ECON 223 Lecture Notes - Lecture 8: Comparative Advantage, Opportunity Cost, Absolute Advantage

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19 Feb 2019

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Gains from Trade

•Domestic workers earn a higher income from cheese production because the relative price of cheese increases with

trade.

•Foreign workers earn a higher income from wine production because the relative price of cheese decreases with trade

(making cheese cheaper) and the relative price of wine increases with trade.

•Think of trade an an indirect method of production that converts into wine or vice versa.

•Without trade, a country has to allocate resources to produce all of the goods that it wants to consume. — Resources

are fixed.

•With trade, a country can specialize its production and exchange for the mix of goods that it wants to consume.

•Consumption possibilities expand beyond the production possibility frontier when trade is allowed. — You can reach a

combination you couldn’t reach before without trade.

•With trade, consumption in each country is expanded because world production is expanded when each country

specializes in producing the good in which it has a comparative advantage. — Production possibilities frontier will

shift further from the origin.

Trade Expands Consumption Possibilities

•International trade allows home and foreign to consume anywhere within colored lines, which lie outside the

countries’ production frontiers.

•As home only produces cheese it doesn’t have to allocate resources to wine production. With trade, home can trade

cheese with wine and reach combinations which it couldn’t reach before.

Recalling the Concept of Comparative Advantage

•Recall that in the US 10 million roses could be produced with same resources as 100,000 computers; and that in

Colombia 10 million roses could be produced with the same resources as 30,000 computers.

•Colombia has a lower opportunity cost of producing roses (0.003 < 0.01), so Colombia has a comparative advantage in

rose production.

-US: opportunity cost of producing roses: 100,000/10M=0.01 computers per unit of rose.

-Colombia: opportunity cost of producing roses: 30,000/10M=0.003 computers per unit of rose.

•Similarly US has a lower opportunity cost of producing computers (100 < 333), so US has a comparative advantage in

computer production.

-US: opportunity cost of producing computers: 10M/100,000=100 roses per unit of computer.

-Colombia: opportunity cost of producing computers: 10M/30,000=333 roses per unit of computer.

A Numerical Example

•What is the home country’s opportunity cost of producing cheese?

-aLC/aLW = 1/2, to produce on pound of cheese, stop producing 1/2 gallon of wine.

-Home has a comparative advantage in the production of cheese. (1/2 gallon of wine vs. 2 gallons of wine)

•Home has an absolute advantage in the production of both goods.

•What is the home country’s opportunity cost of producing wine?

-aLW/aLC = 2, to produce one gallons of wine, stop producing 2 pounds of cheese.

-Foreign country has a comparative advantage in the production of wine. (2 pounds of cheese vs 1/2 pounds of

cheese)

•The home country is more efficient in both industries, both only has a comparative advantage in the production of

cheese.

•With trade, the equilibrium relative price of cheese tow one settles between the two opportunity costs of cheese. (0.5

and 2 for cheese production in home country)

•Suppose that the intersection of RS and RD occurs at Pc/Pw = 1, so one pound of cheese trades for on gallon of wine.

•Trade causes the relative price of cheese to rise in the home country and fall in foreign.

-Relative demand of cheese went up, therefore the price of cheese also went up.

•With trade the foreign country can buy one pound of cheese for Pc/Pw = 1 gallon of wine.

-Instead of stopping production of a*LC/a*LW = 2 gallons of wine to free up enough labor to produce one pound of

cheese in the absence of trade. It won an extra gallon of wine with trade.

-Suppose L* = 3,000. The foreign country can trade its 1,000 gallons maximum production of wine for 1,000

pounds of cheese, instead of the 500 pound of cheese it could produce itself. It won an extra 500 pounds of cheese

with trade.

•With trade, the home country can buy one gallon of wine for Pw/Pc = 1 pound of cheese.

-Instead of stopping production of aLW/aLC = 2 pounds of cheese to free up enough labour to produce one gallon

of wine in the absence of trade.

-The home country can trade its 1,000 pounds maximum production of cheese for 1,000 gallons of wine, instead of

the 500 gallons of wine it could produce by itself.

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Document Summary

Resources are fixed: with trade, a country can specialize its production and exchange for the mix of goods that it wants to consume, consumption possibilities expand beyond the production possibility frontier when trade is allowed. Production possibilities frontier will shift further from the origin. Trade expands consumption possibilities: international trade allows home and foreign to consume anywhere within colored lines, which lie outside the countries" production frontiers, as home only produces cheese it doesn"t have to allocate resources to wine production. With trade, home can trade cheese with wine and reach combinations which it couldn"t reach before. Recalling the concept of comparative advantage: recall that in the us 10 million roses could be produced with same resources as 100,000 computers; and that in. Colombia 10 million roses could be produced with the same resources as 30,000 computers: colombia has a lower opportunity cost of producing roses (0. 003 < 0. 01), so colombia has a comparative advantage in rose production.

