoted favorable trade balance by
encouraging exports and discouraging
imports
Sought rise in domestic output & employment
Advocated government regulation of trade (tariffs,
quotas, other commercial policies)
© 2019 Cengage. All rights reserved.
6
Historical Development of
Modern Trade Theory (2 of 11)
Criticisms of Mercantilism
David Humes price-specie-flow doctrine
A favorable trade balance is possible only in short
run
Adam Smith, The Wealth of Nations (1776)
Static view; worlds wealth not fixed quantity
International trade increases general level of
productivity within a country as well as increases
world output
© 2019 Cengage. All rights reserved.
7
Historical Development of
Modern Trade Theory (3 of 11)
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 only factor of production
© 2019 Cengage. All rights reserved.
8
Historical Development of
Modern Trade Theory (4 of 11)
Principle of Absolute Advantage
Two-nation, two-product world
Each nation produces good absolutely more
efficiently than trading partner
With trade and specialization
Countries export goods if have absolute cost
advantage
Countries import goods if have absolute cost
disadvantage
© 2019 Cengage. All rights reserved.
9
Historical Development of
Modern Trade Theory (5 of 11)
TABLE 2.1 A Case of Absolute Advantage When Each
Nation Is More Efficient in the Production of One Good
World output possibilities in the absence of specialization
OUTPUT PER LABOR HOUR
Nation
Wine
Cloth
United States
5 bottles
20 yards
United Kingdom
15 bottles
10 yards
© 2019 Cengage. All rights reserved.
10
Historical Development of
Modern Trade Theory (6 of 11)
Why Nations Trade: Comparative
Advantage
Emphasizes relative cost differences based
on opportunity costs; basis for trade
Mutually advantageous trade possible even
when nation has absolute cost disadvantage
in production of both goods
© 2019 Cengage. All rights reserved.
11
Historical Development of
Modern Trade Theory (7 of 11)
TABLE 2.2 Examples of Comparative Advantages in
International Trade
Country
Product
Canada
Lumber
Israel
Citrus fruit
Italy
Wine
Jamaica
Aluminum ore
Mexico
Tomatoes
Saudi Arabia
Oil
China
Textiles
Japan
Automobiles
South Korea
Steel, ships
Switzerland
Watches
United Kingdom
Financial services
© 2019 Cengage. All rights reserved.
12
Historical Development of
Modern Trade Theory (8 of 11)
Assumptions of Ricardos Principle of
Comparative Advantage
1. World consists of 2 nations & 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
© 2019 Cengage. All rights reserved.
13
Historical Development of
Modern Trade Theory (9 of 11)
5. Costs do not vary with level of production &
proportional to labor use
6. Perfect competition prevails in all markets;
firms are price takers; products are identical
7. Free trade occurs between nations; no
barriers
8. Transportation costs zero; consumers dont
care whether domestically produced or
imported
© 2019 Cengage. All rights reserved.
14
Historical Development of
Modern Trade Theory (10 of 11)
9. Firms make production decisions 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
© 2019 Cengage. All rights reserved.
15
Historical Development of
Modern Trade Theory (11 of 11)
TABLE 2.3 A Case of Comparative Advantage When the
United States Has an Absolute Advantage in the
Production of Both Goods
World output possibilities in the absence of specialization
OUTPUT PER LABOR HOUR
Nation
Wine
Cloth
United States
40 bottles
40 yards
United Kingdom
20 bottles
10 yards
© 2019 Cengage. All rights reserved.
16
Production Possibilities
Frontiers (1 of 2)
Production possibilities frontiers
Various alternative combinations of two goods
a nation can produce when all factor inputs
are used in their most efficient manner
Maximum output possibilities of a nation,
given land, labor, capital, entrepreneurship
© 2019 Cengage. All rights reserved.
17
Production Possibilities
Frontiers (2 of 2)
Marginal rate of transformation (MRT)
The amount of a product 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 frontier
© 2019 Cengage. All rights reserved.
18
Trading Under Constant-Cost
Conditions (1 of 13)
Constant opportunity costs
Straight line production possibilities
Assumes factors of production perfect
substitutes, and all units of a factor are of
same quality
Autarky
Absence of trade
© 2019 Cengage. All rights reserved.
19
Trading Under Constant-Cost
Conditions (2 of 13)
TABLE 2.4 Gains from Specialization and Trade: Constant
Opportunity Costs
(a) Production Gains from Specialization
BEFORE
SPECIALIZATION
Autos
Wheat
AFTER
SPECIALIZATION
Autos
NET GAIN (LOSS)
Wheat
Autos
Wheat
United States
40
40
120
0
80
?40
Canada
40
80
0
160
?40
80
World
80
120
120
160
40
40
(b) Consumption Gains from Trade
BEFORE TRADE
Autos
Wheat
AFTER TRADE
Autos
NET GAIN (LOSS)
Wheat
Autos
Wheat
United States
40
40
60
60
20
20
Canada
40
80
60
100
20
20
World
80
120
120
160
40
40
© 2019 Cengage. All rights reserved.
