Kelly's Econ Blog

Exam Review Blog Posts: Using the principle of comparative advantage, explain why economic theory suggests that countries should specialize and trade with each other.

January 20, 2011 at 3:32 am (Uncategorized)

1) Demands of the question

For this exam, there is an hour in which to answer three questions. Therefore, this should be 20 minutes per question. For this question, you should define comparative advantage and specialization. You should also use an appropriate diagram and explain it briefly. If possible, you should include a real life example, and evaluate the pros and cons of comparative advantage.

 

2) Definition:

A country has a comparative advantage when they can produce a good or service at a lower opportunity cost than another country. If countries specialise where they have acomparative advantage then the level of output and therefore world welfare will be increased.

 

3) Triple A pages

Absolute and comparative advantage

Free trade

International trade is based on specialisation at a national level. Countries exchange goods with others and pay for imports from the revenues received from exporting. To work effectively, this system relies on few, if any, barriers existing to interfere with ‘free trade’.

The basic principle of free trade dates back to mercantilism and fed through to the early exponents of laissez-faire economics in the seventeenth century. Amongst the most famous early writers on economics was Adam Smith, who produced his ideas on absolute advantage. This was where one country concentrated on developing those goods in which its natural resource base allowed it to produce more than any other country with given resources. Later, David Ricardo developed comparative advantage theory which suggested that a country should exchange goods with another country as long as the domestic opportunity costs were different. As a result of this, production should increase and individual consumption should rise. In essence, these two early economic observations still underpin much of what we know about international trade.

Absolute and comparative advantage

Absolute advantage exists when one country is able to produce a good more cheaply in absolute terms than another country.

Comparative advantage exists when one country is able to produce a good more cheaply, in comparison to other goods produced domestically, than another country.

Comparative advantage is a principle of economics which states that trade between two countries will be mutually beneficial as long as their domestic opportunity costs of production differ.

Comparative advantage – example

Stage 1 – opportunity cost ratios

Let’s say that there are two countries – Utopia and Happyland. These countries produce two products – hardware and software. With one unit of their resources they can each produce as shown in Table 1 below.

This means that the opportunity cost ratios for each country are as follows:

Utopia – for every 1 unit of hardware they produce the opportunity cost is 5 units of software.

Happyland – for every 1 unit of hardware they produce the opportunity cost is 15 units of software.

This means that Utopia has a comparative advantage in the production of hardware as for every unit of hardware they produce they give up less software. This makes them relatively more efficient at the production of hardware.

However, this also means that Happyland has a comparative advantage in the production of software as for every unit of software they produce they only give up one fifteenth of a unit of hardware, whereas Utopia have to give up one fifth of a unit.

We can see this clearly if we plot the production possibility frontiers for the two countries.

Figure 1 PPF’s for Happyland and Utopia pre-trade

Let’s say that they choose to use half their resources on the production of each good. In this case, their consumption (pre-trade) will be as shown in table 2 below.

Stage 2 – specialisation

If each country now specialises where they have a comparative advantage, then we will get production as shown in Table 3.

We can see straight away that world production is greater, but each country has now only produced one good and, so once they have specialised, they will want to trade to get some of the other good. The terms of trade (or exchange rate) that they trade at will be determined by the opportunity cost ratios we worked out in stage 1. The terms of trade will settle somewhere between the two opportunity cost ratios to ensure that both countries benefit.

Let’s say they settle on an exchange rate of 1 unit of hardware = 10 units of software and that they agree to trade 75 units of hardware for 750 units of software. The position now will be as shown in table 4.

If we now draw the pre-trade and post-trade PPF’s for each country we can clearly see as in Figure 2 below how they are better off from specialisation and trade as they can now reach higher levels of consumption of both goods than was possible before specialisation.

Figure 2 Production – post specialisation and trade

So, consumption increases through specialisation and trade compared to a situation of self-sufficiency. It remains the basic idea behind modern free trade. Despite these advantages, many countries still protect their domestic trade-why? You therefore need to know both the advantages that arise from free trade and the reasons why protectionism still exists (see section 4.2 for details on protectionism).

Limitations of comparative advantage theory

We need to be careful, as comparative advantage theory does not explain all changes in trade patterns. It is an important explanation, but you also need to take into account that:

• Transport costs and tariffs will change the relative prices of goods and may therefore ‘blur’ the impact of comparative advantage.
• Exchange rates do not always relate exactly to what comparative advantage theory suggests as they have many other determinants – this may also negate the theory.
• Imperfect competition may lead to prices being different to opportunity cost ratios. Imperfect competition may also lead to the exploitation of economies of scale which may adjust to what comparative advantage theory suggests should happen.
• Comparative advantage theory is a static theory and does not take account of some of the more dynamic elements determining world trade. In particular, the factor of production capital is not a natural resource, and so may come outside the scope of the theory.

 

 

4) – Comparative advantage is between two countries

- Comparing the opportunity cost of producing one product over the other

- The country with the lowest opportunity cost should specialize in that product

- The countries should trade with each other to get the other product.

 

5) Powerpoint Lecture

comparitive advantage

6) Diagrams

A diagram showing how one country would have a comparative advantage, for example.

 

Utopia can produce 200 units of hardware for every 1000 units of software. This is 1 hardware for every 5 software, and 1 software for every 1/5 hardware. Happyland can produce 100 units of hardware for every 1500 units of software. This is 1 hardware for every 15 software, and 1 software for every 0.06 of hardware. Therefore, Utopia should produce hardware, and Happyland should produce software, and then they can trade with each other for the other product.

 

 

 

7) Evaluation

You should go over some limitations to this theory. Perhaps, if time permitting, you can talk about pros and cons and the stakeholders involved in employing comparative advantage and specialization.