1 Comparative Advantage: The Basis of Exchange. 2 Exchange and Supply Basis for exchange Principle of comparative advantage Production possibilities curve

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Comparative Advantage: The Basis of Exchange

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Exchange and Supply

Basis for exchangePrinciple of comparative advantageProduction possibilities curveEconomic efficiency International tradeMultilateral trade agreements

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Basis for Exchange

Why do peoples trade? A difference in the comparative advantage (or

marginal values to be precise) is a precondition for trade to be mutually beneficial.

The exchange benefits the two parties just as much as if there had been a magical, costless increase in goods to the two people.

The following analyses presume costs of transaction are negligible (this assumption will be relaxed later)

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Example 2.1. Basis for exchange

Paul is a house painter whose roof needs replacing. Ron is a roofer whose house needs painting.

Although Paul is a painter, he also knows how to install roofing. Ron, for his part, knows how to paint houses.

Should Paul roof his own house? Should Ron paint his own house?

Paul

Ron

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Example 1 Basis for exchange

Time required by each to complete each type of job:

Ron has an absolute advantage over Paul at both painting and roofing, which means that Ron takes fewer hours to perform each task than Paul does.

Painting Roofing

Paul

300 hrs 400 hrs

Ron 200 hrs 100 hrs

Should Ron do the roofing and painting jobs for both houses?

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Example 1: Basis for exchange

For Paul, the opportunity cost of painting one house = the number of roofing jobs he could do during the same time.

So Paul’s opportunity cost of painting a house is .75 roofing jobs (=300 hrs per painting/400 hrs per roofing).

Opportunity Cost for 1 Painting

Opportunity Cost for 1 Roofing

Paul 0.75 Roofing 1.33 Painting

Ron 2 Roofing 0.5 Painting

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Comparative advantage and opportunity cost

“To have a comparative advantage at a task”

“To have a lower opportunity cost of performing it”

(is the same as)

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Time required by each to complete each type of job:

However, Paul has a comparative advantage over Ron at painting, which means that he is relatively more efficient at painting than Ron is.

Painting Roofing

Paul

300 hrs 400 hrs

Ron 200 hrs 100 hrs

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Paul’s opportunity cost of painting a house is .75 roofing jobs.

Ron’s opportunity cost of painting a house is 2 roofing jobs.

Paul thus has a comparative advantage at painting, because his opportunity cost of painting is lower than Ron’s.

Therefore it makes sense for Paul to do both painting jobs and leave both roofing jobs for Ron.

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Example 1: Basis for exchange

If each person performed both tasks for himself, the total time spent would be 700 hours for Paul and 300 hours for Ron.

In contrast, when each specializes in his comparative advantage, these totals fall to 600 for Paul (300 hrs x 2 houses) and 200 for Ron (100hrs x 2 houses), a savings of 100 hours each. This is the gain from exchange.

Painting Roofing

Paul

300 hrs 400 hrs

Ron 200 hrs 100 hrs

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Principle of Comparative Advantage

Everyone does best when each person (or country) concentrates on the activities in which he or she is relatively most efficient.

“Concentrates on the activities in which he or she is relatively most efficient” means specialization.

Specialization by comparative advantage provides the rationale for market exchange.

By performing only those tasks at which we are relatively most efficient, we can produce vastly more than if we each tried to be self-sufficient.

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Sources of Comparative Advantage

Individual Level Inborn talentEducationTrainingExperience

Non-economicAdoption of a language Institutions

National LevelNatural

resourcesCultural Institutions

What can we do to change our comparative advantage?

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The Production Possibilities Curve

A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.

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Production Possibilities Curve: One-person economy

Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food.

If Chris is the only person in the economy, describe the economy's production possibilities curve.

Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120

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Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120

Production Possibilities Curve:All combinations of shelter and food that can be produced with Chris’s labor.The absolute value of

the slope of the production possibility curve is 6/12 = 1/2. For Chris, this means that the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.

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Shelter (sq yd/wk)

Food (lb/wk)

6

4

2

4 8 120E

C

D

F

A

B

A, B, C, DAttainable and efficientE Attainable but inefficient

F Unattainable

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Production Possibilities Curve: Two-person economy

Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Dana is the only person in the economy, describe the economy's production possibilities curve.

For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter.

Food (lb/wk)

Shelter (sq yd/wk)Production Possibilities Curve:All combinations of shelter and food that can be produced with Dana’s labor.

4

4

2

2

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For Chris, the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.

For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter.

Thus, Chris has a comparative advantage in producing food, while Dana has a comparative advantage producing shelter.

To maximize an economy output, let Chris specialize in producing food, while Dana in producing shelter.

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To derive the economy's production possibilities curve, let Chris specialize in producing food until his full capacity is reached (i.e. 12 lb/wk of food). Then, let Dana produce food after that point. Similarly, Let Dana produce shelter first until her full capacity is reached (i.e. 4 sq yd/wk of shelter). Then, let Chris produce shelter after that point.

