Comparative Advantage and International Trade

This presentation will take you through description of global

trade pattern (with special emphasis on the U.S.) and

explain the principle of comparative advantage

An index of openness

100

GDP

MX

This is a simple

measure of the relative

importance of the foreign

sector

Let

•O denote the index of openness

•X is exports

•M is imports

•GDP is gross domestic product

Thus, we have:

8

12

16

20

24

28

70 75 80 85 90 95 00

Imports + Exports as a Percent of U.S. GDP, 1969-2000

per

cen

t

Imports and Exports of the U.S., Chained 2000 Dollars

0

200

400

600

800

1000

1200

1400

1600

1800

20001

97

8

19

79

19

81

19

83

19

85

19

86

19

88

19

90

19

92

19

93

19

95

19

97

19

99

20

00

20

02

20

04

Year

Exports

Imports

Source: www.bls.gov

U.S. Balance of Trade in Merchandise and Services

U.S. Exports by Category, 2005

6%

26%

40%

11%

13%4%

Foods, Feeds, & Beverages

Industrial Supplies (2)

Capital Goods

Automotive Vehicles, etc.

Consumer Goods

Other Goods

Source: Bureau of Economic Analysis

U.S. Imports by Category, 2005

4%

30%

22%

16%

25%

3%

Foods, Feeds, & Beverages

Industrial Supplies (2)

Capital Goods

Automotive Vehicles, etc.

Consumer Goods

Other Goods

Source: Bureau of Economic Analysis

Top Exporting Countries, 2002

Source: World Trade Organization

U.S.

Germany

Japan

France

China

U.K.

Canada

Italy

Netherlands

Belgium

Billions of U.S. Dollars

800700600500400300200100

213

243

252

253

276

326

330

416

612

694

Country

Current Account (billions of U.S.

dollars) Australia -43.1 Britain -23.5 Canada 16.3

France -25.9

Germany 110.4

Japan 163.7

Netherlands 28.3

Sweden 27.9 U.S. -749.7

Source: The Economist

Current Account balance of selected nations, September 2004 to September 2005

Why do countries trade?

•Nations differ in endowments of natural, capital, and human resources.

Example: Japan is poorly endowed in timber, petroleum, and metal ores—but well endowed in human and capital resources.

•International trade is (in theory, at least) based on mutually beneficial specialization among trading partners according to the principle of comparative advantage.

Pharmaceuticals Digital WatchesUnited States 4 per hour 1 per hourJapan 2 per hour .8 per hour

Labor Productivity in the U.S. and Japan

•On average a U.S. worker can manufacture 4 bottles of pharmaceuticals per hour.

•On average a U.S. worker can manufacture 1 digital watch per hour.

•On average a Japanese worker can manufacture 2 bottles of pharmaceuticals per hour.

•On average a Japanese worker can manufacture 0.8 digital watches per hour.

Thus labor productivity is higher in both activities in the U.S.

A nation is said to have a comparative advantage in the production of a good or service if it can produce that good or service a lower opportunity cost than any other nation

Pharmaceuticals Digital WatchesPer Bottle Per Watch

United States 1/4 watch 4 bottlesJapan 2/5 watch 2.5 bottles

The U.S. has the comparative advantage in pharmaceuticals since it must only sacrifice ¼ watch for every bottle in produces; whereas Japan must sacrifice 2/5 of a watch per bottle.

Japan has the comparative advantage in watches since it must sacrifice 2.5 bottles of pharmaceuticals per watch made; whereas the U.S. must sacrifice 4 bottles per watch.

Opportunity cost in the U.S. and Japan

Pharmaceuticals Digital WatchesUnited States $3.75 per bottle $15 per watchJapan $5.00 per bottle $12.50 per watch

(500 yen) (1,250 yen)

Costs of Production in the U.S. and Japan

Assume that the hourly wage in the U.S. in both sectors is $15.00. Hence the labor cost per bottle of pharmaceuticals produced is $15.00/4 bottles = $3.75 per bottle.The labor cost per digital watch is $15.00/1 watch = $15.00 per watch.

Assume the hourly wage in Japan (both sectors) is 1,000 yen, then production costs in yen are given by: For pharmaceuticals: 1,000 yen/2 bottles = 500 yen per bottle; For digital watches: 1,000 yen/.8 watches = 1,250 yen per watch.

If the exchange rate is $1 = 100 yen, then Japanese production costs in dollars convert to the numbers in the table above

The comparison of relative costs of production explains

why Japan exports digital watches to the U.S. and the

U.S. exports pharmaceuticals to Japan.

Moral of the Story