20
Trading Under Constant-Cost
Conditions (3 of 13)
Consumption Gains from Trade
Consumption gains for both countries
Consumption points:
Beyond domestic production possibilities frontiers,
so countries consume more of both goods
Terms of Trade
Rate at which countrys export product is
traded for other countrys export product
Defines relative prices of the two products
© 2019 Cengage. All rights reserved.
21
Trading Under Constant-Cost
Conditions (4 of 13)
Domestic terms of trade: set of post-trade
consumption points that a nation can achieve is
determined by the rate at which its export product is
traded for the other countrys export product
Slope of production possibilities frontier
Relative prices at which the two commodities can be
exchanged at home
Terms of Trade for exports
For country to consume beyond production
possibilities frontier, international terms of trade must
be more favorable than domestic terms of trade
© 2019 Cengage. All rights reserved.
22
Trading Under Constant-Cost
Conditions (5 of 13)
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
© 2019 Cengage. All rights reserved.
23
Trading Under Constant-Cost
Conditions (6 of 13)
Domestic cost ratio
Negatively sloped production possibilities
frontier
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
© 2019 Cengage. All rights reserved.
24
FIGURE 2.2 Equilibrium Terms of
Trade Limits
© 2019 Cengage. All rights reserved.
25
Trading Under Constant-Cost
Conditions (8 of 13)
Theory of Reciprocal Demand
Within outer limits of the terms of trade, actual
terms of trade determined by relative strength
of each countrys demand for other countrys
product
Production costs determine outer limits of terms of
trade
Reciprocal demand determines terms of trade
within those limits
© 2019 Cengage. All rights reserved.
26
Trading Under Constant-Cost
Conditions (9 of 13)
Theory of Reciprocal Demand
Best applies when both nations are of equal
economic size
If two nations are of unequal economic size
Relative demand strength of smaller nation can be
dwarfed by larger nation
Domestic exchange ratio of larger nation will prevail
Small nation can export as much of the commodity as it
desires
© 2019 Cengage. All rights reserved.
27
Trading Under Constant-Cost
Conditions (10 of 13)
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
© 2019 Cengage. All rights reserved.
28
Trading Under Constant-Cost
Conditions (11 of 13)
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
Export Price Index
Terms of Trade =
? 100
Import Price Index
© 2019 Cengage. All rights reserved.
29
Trading Under Constant-Cost
Conditions (12 of 13)
Improvement in a nations 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 nations terms of trade
Rise in import relative to export prices
Given quantity of imports requires sacrifice of
greater quantity of exports
© 2019 Cengage. All rights reserved.
30
Trading Under Constant-Cost
Conditions (13 of 13)
TABLE 2.5 Commodity Terms of Trade, 2015 (2000 = 100)
Country
Export Price
Index
Import Price Index
Terms of Trade
Germany
242
212
114
Brazil
347
305
114
United States
193
183
105
Australia
295
291
101
Argentina
216
238
91
United Kingdom
162
180
90
Canada
148
178
83
Japan
130
171
76
Sources: From International Monetary Fund, IMF Financial Statistics, Washington, DC, January 2017. See
also World Bank, Export Value Index (2000 = 100) at http://data.worldbank.org/indicator and Import Value
Index (2000 = 100) at http://data.worldbank.org/indicator.
© 2019 Cengage. All rights reserved.
31
Dynamic Gains from Trade
Dynamic gains from international trade
Effect of trade on countrys growth rate and
volume of additional resources made
available to/utilized by trading country
Can arise from increased investment in
equipment, economies of large-scale
production, increased competition, internet
use, etc.
Dwarf static gains from trade
© 2019 Cengage. All rights reserved.
32
Changing Comparative
Advantage (1 of 2)
Patterns of comparative advantage
change over time
Productivity increases
Production possibilities frontier changes
More output can be produced with same amount of
resources
Producers must hone skills to compete in
more profitable areas
© 2019 Cengage. All rights reserved.
33
FIGURE 2.3 Changing
Comparative Advantage
© 2019 Cengage. All rights reserved.
34
Trading Under Increasing-Cost
Conditions (1 of 7)
Increasing opportunity costs
Gives rise to a production possibilities
frontier that appears bowed outward from
diagrams origin
Larger in terms of what is sacrificed
© 2019 Cengage. All rights reserved.
35
FIGURE 2.4 Production Possibilities Frontier
under Increasing-Cost Conditions
© 2019 Cengage. All rights reserved.
36
Trading Under Increasing-Cost
Conditions (3 of 7)
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 countrys exports of one good equal other
countrys imports of the good
Domestic rates of transformation are same
© 2019 Cengage. All rights reserved.
37
FIGURE 2.5 Trading under
Increasing Opportunity Costs
© 2019 Cengage. All rights reserved.