Related Questions

3. Gains from trade

Consider two neighboring island countries called Felicidad and Arcadia. They each have 4 million labor hours available per month that they can use to produce jeans, rye, or a combination of both. The following table shows the amount of jeans or rye that can be produced using 1 hour of labor.

Country	Jeans	Rye
Country	(Pairs per hour of labor)	(Bushels per hour of labor)
Felicidad	8	32
Arcadia	12	24

Initially, suppose Arcadia uses 1 million hours of labor per month to produce jeans and 3 million hours per month to produce rye, while Felicidad uses 3 million hours of labor per month to produce jeans and 1 million hours per month to produce rye. Consequently, Felicidad produces 24 million pairs of jeans and 32 million bushels of rye, and Arcadia produces 12 million pairs of jeans and 72 million bushels of rye. Assume there are no other countries willing to trade goods, so, in the absence of trade between these two countries, each country consumes the amount of jeans and rye it produces.

Felicidad's opportunity cost of producing 1 pair of jeans is _____ of rye, and Arcadia's opportunity cost of producing 1 pair of jeans is _____ of rye. Therefore, _____ has a comparative advantage in the production of jeans, and ____ has a comparative advantage in the production of rye.

Suppose that each country completely specializes in the production of the good in which it has a comparative advantage, producing only that good. In this case, the country that produces jeans will produce ______ millions pairs per month, and the country that produces rye will produce ______ millions bushels per month.

In the following table, enter each country's production decision on the third row of the table (marked "Production").

Suppose the country that produces jeans trades 26 million pairs of jeans to the other country in exchange for 78 million bushels of rye.

In the following table, select the amount of each good that each country exports and imports in the boxes across the row marked "Trade Action," and enter each country's final consumption of each good on the line marked "Consumption."

When the two countries did not specialize, the total production of jeans was 36 million pairs per month, and the total production of rye was 104 million bushels per month. Because of specialization, the total production of jeans has increased by ____ million pairs per month, and the total production of rye has increased by _____ million bushels per month.

Because the two countries produce more jeans and more rye under specialization, each country is able to gain from trade.

Calculate the gains from tradeâthat is, the amount by which each country has increased its consumption of each good relative to the first row of the table. In the following table, enter this difference in the boxes across the last row (marked "Increase in Consumption").

	Felicidad		Arcadia
	Jeans	Rye	Jeans	Rye
	(Millions of pairs)	(Millions of bushels)	(Millions of pairs)	(Millions of bushels)
Without Trade
Production	24	32	12	72
Consumption	24	32	12	72
With Trade ? ? ? ?
Production	?	?	?	?
Trade action	?	?	?	?
Consumption	?	?	?	?
Gains from Trade ? ? ? ?
Increase in Consumption	?	?	?	?

For which of the following nations does international trade account for the largest percentage of GDP?
A) Japan
B) The Netherlands
C) Germany
D) Great Britain
E) the United States

2. Suppose that workers in Transylvania can produce only two goods-- yo-yos or sweat socks. The Transylvanian currency is the dealer. In what unit is the opportunity cost of yo-yos measured?
A) dealers
B) dealers per yo-yo
C) dealers per sweat sock
D) yo-yos
E) sweat socks

3. For each watch Denmark produces, it gives up the opportunity to make 50 pounds of cheese. Germany can produce one watch for every100 pounds of cheese it produces. Which of the following is true with regard to opportunity costs in the two countries?
A) The opportunity cost of producing watches is lower in Denmark.
B) The opportunity cost of producing cheese is lower in Denmark.
C) The opportunity cost of producing watches is identical in both countries.
D) It is impossible to compare opportunity costs because the two countries use different currencies.
E) In Germany the opportunity cost of producing one pound of cheese is one watch.

