The concept of opportunity cost and Comparative Advantage
- The opportunity cost of producing something measures the cost of not being able to produce something else.
- A country has a comparative advantage in producing a good if the opportunity cost of producing that good is lower in the country than it is in other countries.
- A country with a comparative advantage in producing a good uses its resources most efficiently when it produces that good compared to producing other goods.
A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in another country
Opportunity cost of producing
- 1 unit of wine is 4 units of cheese
- 1 unit of cheese is 1/4 units of wine.
Opportunity cost of producing
- 1 unit of wine is 1/2 units of cheese
- 1 unit of cheese is 2 units of wine.
The opportunity cost of producing wine in terms of cheese is lower in Portugal than in England (1/2<4), therefore Portugal has a COMPARATIVE ADVANTAGE in the production of wine.
Likewise, the opportunity cost of producing cheese in terms of wine is lower in England than in Portugal (1/4<2) so England has a COMPARATIVE ADVANTAGE in the production of cheese.
Let England and Portugal expand production in the direction of their comparative advantage.
England reduces production of wine by 1 unit freeing 8 hours of labour which go on to produce an additional 4 units of cheese.
Portugal reduces the production of cheese by 1 unit freeing 4 hours of labour which go on to produce an additional 2 units of wine.
Additional CHEESE Additional WINE
ENGLAND +4 -1
PORTUGAL -1 +2
World +3 +1
Without using any additional resources the world output rises just following the simple rule of Comparative Advantage.
Question: If each country specialises in the good in which it has a comparative advantage and exports it in exchange for the other good would both countries be better off? Why?
Answer: Yes if the relative world price is right!!!
Assume that the Relative World Price: One unit of wine sells for one unit of cheese.
With Trade: Gets 1 unit of cheese from England for 1 unit of wine.
Autarky: For 1 unit of wine Portugal could only get ½ unit of cheese.
Result: Better off!!!
With Trade: Gets 1 unit of wine from Portugal for 1 unit of cheese.
Autarky: For 1 unit of cheese England could only get 1/4 unit of wine.
Result: Better off!!!
1. The principle of comparative advantage predicts the pattern of trade and the gains from trade on the basis of relative prices in autarky (opportunity cost).
2. If a country trades at relative prices that differ from its relative autarky prices, then the country will be better off as a result of trading.
Assume that consumers trade at a new relative price that differs from the autarky price → New Equilibrium
A country will export the good which relative price under autarky is smaller than under trade.
The Ricardian Model is based on
*Technological differences (differences in labour productivities) between countries
*Concepts of opportunity cost and comparative advantage.
- A simple example
Unit labour requirement (number of hours) to produce ONE unit of each good:
ENGLAND 2 (hours) 8 (hours)
PORTUGAL 4 (hours) 2 (hours)
England has an ABSOLUTE ADVANTAGE in producing cheese.
Portugal has an ABSOLUTE ADVANTAGE in producing wine.
Countries are different to each other: preferences, culture and institutions, weather, factor endowment (land, capital and labour), technology, distance and transportation costs.
Differences in labor, physical capital, natural resources and technology create productive advantages for countries.
Also economies of scale (larger is more efficient) create productive advantages for countries.
- Countries are linked via trade (goods and services) and capital (international lending and borrowing, foreign direct investment). In the last decade we have observed the emergence of a ‘Global Economy’
- It is a discipline that deals with economic interactions between sovereign (independent) countries. Governments regulate: trade, investment, the movement of capital (and other factors of production) and the supply of currency (exchange rate).
- International Trade (gains from trade, pattern of trade, how much trade, protectionism)
- International Monetary (open economy macroeconomics and policy): balance of payments, exchange rate determination, international capital markets, international policy coordination)
Trade theory helps address many pressing issues:
- Why do countries trade with each other and what determines what is being traded?
- Across countries: do all countries gain from trading or does trade perpetuate global inequalities?
- Within the same country: how does trade affect the distribution of income among different groups?
- In terms of trade policy
– Can we explain why some sectors tend to receive more protection than others?
– Is it best to retaliate against countries that impose unilateral tariffs?
– What are trade blocks? What are the effects on the welfare of their members and the rest of the world?
- Other issues
– Does international trade undermine the protection of the environment?
– Ethical considerations like: is trade fair with poor countries? Does trade foster the exploitation of children in poorer countries?