Welcome to EC 382 International Economics By Dr Jacqueline Khorassani Week Two 1 Week Two Class One Tuesday September 11 14 00 14 50 AC 202 The library does not have the book You will need to purchase it 2 Last class we defined absolute advantage If India can produce one yard of cloth using fewer resources than the US then India has absolute advantage in production of cloth Or If India uses all of its resources it can produce more cloth than the US then India has absolute advantage in production of cloth According to the theory of absolute advantage A country must export what they have absolute advantage in and import what they have absolute disadvantage in 3 What is Production Possibilities Frontier PPF A curve that shows the different combinations of two goods that a nation can produce efficiently with a given amount of resources and a given technology in a given period of time 4 PPFs in the US and India U S Number of Machines India Yards of Cloth Number of Machines Yards of Cloth 100 0 60 0 90 30 50 50 80 60 40 100 70 90 30 150 60 120 20 200 50 150 10 250 40 180 0 300 30 210 20 240 10 270 0 300 5 Let look at the table again Who has absolute advantage in what US has absolute advantage in production of machines No one has absolute advantage in production of cloth Based on the absolute advantage theory US can export machines to India but India should not export anything to the US In a barter economy trade will not take place India has nothing to offer US U S Number of Machines India Yards of Cloth Number of Machines Yards of Cloth 100 0 60 0 90 30 50 50 80 60 40 100 70 90 30 150 60 120 20 200 50 150 10 250 40 180 0 300 30 210 20 240 10 270 0 300 6 Let look at the PPF table again What is the opportunity cost of producing one machine in each nation 3 yards of cloth in US 5 yards of cloth in India U S India Number of Machines Yards of Cloth Number of Machine s Yards of Cloth 100 0 60 0 90 30 50 50 80 60 40 100 70 90 30 150 60 120 20 200 50 150 10 250 40 180 0 300 30 210 20 240 10 270 0 300 7 Let s draw the PPF for each country Since OPP cost is always the same constant cost Cloth 300 Cloth U S 300 INDIA Opp cost of 1 machine MRT 3 150 A Production and consumption in before trade 100 B 0 Opp cost of 1 machine MRT 5 A B 50 100 Machines 0 40 50 Machines 8 The theory of comparative advantage David Ricardo 1772 Netherlands 1823 A nation has comparative advantage in production of machines if it can produce it at a lower opportunity cost 9 In our example Who has comparative advantage in machines US with opp cost of 3 yards of cloth Who has comparative advantage in cloth India with opp cost of 1 5 of machines U S India Number of Machines Yard s of Clot h Numbe r of Machin es 100 0 60 0 90 30 50 50 80 60 40 100 70 90 30 150 60 120 20 200 50 150 10 250 40 180 0 300 30 210 20 240 10 270 0 300 Yards of Cloth 10 You asked 1 Do we need to know absolute advantage to find comparative advantage No 2 How can a country have comparative advantage but not absolute advantage Look at India 11 Trade based on comparative advantage A nation should specialize in production of the good in which it has comparative advantage and trade that good for a good that it has comparative disadvantage in 12 Assignment 1 Do it in teams of 2 or 3 13 International Economics Week Two Class 2 11 10 12 00 Tyndall 14 Asst 1 PPFs U S U S computer Beer s Germany German computer y Beer s 0 5 0 5 1 4 5 1 4 2 4 2 3 3 3 5 3 2 4 3 4 1 5 2 5 5 0 6 2 7 1 5 8 1 9 0 5 10 0 15 PPFs The slope of US PPF 0 5 opp cost of 1 computer MRT of beer for computer in the US The slope of German PPF 1 opp cost of 1 computer MRT of beer to computer in Germany beer beer Germany U S 5 5 0 computers 10 0 5 computers 16 Which country has absolute advantage in production of what Neither has absolute advantage in production of beer US has absolute advantage in production of computers 17 Based on the theory of absolute advantage who export what No trade Because US can export computers but US does not want German beer 18 Which country has comparative advantage in what Opp cost of Opp cost of 1 beer 1 computer US 2 computers 0 5 beer Germa ny 1 computer 1 beer 19 Notes The opportunity cost of computer slope of PPF The opportunity cost of Beer inverse of the slope of PPF This is always true 20 Which country has comparative advantage in what US has comparative advantage in production of computers Germany has comparative advantage in production of beer This means that the US must trade computers for beer with Germany 21 choose a combination of computers and beer from the PPF Label this point on your graph As point B PPFs beer U S 5 B Pre trade consump tion productio n 2 5 beer Germany 5 B 2 computers 0 5 4 5 10 Pre trade consumpt ion and productio n 0 3 5 computers 22 Pre trade best points were picked arbitrarily US best point represents 5 units of Computers and 2 5 bottles of Beer Germany s best point represents 3 units of Computers and 2 bottles of Beer 23 Who should specialize in production of what Since the US has comparative advantage in production of computers it must specialize in production of computers Produce 10 Computers and 0 Beers Since Germany has comparative advantage in production of beer it must specialize in production of beer Produce 0 Computers and 5 Beers Note partial specialization is also possible 24 Production points after trade are points P P beer Posttrade productio n U S 5 beer Germany Posttrade productio n P 5 B 2 5 B 2 P computers 0 5 4 5 10 0 3 5 computers 25 Determination of the range of the mutually beneficial terms of trade The terms of the trade must be acceptable to both countries An acceptable term of trade is a price less than domestic opportunity cost The opportunity cost of producing 1 beer in the US is 2 computers Or the opportunity cost of 2 computers is 1 beer Therefore US will only trade 2 computers for more than 1 beer That is the US would …