Food (lb/wk)

Shelter (sq yd/wk)

2020


Food (lb/wk)

Shelter (sq yd/wk)

12 16

4

6

8

10

Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food.

Dana and Chris, a married couple, have decided to consume, jointly, 6 sq yd/wk of shelter and 8 lb/wk of food. How should they divide the task of producing these quantities?

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Food (lb/wk)

Shelter (sq yd/wk)

12 16

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8

10 Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food.

Dana has a comparative advantage in producing shelter, but even if she spends all his time producing shelter, she can make only 4 sq yd/wk.

So Chris will have to produce the additional 2 sq yd/wk for them to achieve the desired 6 sq yd/wk.

Since Chris is capable of producing 6 sq yd/wk of shelter on his own, it will take him only 1/3 of a week to produce 2 sq yd.

This leaves 2/3 of a week for him to produce food, which is exactly how much time he needs to produce the desired 8 lb/wk.

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The Principle of Increasing Opportunity Cost (Also called “The Low-Hanging-Fruit Principle”)

In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs.

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The Production Possibilities Curve for an Economy with Many Workers

Food (lbs/wk)

Clothing(garments/wk)

Produce the initial units of clothing using the resources that are relatively most efficient at clothing production, and only then turn to those that are relatively less efficient at clothing production.

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Economic Growth: An Outward Shift in the Economy’s PPC

Coffee(1000s of lb/day)

Nuts(1000s of lb/day)

Original PPC

New PPC

Factors Shifting the PPC1. Increases in productive resources

(i.e. labor or capital)

2. Improvements in knowledge and technology

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Factors That Shift The Economy’s Production Possibilities Curve

Increasing Productive Resources Investment in new factories and equipment Population growth

Improvements in knowledge and technology Increasing educationGains from specialization

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Factors That Shift The Economy’s Production Possibilities Curve

Why Have Countries Like Nepal Been So Slow to Specialize?Low population density Isolation

Factors that may limit specialization in other countriesLawsCustoms

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Gains from specialization will often be far more spectacular!

Division of labor according to talent and temperament

Learning by doing

Specialized capital equipment

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Adam Smith on specialization:

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Adam Smith on specialization:

“One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations... I have seen a small manufactory of this kind where only ten men were employed... [who] could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day...”

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Too much specialization?

Specialization boosts productivity, but it also entails costs.

Variety is one of the first casualties.

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Comparative Advantage and International Trade

The same logic that leads the individuals in an economy to specialize and exchange goods with one another also leads nations to specialize and trade among themselves.

As with individuals, each trading partner can benefit from exchange, even though one may be more productive than the other in absolute terms.

David Ricardo (1772-1823)


mainland can produce 4,000 lengths of tape/day or Can produce 1,333 cases/day o.c. of 1 case is 3 lengths of tape o.c. 1 length of tape is 0.333 case

Taiwan can produce 1,333 lengths of tape/day or can produce 4,000 cases/day o.c. of 1 case is 0.333 lengths oc. of 1 length of tape is 3 cases

Opportunity cost of

One length of tape

one case

mainland 1/3 cases 3 length of tape

Taiwan 3 cases 1/3 length of tape


1 2 3 4 Tape (thousands of lengths per hour)

1

2

3

5

4C

ases

(th

ousa

nds

per

hou

r)

Taiwan’sPPF

1mainland’sPPF


1 2 3 4 Tape (thousands of lengths per hour)

1

2

3

5

4

Cas

es (

thou

sand

s pe

r ho

ur)

Taiwan’sPPF

1mainland’sPPF

4 b'

b

c

a

Taiwan’s opportunity cost:1 tape costs 3 cases, and 1 case costs 1/3 tape

mainland’s opportunity cost:1 tape costs 1/3 case, and 1 case costs 3 tape

Trade line

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Each country now affords a greater bundle of tape and cases that is unavailable without international trade.

The mainland gains from it even though it is a technologically less developed country (note the former’s population size!)

Taiwan gains from it even though it is a technologically more developed country!

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Economic Naturalist

If trade between nations is so beneficial, why are free-trade agreements so controversial?

Three reasons:There are losers and gainers from free trade.There are theories that suggest less freer

trade is better for a country (infant industry argument, increasing returns to scale, etc.)

World trade system is not fair

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Is free trade necessarily good?

Developed countries underwent a stage of protectionism before they began to embrace freer trade

Documented in Chang Ha-Joon (2002), Kicking Away the Ladder: Development Strategy in Historical Perspective

This history is not honestly told to developing countries An infant industry needs protection before maturing

enough to compete with foreign firms (infant industry argument)

Counterargument: under protection, the industry never gets mature because of private interest lobbying!

Remedy: same tariff rate across the board

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External Economies suggest that some government protection may be good

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Evolution of world trade system: GATT

International Trade Organization (ITO) failed to be established.

Post WWII trade negotiations took place under the auspices of General Agreement on Tariffs and Trade (GATT), established on a provisional basis as a draft charter of ITO, on Tariffs and Trade).

