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Economics: Comparative Advantage and Int'l Trade

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  • Type: Video Tutorial
  • Length: 25:35
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 275 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Introduction to Economic Thinking (18 lessons, $33.66)
Economics: Comparative Advantage (4 lessons, $9.90)

This video lesson looks at comparative advantage in the context of international trade. It will explain how to think about this notion as well as what its implications are for international trade. Taught by Professor Tomlinson, this video lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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In the last lesson, we introduced the concept of comparative advantage and showed how two players with different opportunity costs could cooperate, specialize and trade and both be better off. In this lesson, we'll give another illustration of the concept of comparative advantage. This one is a story about international trade and we'll show how two countries with different opportunity costs for producing two products can specialize and trade and both be better off.
Let's look first at the country of Pakistan, and we'll suppose that Pakistan uses one input, labor, to produce two outputs, two agricultural products, wheat and rice. We'll begin with a description of Pakistan's technology. Suppose that the unit labor requirement for producing one good, wheat, is two workers; that is, in Pakistan, it takes two workers to produce one bushel of wheat. Suppose also that the unit labor requirement for rice is three workers. It takes three workers to produce one bushel of rice. Now, if this is the case, the opportunity costs can be calculated from the unit labor requirements; that is, if you want to produce a bushel of rice, it's going to take you three workers. Those three workers divided by the two workers that are needed to produce a bushel of wheat let you know that anytime you produce one bushel of rice, you are giving up one and a half bushels of wheat. The opportunity cost in Pakistan to produce one bushel of rice is one and a half bushels of wheat.
Now, let's introduce the constraint on Pakistan's production. Suppose that there are 60 workers in Pakistan. These 60 workers can be used to produce wheat or they can produce rice, but the amount of wheat and rice that can be produced will be limited by the technology. In particular, suppose we take those 60 workers and divide them by the two workers that are needed to produce one bushel of wheat. The total amount of wheat that can be produced in Pakistan in a given period of time is 30 bushels of wheat. 60 workers divided by 2 workers per bushel of wheat equals a total of 30 bushels of wheat, the maximum wheat output possible in Pakistan.
Suppose instead that all 60 workers are used to produce rice. Divide 60 workers by three workers per bushel of rice and you get a maximum output of 20 bushels of rice. Therefore, we've got the constraints on production possibilities in Pakistan, 60 workers, two workers per bushel of wheat, three workers per bushel of rice. We're ready now to draw a production possibilities frontier for Pakistan's economy.
But before I do that, let me go ahead and introduce a potential trading partner for Pakistan, and that is Malaysia. Malaysia is going to have a different technology, and this different technology will become the basis for trade between Pakistan and Malaysia. Let's suppose that in Malaysia it takes only one worker to produce a bushel of wheat. Notice that Malaysia has an absolute advantage in the production of wheat; that is, Malaysia can produce wheat with fewer workers than it takes to produce wheat in Pakistan. Malaysia is therefore better at producing wheat. They can make more with less and therefore we say Malaysia has an absolute advantage in the production of wheat.
Likewise, it takes two workers to produce one bushel of rice in Malaysia; therefore we say that Malaysia also has an absolute advantage in the production of rice. It only takes two workers to produce a bushel of rice in Malaysia. It takes three workers to produce a bushel of rice in Pakistan. Because Malaysia can do more with less, we say that Malaysia has an absolute advantage.
Notice the way I've set up this example. I've cooked up a case where Malaysia has an absolute advantage in the production of both goods. Economists like examples that work like this. We like to show you that even though Malaysia is better at doing everything; that is, even though Malaysia can produce more wheat and more rice with a given amount of labor than Pakistan, in the end we will find that it is still advantageous for Malaysia and Pakistan to cooperate and trade. Even though Malaysia has an absolute advantage in the production of each good, it will still turn out that Pakistan has a comparative advantage in something.
