Comparative Advantage Essay Example

pound (LC = 1).

The text emphasizes that labor is the exclusive factor of production and highlights the production of two specific goods: wine and cheese. It acknowledges that the labor supply in each country is fixed, as well as the productivity of labor for each good. Furthermore, it mentions that perfect competition prevails in all markets. The total resources of the economy are represented by L, which signifies the overall labor supply.

The PPF (Production Possibility Frontier) showcases the maximum amount of wine that can be produced compared to cheese, and vice versa. In our economy, the PPF equation is aLCQC + aLWQW = L (2-1) L/aLW P. The absolute value of the slope in this equation signifies the opportunity cost of cheese in terms of wine.

The quantities produced for each good rely on their respective prices. The relative price of cheese relative to wine is determined by how much wine can be obtained per unit of cheese. For example, if a can of Coke costs $0.5 and a chocolate bar costs $1, then the relative price of Coke would be 0.5, indicating that half a chocolate bar can be acquired with one can of Coke. Similarly, the relative price of a chocolate bar in terms of Coke would be 2 cans per bar.

To represent these prices numerically, let PC represent the dollar price of cheese and PW represent the dollar price of wine.

The wine industry represents the dollar wage as wW, while the cheese industry represents it as wC. According to perfect competition conditions, the non-negative profit condition can be summarized as follows:
- If PW/aW < wW, there will be no production of QW. -

If PW/aW = wW, there will be production of QW.
- If PC/aC < wC, there will be no production of QC. - If PC/aC = wC, there will be production of QC. Based on these relations, if the relative price of cheese (PC/PW) is higher than its opportunity cost (aLC/aLW), then the economy specializes in cheese production. The assumptions for trade in a one-factor world model include: - Two countries: Home and Foreign. - Each country produces wine and cheese. - Labor is the only factor of production. - Fixed labor supply in each country. - Fixed labor productivity in each good. - No labor movement between countries. - Perfect competition exists in all markets. In trade absence, both goods are produced with PC/PW = aLC/an LW. Absolute Advantage in Trade occurs when a country has lower unit labor requirement for a good compared to another foreign country.The concept of comparative advantage in trade states that a country has an advantage in producing a specific good if its opportunity cost, which is determined by the ratio of unit labor requirements for different goods, is lower than that of another country.

It is assumed that aLC < a and LC and aLW < a and LW. This assumption indicates that Home has an absolute advantage in producing both goods. Another way to understand this is to note that Home is more productive than Foreign in producing both goods. Despite Home having an absolute advantage in both goods, beneficial trade is still possible.

• It is assumed that aLC /aLW < an LC /aLW (2-2). This assumption implies that the opportunity cost of cheese in terms of wine is lower in Home than in Foreign. In other words, without

trade, the relative price of cheese at home is lower compared to the relative price of cheese at Foreign.

The concept of comparative advantage will determine the trade pattern. Home has a comparative advantage in cheese and will export it to Foreign in exchange for wine.

Trade-in a One-Factor World Foreign’s Production Possibility Frontier Foreign wine production, QW, in gallons Trade in a One-Factor World Determining the Relative Price After Trade

• What determines the relative price (e.g., PC/PW) after trade?

To answer this question we have to define the relative supply and relative demand for cheese in the world as a whole. The relative supply of cheese equals the total quantity of cheese supplied by both countries at each given relative price divided by the total quantity of wine supplied, (QC + QC)/(QW + QW). The relative demand for cheese in the world is a similar concept.

Slide 2-17 Copyright © 2003 Pearson Education, L/aLW F +1 P L/aLC Foreign cheese production, QC, in pounds Trade in a One-Factor World: World Relative Supply and Demand Relative price of cheese, PC/PW a LC/a LW Trade in a One-Factor World § The Gains from Trade If countries specialize according to their RS 1 aLC/aLW 2 RD' Q' L/aLC L/aLW RD comparative advantage, they all gain from this specialization and trade.

The text discusses two ways to illustrate the gains from trade. The first approach considers trade as a new technology for producing goods and services, quantifying the benefits by comparing quantities like Q/. The second perspective explores how trade expands consumption possibilities in both countries, represented by quantities of wine (QT, QF) and cheese (QT, QF). However,

due to technical differences between countries, wages are not equalized through trade in goods.When countries engage in international trade, it increases their potential consumption levels. This is because trade allows them to access a variety of goods, such as wine and cheese. To understand the impact of trade on consumption, we analyze the quantities of wine and cheese for both domestic (D) and foreign (F) markets. The consumption possibility frontier represents the maximum level of consumption a country can achieve for one good given any quantity of another good. However, due to technical differences between nations, wage equalization through trading goods is not feasible.

• A country with an absolute advantage in both goods will have a higher wage after the trade.
• Myth 1: Free trade is only beneficial if a country can withstand foreign competition. – This argument ignores that trade is based on comparative advantage, not absolute advantage. The Pauper Labor Argument
• Myth 2: Foreign competition is unfair and harms other countries when based on low wages.

Again in our example, Foreign have lower wages but still benefits from trade. Exploitation Comparative Advantage with Many Goods Determination of Relative Wages Relative wage Rate, w/w Apples 10 8 Bananas RS

• Myth 3: Trade makes workers worse off in countries with lower wages.

In the absence of trade, these workers would be worse off. Denying the opportunity to export is equivalent to condemning poor people to remain poor. 4 3 2 0.

75 Caviar Dates Enchiladas RD Relative quantity

of labor, L/L We examined the Ricardian model, the simplest model that shows how differences between countries give rise to trade and gains from trade. In this model, labor is the only factor of production and countries differ only in the productivity of labor in different industries. In the Ricardian model, a country will export that commodity in which it has comparative (as opposed to absolute) labor productivity advantage.

Summary

The fact that trade benefits a country can be shown in either of two ways: Summary Extending the one-factor, two-good model to a world of many commodities makes it possible to illustrate that transportation costs can give rise to the existence of nontraded goods. The basic prediction of the Ricardian model-that countries will tend to export goods in which they have relatively high productivity- has been confirmed by a number of studies. Slide 2- 30

• We can think of trade as an indirect method of production.
• We can show that trade enlarges a country’s consumption possibilities.

The distribution of the gains from trade depends on the relative prices of the goods countries produce.