ch3 study notes

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17 Jun 2011
Chapter 3:
Countries engage in int’l trade for 2 basic reasons:
1. countries trade b/c they are different from each other
2. countries trade to achieve economies of scale in production
Comparative Advantage:
-there is a tradeoff, i.e. in order to produce one good, the economy must produce
less of other thingsopportunity cost; e.g. the opportunity cost of roses in terms
of computers is the number of computer that could have been produced with the
resources used to produce a given number of roses
-the difference in opportunity costs offers the possibility of a mutually beneficial
rearrangement of world production
* a country has a comparative advantage in producing a good if the opportunity cost of
producing that good in terms of other goods is lower in that country than it is in other
countries. (because the world output is increased by specializing, then in principle
everyone’s standard of living is improved)
** Trade b/w 2 countries can benefit both countries if each country exports the
goods in which it has a comparative advantage.
Ricardian Model:
-international trade is solely due to international diff in the productivity of labour
-unit labour requirement : no of hrs of labour required to produce one unit of output
Production Possibility Frontier/PPF:
-any economy has limited resources, thus to produce more of one good, the
economy must sacrifice some production of another good—tradeoff
-when there is only 1 factor of production, PPF of an economy is a straight line;
thus the opportunity cost of A in terms of B is constant, equals to the absolute
value of the slop of the PPF
-e.g. if it takes 1 labour hour to make a pound of cheese and 2 hours to produce a
gallon of wine, then the opportunity cost of cheese in terms of wine is 1/2
** PPF shows the diff mixes of goods an economy can produce; the relative prices of the
2 goods determine what the economy will actually produce.
The industry will specialize in the production of cheese if the relative price of cheese
exceeds its opportunity cost (i.e. Pc/Pw> aLC/aLW); it will specialize in the production
of wine if the relative price of cheese is less than its opportunity cost.
(in the absence of int’l trade, Home country would have to produce both goods for itself;
but it will produce both goods only if the relative price of cheese equals to its opportunity
cost, i.e. Pc/Pw= aLC/aLW)
Thus in the absence of int’l trade, the relative prices of goods are equal to their
relative unit labour requirements.
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