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International Trade
ECON8069 - Lecture
Trade
Comparative Advantage
Modelling Trade - Exports, Imports, and Intervention
Free Trade - Pros and Cons
Textbook: Chapter 8
(ECON8069) Lecture 12 2 / 26
Comparative Advantage
Absolute Advantage
A situation where one country can produce a good/service at lower
physical cost (labour, capital, etc.) than another country.
Comparative Advantage
A situation where one country can produce a good/service at a lower
opportunity cost than another country.
Important - Every country has Comparative Advantage in something.
(ECON8069) Lecture 12 3 / 26
Comparative Advantage - Example
Assume:
There are only two countries (AUS and FOR)
Only two goods are produced (Wheat and Toys)
Constant returns-to-scale within country
Hours needed per unit
Australia Foreign
Wheat (tonnes) 30 60
Toys (1000’s) 5 8
(ECON8069) Lecture 12 4 / 26
Comparative Advantage - Example
Hours needed per unit
Australia Foreign
Wheat (tonnes) 30 60
Toys (1000’s) 5 8
For Australia (without trade):
Opportunity Cost of Wheat is 6 units of Toys
Opportunity Cost of Toys is 1/6 units of Wheat
For Foreign:
Opportunity Cost of Wheat is 7.5 units of Toys
Opportunity Cost of Toys is 2/15 units of Wheat
(ECON8069) Lecture 12 5 / 26
Comparative Advantage - Example
For Australia (without trade):
Opportunity Cost of Wheat is 6 units of Toys
Opportunity Cost of Toys is 1/6 units of Wheat
For Foreign:
Opportunity Cost of Wheat is 7.5 units of Toys
Opportunity Cost of Toys is 2/15 units of Wheat
Australia has Comparative Advantage in Wheat (lower Opportunity
cost)
Foreign has Comparative Advantage in Toys (lower Opportunity cost)
(ECON8069) Lecture 12 6 / 26
Production Possibility Curve without Trade
Suppose:
Australia has 15,000 hours of labour:
Could produce up to 500 units of Wheat, or
could produce up to 3000 units of Toys.
Foreign has 48,000 hours of labour:
Could produce up to 800 units of Wheat, or
could produce up to 6000 units of Toys.
(ECON8069) Lecture 12 7 / 26
Gains from Trade
Each country expands what it can consume by exporting the good it
has a comparative advantage in, and importing the other good.
An example production change; world production of both goods
increases.
Change in Wheat Change in Toys
AUS +6 -36
FOR -5 +37.5
WORLD +1 +1.5
The PPF with trade.
(ECON8069) Lecture 12 8 / 26
Reasons for Comparative Advantage
1. Climate: Impacts agricultural production, tourism
2. Natural Resources: Oil in OPEC, gold in Australia, not Singapore
3. Technology/Human Capital: E.g. Growth of Australian wine industry,
manufacturer of high-speed ferries, exporter of education.
4. Capital-Labour Ratio: Capital abundant US and Europe produce
aeroplanes; Labour abundant Myanmar produces clothing and toys.
Comparative Advantage changes over time due to changes in these
factors. We observe dynamic comparative advantage.
(ECON8069) Lecture 12 9 / 26
Wage Costs
Let the hourly wage be w in Australia, and w f in Foreign.
Monetary Cost per unit of production
Australia Foreign
Wheat (tonnes) 30w 60w f
Toys (1000’s) 5w 8w f
A Lowest Cost Producer (LCP) of a good is a county which can
produce each unit of the good at the lowest monetary cost.
The LCP will depend on the relative wages in each country.
Competition means goods will only be produced by a LCP.
(ECON8069) Lecture 12 10 / 26
Lowest Cost Producer - Example
AUS is a LCP of Wheat iff 30w ≤ 60w f . That is, w/w f ≤ 2.
AUS is a LCP of Toys iff 5w ≤ 8w f . That is, w/w f ≤ 1.6.
Situations:
I. If w/w f < 1.6, then AUS is unique LCP of both goods.
II. If 1.6 ≤ w/w f ≤ 2, then AUS is a LCP of Wheat, and FOR is a LCP
of Toys.
III. If w/w f > 2, then FOR is LCP of both goods.
Situations I and III can be ruled out in equilibrium as one country is
producing no goods. Equilibrium relative wages are 1.6 ≤ w/w f ≤ 2.
(ECON8069) Lecture 12 11 / 26
Production and Equilibrium Wages
Given Equilibrium Relative Wages, there are three cases:
X. If w/w f = 1.6, both are LCP of Toys, AUS is unique LCP of Wheat.
AUS produces Wheat and Toys.
FOR produces only Toys.
Y. If 1.6 < w/w f < 2, FOR is LCP of Toys, AUS is LCP of Wheat.
AUS produces only Wheat.
FOR produces only Toys.
Z. If w/w f = 2, FOR is unique LCP of Toys, both are LCP of Wheat.
AUS produces only Wheat.
FOR produces Wheat and Toys.
(ECON8069) Lecture 12 12 / 26
Production and Equilibrium Wages
Regardless of wages, AUS produces and exports Wheat to buy Toys;
FOR produces and exports Toys to buy beef.
The particular equilibrium wage will depend on consumer preferences.
E.g. if consumer preference on the world PPF is in region X , then
w/w f must be 1.6.
A high productivity country pays higher wages; low productivity
countries compete by paying lower wages.
Wage differences are limited by differences in labour productivity.
(ECON8069) Lecture 12 13 / 26
Welfare without Trade - Recall
Consumer Surplus is Value to Consumers of their consumption minus
their expenditure
The gap between the MB/Demand curve and the price paid, up to the
quantity consumed
Producer Surplus is Revenue from sales minus the cost of production
The gap between the MC/Supply curve and the price paid, up to the
quantity sold
Government Revenue/Spending may also feature into Total Surplus,
if the government intervenes in the market.
Deadweight Loss is the difference between the maximum possible
total surplus, and the total surplus that is actually realised.
The ‘without trade’ equilibrium is called the autarky equilibrium.
(ECON8069) Lecture 12 14 / 26
‘Small’ Economies
An economy is a ‘small economy’ if it is small in size relative to the
world market.
Small economies are price-takers in the world market. There is a world
price, and any amount of goods can be bought and sold at that price.
Australia is (usually) a ‘small’ economy.
Most of the insights here also hold for ‘large’ economies, like China
and the USA.
(ECON8069) Lecture 12 15 / 26
Exporting Country
If world price pw is greater than the autarky domestic price, then the
country wants to export goods.
This is caused by having a comparative advantage in production of
that good.
Domestically, exporting will cause the price to increase, the domestic
qd to fall, and domestic qs to increase.
Domestically, this sees an increase in Producer Surplus, a fall in
Consumer Surplus, and an increase in Total Surplus.
(ECON8069) Lecture 12 16 / 26
Importing Country
If world price pw is less than the autarky domestic price, then the
country wants to import goods.
This is caused as foreign countries have a comparative advantage in
production of that good.
Domestically, importing will cause the price to fall, the domestic qd to
rise, and domestic qs to fall.
Domestically, this sees a decrease in Producer Surplus, an increase in
Consumer Surplus, and an increase in Total Surplus.
(ECON8069) Lecture 12 17 / 26
Opposition to Trade
Given that both imports and exports result in increased total surplus,
why do we see aversion to imports?
Gains can be large, but are widely dispersed among many consumers.
Each consumer benefits only a little.
Losses are smaller, but concentrated among a small number of
producers. Each producer is harmed substantially.