Now, let's suppose then that these numbers represent technology in Malaysia. What is the opportunity cost for Malaysians of producing a bushel of rice? Well, if they produce a bushel of rice, they are going to need two workers to do so. And those two workers, divided by one worker needed per bushel of wheat, means that in Malaysia anytime you're producing one bushel of rice, you are giving up two bushels of wheat. The opportunity cost in Malaysia of producing one bushel of rice is two bushels of what. Now, in a minute, we're going to compare Malaysia's opportunity cost with Pakistan's opportunity cost to calculate comparative advantage.
But first, let's look at the constraints on the production possibilities in Malaysia. Suppose there are 60 Malaysian workers and they can spend their time either producing wheat or rice. What's possible in Malaysia? If you take the 60 workers and divide by one worker needed per bushel of wheat, you get the total maximum wheat production possible in Malaysia is 60 bushels of wheat. 60 workers at one worker per bushel gives you a maximum output of 60 bushels of wheat. Likewise, if those 60 workers go into the production of rice instead, 60 workers divided by two workers per bushel of rice gives you a maximum rice output possible of 30 bushels. Notice that because Malaysia has lower unit labor requirements, Malaysia can make more output with its 60 workers than Pakistan can.
Now, given these numbers, we can write out a table of the production possibilities for Pakistan and for Malaysia. Let's look at those tables now. First, we'll look at the production possibilities for Pakistan. If Pakistan has 60 workers, then it's possible for Pakistan to produce any combination of wheat and rice given in this table. Pakistan can use all of its workers in wheat and produce no rice. Pakistan can produce 20 units of wheat, moving some workers into the production of rice. It can produce 15 and 10, 10 and 13 , and so forth. Any of these combinations is possible. Remember anytime Pakistan wants to produce an extra unit of rice, it has to move three workers into the production of rice. Those are three workers that are not available for wheat production and three divided by two workers needed per bushel of wheat means that anytime Pakistan produces one extra bushel of rice, it's giving up one and a half bushels of wheat that it might otherwise produce. So we will use these numbers in a moment, when we draw the production possibilities frontier for Pakistan. Notice as you look at these numbers, these are the production possibilities. We'll move this number over to the board and we'll look at the production possibilities now for Malaysia.
Notice the numbers are bigger, because Malaysia has an absolute advantage. It is more productive than Pakistan with its labor. Here are all the possibilities, 60 and 0, 40 and 10, 20 and 20 - I say all, these are some. What I mean is all of these combinations are possible with 60 workers and Malaysia's technology. Notice that the opportunity cost of producing 10 bushels of rice is 60 - 40, or 20 bushels of wheat that Malaysia has to give up. As we saw before, anytime Malaysia wants to produce an extra bushel of rise, Malaysia has to give up two bushels of wheat. We'll move these numbers now over to the board and use them whenever we plot the production possibilities frontier for Malaysia.
Let's go ahead now and plot that production possibilities frontier. The first diagram we'll let represent the production possibilities of Malaysia. The second set of axes we'll let represent the production possibilities of Pakistan. Now, we've got to label the axes carefully or the diagram doesn't mean anything, so let's put wheat on the vertical axis in each case and we will put rice on the horizontal axis in each diagram. Now we are ready to draw the production possibilities frontiers and we have two options. The first option is to plot points directly from the schedules that are over on the board. That's easy enough to do, so we can start with Malaysia's. Malaysia, if they produce only wheat, can produce up to 60 bushels of wheat, so I'll go up here to the point 60. That leaves them no labor for producing rice, so we have this point, 60 and 0. If they use all of their labor to produce rice, they can produce 30 bushels of rice and no wheat, so that would be this point, 30 and 0, on the horizontal axis. And then we could just go through and plot other combinations, like 40 and 10, 20 and 20, 10 and 25 and so forth on down. Once we have plotted all of these points, we can connect them in the diagram and draw the production possibilities frontier.
