Eco 13.2 Free trade: absolute and comparative advantage (higher level topic)

why Specialisation according to comparative advantage may not allow necessary structural changes to occur in an economy.

if countries specialise according to their comparative advantage would have to go on producing and exporting according to that same advantage this would not permit the necessary structural changes to take place in the economy agricultural sector becoming less important, and manufacturing and services becoming more important

theory of absolute advantage

if countries specialise in and export the good in which they have an absolute advantage (can produce with fewer resources), the result is increased production and consumption in each country.

PPC curve of country w/absolute advantage in the production of both goods

its PPC lies entirely above the PPC of the other country

why Trade on the basis of comparative advantage may lead to excessive specialisation 2

may lead to too much specialisation, which may make countries vulnerable if they become too dependent on factors beyond their control. eg global recession primary products (including agricultural products) are subject to strong price fluctuations, which lead to unstable export revenues, also with negative impacts on the economy

how to calculate opportunity cost

opportunity cost of cotton = Q of microchips that must be sacrificed to produce an extra unit of cotton divide the maximum number of microchips that can be produced by the maximum amount of cotton in the same country

sources of comparative advantage 3

specialisation and trade because of differences in - factor endowments (quantities and quality FOP) -levels of technology -climate eg coffee production

Absolute advantage

the ability of one country to produce a good using fewer resources than another country

Free trade

the absence of government intervention of any kind in international trade, so that trade takes place without any restrictions (or barriers) between individuals or firms in different countries

If the PPCs do not intersect

the country with the PPC lying fully above the second PPC has an absolute advantage in the production of both goods

comparative advantage in the good measured along the vertical axis

the country with the steeper PPC

oppourtunity cost

the next best alternative that must be sacrificed in order to obtain something else

Comparative advantage

the situation where one country has a lower opportunity cost (relative cost) in the production of a good than another country.

free trade assumptions

theories of absolute and comparative advantage, which offer explanations for the principle that countries can gain through specialisation and trade

parallel PPC comparative advantage

two countries face identical opportunity costs for the two goods no country in which one good is relatively cheaper therefore, there is no country that has a comparative advantage no possibilities for countries to gain from specialisation and trade no point in these countries specialising and trading with each other

If the PPCs intersect

each country has an absolute advantage in one of the two goods

no trade impact on PPC with 2 countries 2 products

each country produces both robots and coffee, as this is the only way they can consume both

real-world relevance of the theory of comparative advantage

forms the basis of trade policies in many countries justification of the major policy trend since the early 1990s around the world toward trade liberalisation involving the freeing up of trade through the gradual removal of trade restrictions

comparative advantage key conclusion

free trade increases global production and consumption leading to an improved global allocation of resources

theory (or law) of comparative advantage explained

global allocation of resources improves resulting in greater global output and greater global consumption allowing countries to consume outside their PPC.

use of production possibilities curves (PPCs)

if comparing 2 economies and 2 products the country whose PPC extends the furthest on the axis of a certain product has an absolute advantage in that product

comparative advantage and oppourtunity cost relationsip

A country has a comparative advantage in the production of the good that has a lower opportunity cost (lower relative cost).

how consumption is at a point outside their PPC

Both countries become better off because specialisation according to absolute advantage leads to a 'global' reallocation of resources where production takes place by the most efficient (lowcost) producers.

Using data to draw comparative advantage diagrams

Country X has an absolute advantage in the production of both good a and good b, because with the same resources (one worker in one day) it can produce more of both goods than Country Y

comparative advantage assumptions

Factors of production are immobile and fixed - can move between countries technology is fixed - new tech always There is perfect competition - rarely full employment of all resources - countries producing on PPC, esp not developing Imports and exports balance each other - deficit, payment problems free trade - influences inequalties of imports/exports transportation costs - impact prices limit benefits

theory (or law) of comparative advantage

as long as opportunity costs in two (or more) countries differ it is possible for all countries to gain from specialisation and trade according to their comparative advantage

Absolute advantage explained

a country has an absolute advantage in a good if with the same quantity of resources it can produce more of the good than another country.

autarky

absence of trade

Absolute advantage as a special case of comparative advantage

according to comparative advantage countries gain from specialisation and trade as long as they have different relative costs of production, regardless of whether or not one country has an absolute advantage in the production of all the goods. so absolute advantage is simply a special case that is included in the theory of comparative advantage. absolute advantage does not affect the conclusions of the theory of comparative advantage.

Production and consumption with trade on PPC with 2 countries 2 products

both countries are producing on their PPC due to trade they can consume at a point outside their PPC

comparative advantage criticisms 3

depends on many unrealistic assumptions Specialisation according to comparative advantage may not allow necessary structural changes to occur in an economy Trade on the basis of comparative advantage may lead to excessive specialisation

If the PPCs do not intersect how is comparative advantage determined

country w/the flatter PPC has a comparative advantage in the good measured on the horizontal axis