Foundations of Modern Trade Theory:

Comparative Advantage

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PowerPoint slides prepared by:Andreea ChiritescuEastern Illinois University

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Absolute advantage; each nation is more efficient in producing one goodTABLE 2.1

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Examples of comparative advantages in international tradeTABLE 2.2

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Comparative advantage, U.S. -absolute advantage in producing both goodsTABLE 2.3

With constant opportunity costs, a nation will specialize in the product of its comparative advantage. The principle of comparative advantage implies that with specialization and free trade, a nation enjoys production gains and consumption gains. A nation’s trade triangle denotes its exports, imports, and terms of trade. In a two nation, two product world, the trade triangle of one nation equals that of the other nation; one nation’s exports equal the other nation’s imports, and there is one equilibrium terms of trade.© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use‐ 5

Trading under constant opportunity costsFIGURE 2.1

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Gains from specialization & trade: constant opportunity costsTABLE 2.4

The supply-side analysis of Ricardo describes the outer limits within which the equilibrium terms of trade must fall. The domestic cost ratios set the outer limits for the equilibrium terms of trade. Mutually beneficial trade for both nations occurs if the equilibrium terms of trade lies between the two nations’ domestic cost ratios. According to the theory of reciprocal demand, the actual exchange ratio at which trade occurs depends on the trading partners’ interacting demands.

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Equilibrium terms-of-trade limitsFIGURE 2.2

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Commodity terms of trade, 2008 (2000 = 100)TABLE 2.5

If productivity in the Japanese computer industry grows faster than it does in the U.S. computer industry, the opportunity cost of each computer produced in the United States increases relative to the opportunity cost of the Japanese. For the United States, comparative advantage shifts from computers to autos.

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Changing comparative advantageFIGURE 2.3

Increasing opportunity costs lead to a production possibilities schedule that is concave, viewed from the diagram’s origin. The marginal rate of transformation equals the (absolute) slope of the production possibilities schedule at a particular point along the schedule.

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Production possibilities schedule; increasing-cost conditionsFIGURE 2.4

With increasing opportunity costs, comparative product prices in each country are determined by both supply and demand factors. A country tends to partially specialize in the product of its comparative advantage under increasing cost conditions.

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Trading under increasing opportunity costsFIGURE 2.5

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Gains from specialization and trade: increasing opportunity costsTABLE 2.6

Increased international trade tends to neither inhibit overall job creation nor contribute to an increase in the overall rate of unemployment. As seen in the figure, the increase in U.S. imports as a percentage of GDP over the past several decades has not led to any significant trend in the overall unemployment for Americans.

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The impact of trade on jobsFIGURE 2.6

When a large number of goods is produced by two countries, operation of the comparative-advantage principle requires the goods to be ranked by the degree of comparative cost. Each country exports the product(s) in which its comparative advantage is strongest. Each country imports the product(s) in which its comparative advantage is weakest.

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Hypothetical spectrum of comparative advantages, U.S. and JapanFIGURE 2.7

When many countries are involved in international trade, the home country will likely find it advantageous to enter into multilateral trading relations with a number of countries. This figure illustrates the process of multilateral trade for the United States, Japan, and OPEC.

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Multilateral trade: U.S., Japan, and OPECFIGURE 2.8

The figure displays a scatter plot of U.S./Japan export data for 33 industries. It shows a clear negative correlation between relative exports and relative unit labor costs. A rightward movement along the figure’s horizontal axis indicates a rise in U.S. unit labor costs relative to Japanese unit labor costs; this correlates with a decline in U.S. exports relative to Japanese exports, a downward movement along the figure’s vertical axis.

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Relative exports & relative unit labor costs: U.S./Japan, 1990FIGURE 2.9

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U.S. occupations regarded as highly likely to go offshoreTABLE 2.7

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Producing the Boeing 787: how Boeing outsources its workTABLE 2.8