4. For each bow the Romans are producing, they give up the opportunity to make 10 arrows. The Dacians are giving up producing2 bows for every 40 arrows they are producing. Which of the following is true regarding comparative advantage?
A) The Romans have a comparative advantage in producing arrows
B) The Romans have a comparative advantage in producing bows
C) The Romans have a comparative advantage in producing arrows and bows
D) The Dacians have a comparative advantage in producing arrows and bows
E) The Dacians have a comparative advantage in producing bows

5. Which of the following is not a basis for trade between two nations?
A) different skill levels of the labor forces
B) one nation's absolute advantage
C) a difference in tastes between countries
D) economies of scale
E) different capital stocks

6. The opportunity cost of producing one car in Germany is 2,000bushels of wheat, and the opportunity cost of producing one car in Canada is 1,200 bushels of wheat. The two countries can realize mutual gains from trade if they agree on terms of trade that are
A) greater than 2,000 bushels of wheat per car
B) less than 1,200 bushels of wheat per car
C) greater than 1,200 bushels of wheat per car and less than 2,000bushels of wheat per car, and Germany produces wheat
D) greater than 1,200 bushels of wheat per car and less than 2,000bushels of wheat per car, and Germany produces cars
E) greater than 1,200 bushels of wheat per car and less than 2,000bushels of wheat per car, and each country produces both goods

7. The rate at which two countries trade one good for another
A) is known as the foreign exchange rate
B) is known as the terms of trade
C) is known as the export line
D) equals the slope of the import line
E) equals the common slope of the countries' production possibilities frontiers

8. Which of the following is true?
A) International trade makes it possible for a country's consumption possibilities to exceed its production possibilities.
B) International trade requires that a country's production possibilities exceed its consumption possibilities.
C) A country's production possibilities always equal its consumption possibilities.
D) A country's consumption possibilities can never equal its production possibilities because of leakages in the system.
E) As long as there is full employment of resources, a country's production possibilities will exceed its consumption possibilities even with trade.

9. Which of the following is not a reason for international specialization?
A) some countries have educated, trained workers, while other countries have unskilled workers
B) tastes and preferences tend to be different in different countries
C) economies of scale can allow larger, specialized producers to operate at a lower average cost
D) mineral resources are often concentrated in particular countries
E) the world price of a good is determined by the world supply and demand for it

10. Ad valorem tariffs on imports are based on a percentage of an import's value; specific tariffs are based on a lump sum per physical unit imported.
A) True
B) False

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3. Gains from trade

Consider two neighboring island countries called Euphoria and Contente. They each have 4 million labor hours available per week that they can use to produce rye, jeans, or a combination of both. The following table shows the amount of rye or jeans that can be produced using 1 hour of labor.

Country	Rye	Jeans
Country	(Bushels per hour of labor)	(Pairs per hour of labor)
Euphoria	8	32
Contente	12	24

Initially, suppose Contente uses 1 million hours of labor per week to produce rye and 3 million hours per week to produce jeans, while Euphoria uses 3 million hours of labor per week to produce rye and 1 million hours per week to produce jeans. Consequently, Euphoria produces 24 million bushels of rye and 32 million pairs of jeans, and Contente produces 12 million bushels of rye and 72 million pairs of jeans. Assume there are no other countries willing to trade goods, so, in the absence of trade between these two countries, each country consumes the amount of rye and jeans it produces.

Euphoria's opportunity cost of producing 1 bushel of rye isï¼ ï¼ of jeans, and Contente's opportunity cost of producing 1 bushel of rye isï¼ ï¼ of jeans. Therefore, ï¼ ï¼has a comparative advantage in the production of rye, andï¼ ï¼ has a comparative advantage in the production of jeans.

Suppose that each country completely specializes in the production of the good in which it has a comparative advantage, producing only that good. In this case, the country that produces rye will produce ï¼ ï¼million bushels per week, and the country that produces jeans will produce ï¼ ï¼ million pairs per week.

In the following table, enter each country's prod uction decision on the third row of the table (marked "Production").

Suppose the country that produces rye trades 26 million bushels of rye to the other country in exchange for 78 million pairs of jeans.

When the two countries did not specialize, the total production of rye was 36 million bushels per week, and the total production of jeans was 104 million pairs per week. Because of specialization, the total production of rye has increased byï¼ ï¼million bushels per week, and the total production of jeans has increased by ï¼ ï¼million pairs per week.

Because the two countries produce more rye and more jeans under specialization, each country is able to gain from trade.

	Euphoria		Contente
	Rye	Jeans	Rye	Jeans
	(Millions of bushels)	(Millions of pairs)	(Millions of bushels)	(Millions of pairs)
Without Trade
Production	24	32	12	72
Consumption	24	32	12	72
With Trade
Production
Trade action
Consumption
Gains from Trade
Increase in Consumption

ECON 223 Lecture Notes - Lecture 8: Comparative Advantage, Opportunity Cost, Absolute Advantage

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