Macroeconomics Chapter 20 International Trade Study Guide I The Economic Basis for Trade Nations trade because it is beneficial Nations differ in Distribution of natural human and capital resources Quality and other attributes of goods Technological expertise efficient production of various goods require different technologies Basically nations differ in the 4 factors of production Land labor capital and entrepreneurship Some countries have more Labor intensive goods products requiring relatively large amounts of labor to produce I e China Has abundant and inexpensive labor Land intensive goods products requiring relatively large amounts of land to produce I e Australia Vast amounts of land and can inexpensively produce beef wool and meat Capital intensive goods products requiring relatively large amounts of capital to produce I e The United States Large amounts of capital and can inexpensively produce goods that require a lot of capital such as airplanes automobiles machinery and chemicals As national economies evolve size quality of labor force capital land and technology may change which will affect the efficiency in which a nation can produce specific goods International trade enables nations to 1 Specialize 2 3 Increase productivity Increase the amount of output available for consumption II Absolute v Comparative Advantage Absolute advantage of a product When a country is the most efficient producer of that product It can produce more output of that product from any given amount of resource inputs than can any other producer Adam Smith 1776 argued that nations would be better off if each specialized in the production of those products in which it had an absolute advantage and therefore the most efficient producer Comparative advantage of a product When a country can produce that product at a lower opportunity cost It can give up producing less output of other products when allocating resources to producing this product David Ricardo early 1800s argued that a nation does not need absolute advantage to benefit from specialization and trade All it needs is comparative advantage aka a lower opportunity cost to produce certain products Example The world consists of only 2 countries the U S and Mexico There are only 2 goods in the world beef and vegetables Both the U S and Mexico can produce both goods But they can produce them at different opportunity costs 30 Vegetables tons 20 Vegetables tons 30 Beef tons United States 10 Beef tons Mexico The graphs above are the production possibilities curves for the U S and Mexico with the blue line representing the opportunity costs to produce vegetables and beef in each country domestically Opportunity cost ratios The U S 1 vegetables 1 beef 1V 1B Mexico 2 vegetables 1 beef 2V 1B Interpretation The U S can produce 1 more ton of Vs by giving up 1 ton of B Mexico can produce 1 more ton of Vs by giving up only ton of B Because Mexico can produce a ton of Vs more cheaply 1 2 ton of B as compared to 1 ton of B it has a comparative advantage in Vs Because the U S would have to give up 1 ton of Vs to produce 1 more ton of B 1 ton of Vs as compared to 2 ton of Vs it has a comparative advantage in B Assumptions of PPC curves 1 Constant opportunity costs hence why the slope is straight instead of a curve 2 Different slopes different costs because the resources in each nation are different and are at different levels In our example the U S has an absolute advantage in both Vs and B not comparative advantage 3 Summary The Principal of Comparative Advantage Total output will be greatest when each good is produced by the nation that has the lowest domestic opportunity cost for producing that good So why doesn t Mexico only produce vegetables and the U S only produce Beef aka why don t they specialize in only those goods 1 Law of increasing opportunity cost As one country begins to specialize in one good the trade off between the two goods changes As that happens it makes more sense for a country to stop the specialization process and produce a little bit of the other good as well 2 World prices of the 2 goods If one good is in higher demand worldwide than the other good then it will be beneficial for both countries to produce that good 3 If there are 2 goods 1 that is easy to trade and one that is not then every country will produce some of each because it is more beneficial A country will not produce only a good that is hard to trade because it is not profitable Terms of trade The rate at which units of one product can be exchanged for units of another product 45 30 Vegetables tons 20 Vegetables tons 30 Beef tons United States 10 15 Beef tons Mexico As a result of specialization and trade the U S and Mexico can have higher levels of output than the levels attainable on their domestic production possibilities curve The red line is called the trading possibilities line which shows the amount of the two products that a nation can obtain by specializing in one product and trading for the other Review Questions Answers at the end 1 The production possibilities curves above imply a Increasing domestic opportunity costs b Decreasing domestic opportunity costs c Constant domestic opportunity costs d First decreasing then increasing domestic opportunity costs 3 There are 2 countries A and B The opportunity cost ratios for shoes S and T shirts T for each 2 One reason why countries don t specialize in only 1 good is because they will eventually run out of resources to produce that good a some goods are not easily tradable b c eventually demand for that good will cease to exist d they will stop making profit from trading that good country are as follows A 1S 3T B 1S 1T Which of the following statements is true a Country A has a comparative advantage in shoes b Country A has an absolute advantage in both shoes and t shirts c Country B has a comparative advantage in t shirts d Country B has a comparative advantage in shoes 4 Nations have comparative advantages of certain goods because they differ in a Technology b Education of its workers c Worker productivity d All of the above 5 Which of the following statements is true a Comparative advantage means that total world output will be greatest when each good is produced by the nation that has the highest domestic opportunity cost of producing it b Comparative advantage means that a nation can gain from trade only if it has a lower labor c Specialization will be complete among nations when opportunity costs increase