Chapter 1 appendixComparative Advantage

Management 3460 Institutions and Practices in

International Finance

Fall 2003Greg Flanagan

2

Comparative Advantage

Production and Trade Possibilities Curves

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Comparative advantageDiffering opportunity costs

consumption possibilities through trade are greater than a country’s production possibilities.

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Production & Trade Possibilities Curves

Quantity of milk

(Opp cost = 1)

Quantity of bread (Opp cost = 1)

30

PPC

30|Slope| = 1

Country A

|Slope| = 2 The PPC slope for Country B

60

Produce bread and trade for milk0< Terms of Trade <1

45 Trade Possibilities Curve: |Slope| = 1.5

TPC

5

Production & Trade Possibilities Curves

Quantity of milk

(Opp cost = .5)

Quantity of bread (Opp cost = 2)

Country B

20

|Slope| = 1 The PPC slope for Country A

Produce Milk and trade for bread0< Terms of Trade <1

15

Trade Possibilities Curve: |Slope| = 1.5

TPCPPC

|Slope| = 2

20

10

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Textbook Problem Solutions

1. The opportunity cost of producing food instead of textiles is one yard of textiles per 7/4 = 1.75 pounds of food. A pound of food has an opportunity cost of 4/7 = .57 yards of textiles.

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7Food

Textiles

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Textbook Problems

2. Examination of the no-trade input/output table indicates that Country X has an absolute advantage in the production of food and textiles. Country X can “trade off” one unit of production needed to produce 17 pounds of food for five yards of textiles. Thus, a yard of textiles has an opportunity cost of 17/5 = 3.40 pounds of food, or a pound of food has an opportunity cost of 5/17 = .29 yards of textiles. Analogously, Country Y has an opportunity cost of 5/2 = 2.50 pounds of food per yard of textiles, or 2/5 = .40 yards of textiles per pound of food. In terms of opportunity cost, it is clear that Country X is relatively more efficient in producing food and Country Y is relatively more efficient in producing textiles. Thus, Country X (Y) has a comparative advantage in producing food (textile) is comparison to Country Y (X).

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Textbook Problems

2. When there are no restrictions or impediments to free trade the economic-well being of the citizens of both countries is enhanced through trade. Suppose that Country X shifts 20M units from the production of textiles to the production of food where it has a comparative advantage and that Country Y shifts 60M units from the production of food to the production of textiles where it has a comparative advantage. Total output will now be (90M x 17 =) 1,530M pounds of food and [(20M x 5 =100M) + (90M x 2 =180M) =] 280M yards of textiles. Further suppose that Country X and Country Y agree on a price of 3.00 pounds of food for one yard of textiles, and that Country X sells Country Y 330M pounds of food for 110M yards of textiles. Under free trade, the following table shows that the citizens of Country X (Y) have increased their consumption of food by 10M (30M) pounds and textiles by 10M (10M) yards.

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Production & Trade Possibilities Curves

Food (..29)

Textiles (3.4)

Country X

6.8

|Slope| = 2.5 The PPC slope for Country X

Produce Food and trade for Textiles0< Terms of Trade <1

Trade Possibilities Curve: 2.5 < |Slope| < 3.4i.e. 3

TPCPPC

|Slope| = 3.4

17

5

10

Production & Trade Possibilities Curves

Food(.4)

Textiles (2.5)

2

PPC

5|Slope| = 2.5

Country Y

|Slope| = 3.4 The PPC slope for Country X

6.8

Produce textiles and trade for food0< Terms of Trade <1

Trade Possibilities Curve: 2.5 < |Slope| < 3.4i.e. 3

TPC