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Earlier Rounds

Developing countries played only a small role in the first seven rounds of trade negotiations

Article XVIII in GATT allows them to “implement programmes and policies of economic development designed to raise the general standard of living of their people, to take protective or other measures affecting imports.”

Developed countries were far more interested in each others’ market than in those of developing countries

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Kennedy Round (63-67)

The initial creation of the European Common Market in the late 1050s was one of the key motivations for the American initiative to launch the Kennedy Round in the early 1960s.

The US wanted to reduce the newly created discrimination against American exports.

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Tokyo Round (1973-79)

The extension of its discrimination in important new markets, was an important factor in the American decision to insist on the Tokyo Round in the 1970s.

As a result, the word trade system was tailored to the interests of the developed countries.

Protection was progressively reduced on the goods of export interest to developed countries, but remained on goods exported intensively by developing countries.

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Outcome

The GATT came to cover trade in all goods except agriculture and textiles.

Textiles were covered by the Multifiber Arrangement (MFA), through which developing countries had quotas on the amount of textiles they could export to developed countries.

Developed countries didn’t impose any restrictions on textile imports from other developed countries.

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Unfair trade

“When they [the developed countries] do not discriminate against those countries [the developing countries] in the form proscribed by the most-favored-nation principle,… their policies are in effect discriminatory in that the most serious barriers are erected in goods which the less developed countries typically have a comparative advantage in producing —agricultural commodities in raw or processed form, and labor-intensive, technologically unsophisticated consumer goods” (Johnson 1967)

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Uruguay Round (86-94)

The round started in 1986 and ended in 1993.Expanding service tradetrade-related aspects of intellectual property

rights (TRIPs)trade-related investment measures (TRIMs).Dispute settlement schemeTo form WTO

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Outcome

Many of the new obligations imposed significant burdens on developing countries.

“the developing countries took bound commitments to implement in exchange for unbound commitments of assistance”

It is estimated that the vast majority of the gains from the Uruguary Round accrue to developed countries, with most of the rest going to a relatively few large export-oriented developing countries.

Some estimates report that the 48 least developed countries are actually losing a total of US$600M a year as a result of the Uruguay Round.

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Outcome

After the implementation of Uruguay Round commitments, the average OECD tariff on imports from developing countries is four times higher than on imports originating in the OECD.

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Doha Round

Seattle Round: started and ended on November 30, 1999.

Doha Round: started in Nov 2001The developed countries promised to make

the talks a “development round”; to redress the imbalances of previous rounds.

Cancun, 2003Hong Kong, 2005Basically dead

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Agriculture Subsidies

“The aggregate agriculture subsidies of the US, EU, and Japan (including hidden subsidies, such as water), if they do not actually exceed the total income of sub-Saharan Africa, amount to at least 75% of that region’s income.” (Stiglitz, MGW, p.85)

“The US is the world’s largest cotton exporter, Some 25,000 very rich cotton farmers get to divide $3 billion to $4billion in subsidies” (Stiglitz MGW, p.85)

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Sub-Sahara Africa isn’t tiny!

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Service Trade

The Uruguay Round expanded trade negotiations into the area of services.

It covered liberalization in services such as banking, insurance, and information technology, while leaving unskilled services, such as shipping and construction, off the agenda.

The US, and some other 40 countries, have laws requiring the use of local ships for transporting goods domestically.

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Service Trade

The Jones Act of 1920 requires not only the ships be owned by Americans but that they be built in American shipyards and manned by Americans.

It was estimated that as far as 1986, the Jones Act cost the America US$250,000 for every job in the shipping industry it saved.

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Nontariff Barriers: Safeguards

Safeguards—temporary tariffs that are supposed to help a country adjust as it faces an unanticipated large increase in the level of imports, a “surge.”a real increase in imports (an absolute

increase), oran increase in the imports’ share of a

shrinking market, even if the import quantity has not increased (relative increase).

Safeguards are usually seen as responses to fair trade behavior, as opposed to responses to unfair trade practices such as dumping or subsidy

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Supposed to be used only in very specific circumstances, with compensation (or accepting retaliation from exporting countries), and on a universal basis, i.e. a member restricting imports for safeguard purposes will have to restrict imports from all other countries.

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A safeguard measure should not last more than four years, extendable up to eight years. Measures imposed for more than a year must be progressively liberalized.

The exporting country, in absence of compensation, has to wait for three years after the measure was introduced before it can retaliate— e.g., if it is taken as a result of an increase in the quantity of imports from the exporting country.

Exceptions to this non-discriminatory rule are provided for in the Agreement on Safeguards itself as well as in some ad hoc agreements. In this last respect it is worthwhile noting that China has accepted that discriminatory safeguards may be imposed on its exports to other WTO members until 2013.

Documents

1 Comparative Advantage: The Basis of Exchange. 2 Exchange and Supply Basis for exchange Principle of comparative advantage Production possibilities curve