38
Trading Under Increasing-Cost
Conditions (5 of 7)
Production Gains
More of each good is being produced
Consumption gains
Both countries consume more of at least one
good
Trade Triangle
Denotes countrys exports, imports, and terms
of trade
Same for both countries
© 2019 Cengage. All rights reserved.
39
Trading Under Increasing-Cost
Conditions (6 of 7)
TABLE 2.6 Gains from Specialization and Trade: Increasing
Opportunity Costs
(a) Production Gains from Specialization
BEFORE
SPECIALIZATION
Autos
Wheat
AFTER
SPECIALIZATION
Autos
NET GAIN (LOSS)
Wheat
Autos
Wheat
United States
5
18
12
14
7
?4
Canada
17
6
13
13
?4
7
World
22
24
25
27
3
3
(b) Consumption Gains from Trade
BEFORE TRADE
Autos
Wheat
AFTER TRADE
Autos
NET GAIN (LOSS)
Wheat
Autos
Wheat
United States
5
18
5
21
0
3
Canada
17
6
20
6
3
0
World
22
24
25
27
3
3
© 2019 Cengage. All rights reserved.
40
Trading Under Increasing-Cost
Conditions (7 of 7)
Partial Specialization
Trade generally leads each country to
specialize only partially in production of good
in which it has comparative advantage.
Increasing costs constitute mechanism that
forces costs in two trading nations to
converge.
When cost differentials are eliminated, the
basis for further specialization ceases to exist.
© 2019 Cengage. All rights reserved.
41
The Impact of Trade on Jobs
(1 of 2)
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
© 2019 Cengage. All rights reserved.
42
FIGURE 2.6 The Impact of Trade
on Jobs
© 2019 Cengage. All rights reserved.
43
Wooster, Ohio, Bears the Brunt
of Globalization
When resin prices skyrocketed, Rubbermaid
tried to raise 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.
Newell Corp purchased Rubbermaid; 1,000
more jobs lost in Wooster.
© 2019 Cengage. All rights reserved.
44
Comparative Advantage Extended to
Many Products & Countries (1 of 3)
More than two products:
Comparative advantage ranks goods by
degree of comparative cost.
Each country exports products in which it has
greatest comparative advantage.
Each country imports products in which it has
greatest comparative disadvantage.
Cutoff point between exports & imports
depends on relative strength of international
demand.
© 2019 Cengage. All rights reserved.
45
Comparative Advantage Extended to
Many Products & Countries (2 of 3)
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
© 2019 Cengage. All rights reserved.
46
FIGURE 2.8 Multilateral Trade among
the United States, Japan, and OPEC
© 2019 Cengage. All rights reserved.
47
Factor Mobility, Exit Barriers,
and Trade (1 of 2)
Trading assumes factors of production are
mobile between different uses.
Factor mobility: ability to move factors of
production out of one production process into
another.
How realistic is it that factors of production can
move freely within an industry in a country, can
move across industries in a country, and are
immobile across national borders?
© 2019 Cengage. All rights reserved.
48
Factor Mobility, Exit Barriers,
and Trade (2 of 2)
Exit barriers hinder market adjustments
that would occur through comparative
advantage.
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.
© 2019 Cengage. All rights reserved.
49
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
© 2019 Cengage. All rights reserved.
50
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
© 2019 Cengage. All rights reserved.
51
Can American Workers Compete
with Low-Wage Workers Abroad?
Argument highly political
Bernie Sanders believes U.S. cannot
compete.
Opponents believe that Sanderss
understanding of free trade is inaccurate.
Lawrence found a strong relationship
between average productivity (GDP per
capita) and average wages.
© 2019 Cengage. All rights reserved.
52
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.
It allows each individual nation to achieve
higher level of production and consumption
than would be achieved in isolation.
© 2019 Cengage. All rights reserved.
53
The Case for Free Trade (2 of 2)
Additional benefits of free trade:
Increased monopoly
More innovation
Wider range of product choices
Reduces international political animosities
However, trade sometimes harms particular
domestic industries and workers, prompting
calls for protections from imports.
© 2019 Cengage. All rights reserved.
54
Comparative Advantage & Global
Supply Chains (1 of 3)
Ricardian theory assumes production
cannot move to other nations.
Today, labor, technology, capital, and ideas
all shift around globe.
Today, many goods are supplied by global
supply chains, international production
networks that allow firms to move goods
and services efficiently across national
borders.
© 2019 Cengage. All rights reserved.
55
Comparative Advantage & Global
Supply Chains (2 of 3)
Global supply chains use outsourcing
Subcontracting work to another firm, or
purchasing components rather than
manufacturing them
Advantages of outsourcing
Reduced costs & increased competitiveness
Creation of new industries and products
© 2019 Cengage. All rights reserved.
56
Comparative Advantage & Global
Supply Chains (3 of 3)
Reshoring Production to U.S.
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.
© 2019 Cengage. All rights reserved.
57
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