Question

During the 1950s, the United States imported wool from Great Britain, exporting wheat, while Great Britain imported wheat from the United States, exporting wool. In 1957 Hungarian-American economist Bela Balassa compared the production of wool and wheat in the United States and Great Britain. For both of these products, Balassa found that the United States could produce a larger amount of output than Great Britain. Some American politicians used this result to argue that there was no gain to the United States from continuing to import wool from Great Britain. Were the American politicians correct? Explain whether or not gains from free trade exist when one of the trading countries has the absolute
advantage in producing both goods. Explain why or why not gains from trade would exist in this case and what determines whether gains from trade exist

Answer 1

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Introduction to International Trade:

Reasons for Trade

Countries benefit when they specialize in producing goods for which they have a comparative advantage and engage in trade for other goods.

LEARNING OBJECTIVES

Discuss the reasons that international trade may take place

KEY TAKEAWAYS

Key Points

• International trade is the exchange of capital, goods, and services across international borders or territories.
• Each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.
• Benefits of trade include lower prices and better products for consumers, improved political ties among nations, and efficiency gains for domestic producers.

Key Terms

• comparative advantage: The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.

International trade is the exchange of capital, goods, and services across international borders or territories. Trading-partners reap mutual gains when each nation specializes in goods for which it holds a comparative advantage and then engages in trade for other products. In other words, each nation should produce goods for which its domestic opportunity costs are lower than the domestic opportunity costs of other nations and exchange those goods for products that have higher domestic opportunity costs compared to other nations.

International Trade: Countries benefit from producing goods in which they have comparative advantage and trading them for goods in which other countries have the comparative advantage.

In addition to comparative advantage, other reasons for trade include:

• Differences in factor endowments: Countries have different amounts of land, labor, and capital. Saudi Arabia may have a lot of oil, but perhaps not enough lumber. It will thus have to trade for lumber. Japan may be able to produce technological goods of superior quality, but it may lack many natural resources. It may trade with Indonesia for inputs.
• Gains from specialization: Countries may gain economies of scale from specialization, experiencing long run average cost declines as output increases.
• Political benefits: Countries can leverage trade to forge closer cultural and political bonds. International connections also help promote diplomatic (rather than military) solutions to international problems.
• Efficiency gains: Domestic firms will be forced to become more efficient in order to be competitive in the global market.
• Benefits of increased competition: A greater degree of competition leads to lower prices for consumers, greater responsiveness to consumer wants and needs, and a wider variety of products.

To summarize, international trade benefits mostly all incumbents and generates substantial value for the global economy.

Understanding Production Possibilities

The production possibility frontier shows the combinations of output that could be produced using available inputs.

LEARNING OBJECTIVES

Explain the benefits of trade and exchange using the production possibilities frontier (PPF)

KEY TAKEAWAYS

Key Points

• The production possibilities curve shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.
• Points outside the production possibilities curve are unattainable with existing resources and technology if trade does not occur with an external producer.
• Without trade, each country consumes only what it produces. However, because of specialization and trade, the absolute quantity of goods available for consumption is higher than the quantity that would be available under national economic self-sufficiency.

Key Terms

• Production possibilities frontier: A graph that shows the combinations of two commodities that could be produced using the same total amount of each of the factors of production.
• Autarky: National economic self-sufficiency.

In economics, the production possibility frontier (PPF) is a graph that shows the combinations of two commodities that could be produced using the same total amount of the factors of production. It shows the maximum possible production level of one commodity for any production level of another, given the existing levels of the factors of production and the state of technology.

PPFs are normally drawn as extending outward around the origin, but can also be represented as a straight line. An economy that is operating on the PPF is productively efficient, meaning that it would be impossible to produce more of one good without decreasing the production of the other good. For example, if an economy that produces only guns and butter is operating on the PPF, the production of guns would need to be sacrificed in order to produce more butter. If production is efficient, the economy can choose between combinations (i.e., points) on the PPF: B if guns are of interest, C if more butter is needed, or D if an equal mix of butter and guns is required.

Production Possibilities Frontier: If production is efficient, the economy can choose between combinations on the PPF. Point X, however, is unattaible with existing resources and technology if trade does not occur.

If the economy is operating below the curve, it is operating inefficiently, because resources could be reallocated in order to produce more of one or both goods without decreasing the quantity of either. Points outside the curve are unattainable with existing resources and technology if trade does not occur with an outside producer.

