BICG 9102- Concepts of International Trade

Prof: Dr. Anjum Siddiqui

Lecture Notes on Chapter 6

There is no short cut to reading the textbook, but these notes provide an alternative explanation with different examples of the ideas presented in the course text. Hopefully you will find this treatment of the selected subject matter useful. The key concepts in the chapter are an understanding of why the gains from trade depend on the pattern of comparative advantage. How factor endowments and climate can influence a countrys comparative advantage. Why countries export some goods and import other goods. The graphical tool used in the chapter is the Production Possibilities Frontier. A PPF is a line or curve that shows all maximum production possibilities of 2 or more goods given a set of inputs (raw materials or intermediate goods and factors of production Land, Labor, Capital) Interpersonal, Interregional, and International trade Without trade each person would have to be self sufficient- for example the grocer has to make his shoes, and supply all goods and services to himself relating to either necessities or entertainment. A world of individual self sufficiency would be a world of very low standard of living. Trade among individuals allows people to specialize in activities they can do well and to buy from others the goods and services they cannot easily produce.A good doctor who is a bad carpenter can provide medical services not only for her won family but also for an excellent carpenter without the training or the ability to practice medicine. Thus trade and specialization are intimately connected. Without trade, everyone must be self sufficient, with trade people can specialize in what they do well and satisfy other needs through trading. The same principle applies to regions. Without interregional trade each region would be forced to be self sufficient. With trade each region can specialize in producing products for which it has some natural or acquired advantage. For example, the mountain regions can engage in mining and the plains in wheat production etc. The same basic principle applies to nations. Nations like individuals and regions can gain from specialization. More of some goods are produced that can be consumed locally and citizens desire more of other goods than are produced domestically.

With trade each individual, region or nation is able to concentrate on producing goods and services that it produces efficiently while trading to obtain goods that it does not produce efficiently. Specialization and trade go hand in hand because there is no incentive to achieve the gains from specialization without being able to trade the goods produced for goods that are desired. Economists use the term gains from trade to embrace the results from both. The Gains from Trade What do we mean by gains from Trade? The increased output made possible when countries engage in specialization in production (and the specialization in production itself depends on the commodity that a country has comparative advantage in) We will be studying 2 theories which will first demonstrate to us why is trade good for individuals, countries or regions. These are (i) (ii) Theory of Absolute Advantage (AA) Theory of Comparative Advantage (CA)

Then we will study that if the world specializes in a good in which it has comparative advantage then overall world production of goods will increase and so will world consumption. Absolute Advantage One country has an absolute advantage in the production of a specific product if, relative to another country, it can produce more of the product while using the same resources. The AA theory tells us that a country should export only those goods and services in the production of which it is more productive (or more efficient). Here more efficient means less input per unit of output By more productive Adam Smith means in which it has an absolute advantage. Absolute advantage can be measured in terms of dollar costs of production. The AA theory is a worry. According to this theory only those countries which have an absolute advantage in producing some good should be the ones exporting those same goods. Does this mean that high cost countries stand no chance of producing those goods in our globalized world of international trade? Will the low cost countries produce everything leaving nothing to be produced by high cost countries? The answer is no. We shall see that the gains from trade do not depend on the pattern of absolute advantage. Example of Absolute Advantage See Table on Absolute Costs and Absolute Advantage Comparative Advantage One country has a comparative advantage in the production of a specific product if, relative to another country, its opportunity cost for producing the product is lower.

David Ricardo was the first to provide an explanation of the pattern of international trade in a world in which countries had different costs. This has been accepted as a valid theory of the gains from international trade. A country is said to have a comparative advantage in the production of good X if the cost in terms of foregone output of other goods is lower in that country than in another. Example of Comparative Advantage: See Table on Opportunity Costs and Comparative Advantage Suppose Canada gives up other production equal in value to $500 in order to produce an extra ton of lumber, but that in the United States, the opportunity cost of an extra ton of lumber is $550. In this case, Canada has a comparative advantage in the production of lumber. Specialization As discussed above specialization is an incentive only when we have trade. Because only through trade we can specialize and sell surplus output otherwise in the case of no trade (autarky) we will produce all goods and not specialize in anything. Example of Gains from Specialization: See Table on Gains from Specialization. The gains from specialization and trade depend on the pattern of comparative, not absolute, advantage. World output increases if countries specialize in the production of the goods in which they have a comparative advantage. Note that not any pattern of specialization is beneficial for the world. In this example, if Canada were to specialize in the production of cloth and the EU in wheat, total world output would fall. To see this note that to produce one extra metre of cloth in Canada 5 kg of wheat has to be sacrificed (see attached table on Opportunity Costs and Comparative Advantage). Similarly, to produce 4 extra kg of wheat in EU, 2 metres of cloth have to be sacrificed.. Thus if each country produced these extra units of the wrong good, total world output of wheat would fall by 1 kg and total world output of cloth would fall by 1 kg. Conclusions The conclusions about gains from trade arising from international differences in opportunity costs are summarized below. 1. Country A has a comparative advantage over country B in producing a product when the opportunity cost of production in country A is lower. This implies however, that it has a comparative disadvantage in the other product. 2. Opportunity costs depend on the relative costs of producing two products, not on absolute costs. 3. When opportunity costs are the same in all countries, there is no comparative advantage and there is no possibility of gains from specialization and trade. 4. When opportunity costs differ in any two countries and both countries are producing both products, it is always possible to increase production of both products by a suitable reallocation of resources within each country.