International Trade

Comparative and Absolute Advantage

©2012, TESCCC

International Trade

International trade - voluntary exchange of goods and services between people of different nations

©2012, TESCCC

International Trade

• Trade helps a nation move beyond their Production Possibility Curve or FrontierG

uns

Butter

B

C

A F

©2012, TESCCC

3 Ways to Move Beyond PPF

1. Additional Resources

2. New Technology

3. International Trade

©2012, TESCCC

Billy bakes 10 cakes a day OR

mows 5 lawns

Brenda bakes 9 cakes a dayOR

mows 3 lawns

Absolute Advantage:

The ability to produce more of a given product with given resources than another country.

• Who has the absolute advantage in cake production?

• Who has the absolute advantage in lawn mowing production?

©2012, TESCCC

Billy bakes 10 cakes a day OR

mows 5 lawns

Brenda bakes 9 cakes a dayOR

mows 3 lawns

Absolute Advantage:

The ability to produce more of a given product with given resources than another country.

• Who has the absolute advantage in cake production? Billy - 10 is more than 9

• Who has the absolute advantage in lawn mowing production? Billy - 5 is more than 3

©2012, TESCCC

Billy bakes 10 cakes a day OR

mows 5 lawns

Brenda bakes 9 cakes a dayOR

mows 3 lawns

©2012, TESCCC

COMPARATIVE ADVANTAGEAccording to David Ricardo, whoever can make a product at the lowest opportunity cost should produce it.

To determine who has the lower opportunity cost we need to get our ratio to show for every one item produced what will be given up or what could have been produced using those resources.

Billy bakes 10 cakes a day OR

mows 5 lawns

Brenda bakes 9 cakes a dayOR

mows 3 lawns

©2012, TESCCC

Billy bakes 10 cakes a day

OR

mows 5 lawns

Cakes Lawns Opportunity Cost

10 5

10÷5 5÷5

2 1 To produce 1 lawn, it costs 2 cakes

2÷2 1÷2 1 1/2 To produce 1 cake, the

opportunity cost is 1/2 a lawn

©2012, TESCCC

Brenda bakes 9 cakes a day OR

mows 3 lawns

Cakes Lawns

9 3

9÷3 3÷3

3 1 To produce 1 lawn it costs 3 cakes

3÷3 1÷3

1 1/3 To produce 1 cake it costs 1/3 lawn

©2012, TESCCC

Who has the comparative advantage in cake production?

Who has the comparative advantage in lawn production?

Billy

Cakes Lawns

10 5

2 1

1 1/2

Brenda

Cakes Lawns

9 3

3 1

1 1/3

©2012, TESCCC

Who has the comparative advantage in cakeproduction? Brenda because 1/3 is less than 1/2

Who has the comparative advantage in lawn production? Billy because 2 is less than 3

Billy

Cakes Lawns

10 5

2 1

1 1/2

Brenda

Cakes Lawns

9 3

3 1

1 1/3

©2012, TESCCC

Terms of trade, or trading range

1 lawn mowing for 2-3 cakes

If trade takes place in this range it will be beneficial to both parties.

Billy

Cakes Lawns

10 5

2 1

1 1/2

Brenda

Cakes Lawns

9 3

3 1

1 1/3

©2012, TESCCC

Advantages of trade based on comparative advantage:

1. All countries benefit - obtain more goods than if they produced everything on their own

2. Interdependence between countries is greater, countries no longer produce everything themselves

3. Standard of living increases for all

©2012, TESCCC

012345678910

0 1 2 3 4 5

CAKES

LAWNS

PPF for Billy

When Billy makes 1 more cake, he gives up 1/2 lawn.

©2012, TESCCC

012345

678910

0 1 2 3 4 5

CAKES

LAWNS

PPF for Billy

When Billy mows 1 more lawn, he gives up 2 cakes.

©2012, TESCCC

0

12

3

45

6

7

89

10

0 1 2 3

CAKES

LAWNS

PPF for Brenda

When Brenda bakes 1 more cake, she gives up 1/3 lawn.

©2012, TESCCC

0

1

2

3

45

6

7

8

9

10

0 1 2 3

CAKES

LAWNS

PPF for Brenda

When Brenda mows 1 more lawn, she gives up 3 cakes.

©2012, TESCCC

International TradeIs based onComparative advantage; countries specialize in what they can produce more cheaplySpecializationleads to Economic efficiencyleads to Less Self Sufficiencyleads to Economic InterdependenceSpecialization allows more efficient use of our scarce resources.

©2012, TESCCC