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interantional economics 5th by gerber ch03

Chapter 3
Comparative
Advantage
and the Gains
from Trade

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Introduction: The Gains from Trade

• The improvement in national welfare is
known as the gains from trade

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Adam Smith
• 1776, Adam Smith published An Inquiry into the Nature

and Causes of the Wealth of Nations
– Attacked mercantilism—it dominated economic thought
in the 1700s
– Proved wrong that trade was a zero sum game
• that the gain of one nation from trade was the loss of another

– Voluntary exchange (trade) is a positive sum game —
both nations gain

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Implications of Adam Smith’s Theory
• Specialization is important
• Key to wealth creation is access to international
markets
– Imports enable a country to obtain goods that it
cannot make itself or can make only at very
high costs

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Adam Smith and Trade Barriers
• Highly critical of trade barriers
• Trade barriers decrease
- Specialization
- Technological progress
- Wealth creation
• Widely accepted by modern economists

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A Simple Model of Production
and Trade
• Referred to as the Ricardian model, named after
economist David Ricardo
• Assumptions
– Markets are competitive: Firms are price takers
– Static world: Technology is constant and there
are no learning effects
– Labor is perfectly mobile: It can easily move
back and forth between industries
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Absolute Productivity Advantage
and the Gains from Trade
– Productivity: The amount of output obtained
from a unit of input
– Labor productivity:
(units of output) / (hours worked)
– Absolute productivity advantage: Country
that produces more of a certain good per hour
worked

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TABLE 3.1 Output per Hour Worked

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Absolute and Comparative
Productivity Advantage Contrasted
• Benefits from trade have nothing to do with
country’s absolute advantage.
• Comparative productivity advantage (or
comparative advantage): Country has lower
opportunity costs of producing a good than its
trading partners
• Comparative advantage allows a country that
lacks absolute advantage to sell its products
abroad
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Production Possibilities Curve (PPC)

• A production possibilities curve (PPC)
shows the tradeoffs a country faces when
choosing between two goods

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The Price Line or Trade Line

• Autarky: The complete absence of trade; all nations
can only consume the goods they produce at home

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Case Study – Comparative Advantage in
Single Natural Resource
– Comparative advantage in crude largely
depends on endowment
– Oil is valuable resource, so develop oil industry
– Becomes difficult to develop other economic
activities
– Only Saudi Arabia, Kuwait and United Arab
Emirates (UAE) are high income

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Case Study – Comparative Advantage in
Single Natural Resource
– Resource Curse: negative economic effects
when country has single, valuable resource
– Difficult to develop diversified, educated work
force
– National income greatly impacted when price of
dominant commodity changes
– Can lead to political strife

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Table 3.2 Ten Largest Oil Reserves

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Domestic Prices and the Trade
Price
• If trade price is 4 loaves/ton:





Nothing changes for US
Canada will also specialize in steel and trade for bread
Nobody is producing bread
Shortage of bread, surplus of steel: bread price increases
and steel price falls
– World price falls to less than 3.

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TABLE 3.3 Output per Hour Worked

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Table 3.4 Indicators of the Korean Economy

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Changing Comparative Advantage
• Since 1960, real per capita income in Republic of Korea
grew 5.6%
• After Korean War, grew economy by limiting imports
and concentrate on import substitutes.
• In 1960, removed import barriers and promoted export
oriented industries
• Evolved from simple goods and few skills to capital
goods with more skills and capital
• Now high income country capable of exporting
technologically advanced goods
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Changing Comparative Advantage
• Comparative advantage can change and can
increase incomes and product development, but
need:
– Development of education and research
– Organizational changes
– To raise financial capital

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Comparative Advantage and
“Competitiveness”
• Comparative advantage = competitive advantage
when the prices of both inputs and outputs are an
accurate indication of their relative scarcity
• Comparative advantage ≠ competitive advantage
when the markets fail to correctly value the price of
inputs and outputs
-Imbalances result from government policies,
such as subsidies or protection
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Economic Restructuring
• Economic restructuring: Changes in the economy
that may require some industries to grow and others
to shrink or disappear
– Often due to increased foreign competition
– If there’s a net gain from trade, economic gains
from winners exceed losses of losers
– Increased foreign competition can create new
problems

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Economic Restructuring
• Government can pass policies to make adjustment
less painful
– Increases support for free trade
– Trade adjustment assistance (TAA) Provides
extended unemployment benefits, and worker
retraining

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Table 3.5 Low-Cost and High-Cost Cotton Producers

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Table 3.5 (continued) Low-Cost and High-Cost Cotton
Producers

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