The PPF will shift outwards if more inputs (such as capital or labor ) become available or if technological progress makes it possible to produce more output with the same level of inputs. An outward shift means that more of one or both outputs can be produced without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital.

Without trade, each country consumes only what it produces. In this instance, the production possibilities frontier is also the consumption possibilities frontier. Trade enables consumption outside the production possibility frontier. The world PPF is made up by combining countries’ PPFs. When countries’ autarkic productions are added (when there is no trade), the total quantity of each good produced and consumed is less than the world’s PPF under free trade (when nations specialize according to their comparative advantage). This shows that in a free trade system, the absolute quantity of goods available for consumption is higher than the quantity available under autarky.

Defining Absolute Advantage

A country has an absolute advantage in the production of a good when it can produce it more efficiently than other countries.

LEARNING OBJECTIVES

Relate absolute advantage, productivity, and marginal cost

KEY TAKEAWAYS

Key Points

• A country that has an absolute advantage can produce a good at lower marginal cost.
• A country with an absolute advantage can sell the good for less than the country that does not have the absolute advantage.
• Absolute advantage differs from comparative advantage, which refers to the ability to produce specific goods at a lower opportunity cost.

Key Terms

• Absolute advantage: The capability to produce more of a given product using less of a given resource than a competing entity.

Absolute advantage refers to the ability of a country to produce a good more efficiently than other countries. In other words, a country that has an absolute advantage can produce a good with lower marginal cost (fewer materials, cheaper materials, in less time, with fewer workers, with cheaper workers, etc.). Absolute advantage differs from comparative advantage, which refers to the ability of a country to produce specific goods at a lower opportunity cost.

A country with an absolute advantage can sell the good for less than a country that does not have the absolute advantage. For example, the Canadian economy, which is rich in low cost land, has an absolute advantage in agricultural production relative to some other countries. China and other Asian economies export low-cost manufactured goods, which take advantage of their much lower unit labor costs.

Imagine that Economy A can produce 5 widgets per hour with 3 workers. Economy B can produce 10 widgets per hour with 3 workers. Assuming that the workers of both economies are paid equally, Economy B has an absolute advantage over Economy A in producing widgets per hour. This is because Economy B can produce twice as many widgets as Economy B with the same number of workers.

Absolute Advantage: Party B has an absolute advantage in producing widgets. It can produce more widgets with the same amount of resources than Party A.

If there is no trade, then each country will consume what it produces. Adam Smith said that countries should specialize in the goods and services in which they have an absolute advantage. When countries specialize and trade, they can move beyond their production possibilities frontiers, and are thus able to consume more goods as a result.

Defining Comparative Advantage

A country has a comparative advantage over another when it can produce a good or service at a lower opportunity cost.

LEARNING OBJECTIVES

Analyze the relationship between opportunity cost and comparative advantage

KEY TAKEAWAYS

Key Points

• Even if one country has an absolute advantage in the production of all goods, it can still benefit from trade.
• Countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.
• Specialization according to comparative advantage results in a more efficient allocation of world resources. A larger quantity of outputs becomes available to the trading nations.
• Competitive advantage is distinct from comparative advantage because it has to do with distinguishing attributes which are not necessarily related to a lower opportunity cost.

Key Terms

• Opportunity cost: The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.
• comparative advantage: The ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another.
• competitive advantage: Something that places a company or a person above the competition

Comparative Advantage

In economics, comparative advantage refers to the ability of a party to produce a particular good or service at a lower marginal and opportunity cost over another. Even if one country is more efficient in the production of all goods (has an absolute advantage in all goods) than another, both countries will still gain by trading with each other. More specifically, countries should import goods if the opportunity cost of importing is lower than the cost of producing them locally.

Specialization according to comparative advantage results in a more efficient allocation of world resources. Larger outputs of both products become available to both nations. The outcome of international specialization and trade is equivalent to a nation having more and/or better resources or discovering improved production techniques.

Determining Comparative Advantage

Imagine that there are two nations, Chiplandia and Entertainia, that currently produce their own computer chips and CD players. Chiplandia uses less time to produce both products, while Entertainia uses more time to produce both products. Chiplandia enjoys and absolute advantage, an ability to produce an item with fewer resources. However, the accompanying table shows that Chiplandia has a comparative advantage in computer chip production, while Entertainia has a comparative advantage in the production of CD players. The nations can benefit from specialization and trade, which would make the allocation of resources more efficient across both countries.