FIN 376 Lecture Notes - Lecture 5: Foreign Worker, Absolute Advantage, Comparative Advantage

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6 Nov 2016
Copyright Stephen P Magee 2001-2016 Revised 1-7-2016
Prof Steve Magee Topic 1A Global Finance
Comparative Advantage and Trade
A. Do low wages in China mean it will sell all the labor-intensive products and the US none?
B. Do multinationals pick world production sites based on wage rates?
C. If not, then, then based on what?
A. The Theory of Comparative Advantage: Specialize
1. The theory of comparative advantage was invented by David Ricardo. It states that every country should
specialize and produce only those products which it can produce relatively cheaper than other countries.
2. This means that even if China could produce every product in the world cheaper than anywhere else, it will
still not produce all products. For example, assume there were only two products in the world and that:
product C was 10 times more profitable to produce in China than in the US and
product U was 2 times more profitable to produce in China than the US.
Even though China has an absolute advantage in both U and C (can produce both at lower dollar costs),
Ricardo says that China will still produce only product C and China will import product U from the United
States. Why? Self interest. The answer comes from the theory of opportunity costs ---- >
Given the choice of making $2 per hour in profits doing product U or $10 an hour making
product C for the same amount of time, even a communist manager will choose product C. Both
Chinese laborers and manager would choose that Chinese laborers work on product C all of the time
because both profits and wages would be higher.
In other words, China will choose only to work on what they are comparatively best at, not
everything. Thus, China will not end up producing everything, even though it could.
B. Which country would you produce in?
% of US wage
India 12%
Philippines 20%
Mexico 40%
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