Now, I didn't go through and plot all of those points, because I don't want to make my diagram too cluttered, but it's clear to you that you can plot all of these points and then just connect them with a straight line. Notice the production possibilities frontier will be a straight line in this case. You'd find that out if you'd plotted all of the points. What does it mean? What does it mean that the production possibilities for Malaysia is a straight line? It means that the opportunity cost is constant. Anytime Malaysia wants to produce an extra bushel of rice, it has to give up two bushels of what. If Malaysia wants to move one more bushel of rice outwards in the horizontal axis, then it has to move down two bushels of wheat. And that doesn't matter whether it's producing its first bushel of rice, its tenth or its thirtieth bushel of rise. Every bushel of rice in Malaysia has the same opportunity cost of two bushels of wheat. That's why the slope of Malaysia's production possibilities frontier is constant at -2. There is no increasing opportunity cost. Opportunity cost is constant for Malaysia, and that means that all resources that are used to produce wheat and rice are equally well suited to the production of either good. There is no kind of specialization or special characteristics of resources. All resources are equally well suited and that's why the opportunity cost is constant and the production possibilities frontier is a straight line.
Alternatively, if we hadn't wanted to use the numbers and plot the points from over in the diagram, we could have used the formula for Malaysia's production possibilities frontier. This is the formula that I used to get those numbers to begin with. Before I started this example, I wrote down this formula, because it's what I wanted my production possibilities frontier to look like. If I'd given you this formula to being with, you could have simply plotted the equation. Here's the formula for Malaysia's production possibilities frontier: wheat = 60 - 2 times the amount of rice that Malaysia produces. I'll move this equation now over to the board and you can see that the equation is what I've drawn here in this diagram, that the vertical intercept is at the point of 60, the maximum wheat production that Malaysia can turn out if it uses all 60 of its workers to produce wheat. The horizontal intercept is going to be 30; that is, if you plug in 30 for R, the rice production, you get zero wheat left over to be produced. If all workers are in rice, you get 30 units of rice produced. And the slope of this line is -2. That's the coefficient on rice in the formula. Anytime Malaysia wants to produce one more bushel of rice, it gives up two units of wheat. So the slope of this line is -2, and I'll go ahead and write that in. -2 is the slope of Malaysia's production possibilities frontier.
I can use the same technique now to derive the production possibilities frontier for Pakistan. I know what the end points are. The end points are going to be 30 bushels of wheat if Pakistan uses all of its labor to produce wheat. I got this number for over in the table. Also, if it uses its labor to produce only rice, then we get 20 bushels of rice, so there's the other end point. You could plot some of the intermediate points and you'd see that they lie on a straight line, or you can simply connect the two dots at the ends and get the production possibilities frontier for Pakistan. So let me draw this line in carefully. There's the production possibilities frontier for Pakistan. The end points tell us about the maximum production that's possible if Pakistan completely specializes in one good or the other; that is, the maximum wheat production Pakistan can get is 30 bushels of wheat and the maximum rice production that Pakistan can get is 20 bushels of rice. I could get the same information if I use the formula for Pakistan's production possibilities frontier. Wheat = 30 bushels, that's the maximum production, minus times the amount of rice production. Remember - or negative 1, is the opportunity cost in Pakistan of producing another bushel of rice. Anytime Pakistan adds one unit of rice to its output, it does so by giving up one and a half bushels of wheat. So the slope of the curve here is going to be -. That's the opportunity cost of rice, measured in terms of wheat, that Pakistan would have to give up. Again, notice in Pakistan's case that we have the production possibilities frontier being a straight line, indicating that all resources being used in Pakistan are equally well suited to the production of rice or wheat.
So here we have our situation. Here are Malaysia's production possibilities and here are Pakistan's production possibilities. If now these two countries wanted to produce independently of each other, that is, if we had them separated so that they can't trade, then we could pick a point on each production possibilities frontier and call that the consumption point in the separated economies. Let's suppose that Malaysia cannot trade with Pakistan. If Malaysia cannot trade with Pakistan, then all of the consumption possibilities lie on this curve, too. If Malaysia is going to eat some combination of wheat and rice, then it has to make that combination of wheat and rice for itself. And let's suppose that the mix that they choose is a mix like 20 and 20; that is, Malaysia chooses to produce at this point right here with equal quantities of wheat and rice produced. So here we have 20 bushels of rice produced in Malaysia and 20 bushels of wheat produced in Malaysia. This combination, 20 and 20, is one of Malaysia's production possibilities. And it's the production possibility that we are going to imagine that Malaysia chooses if they have to produce on their own.
We can say the same then about Pakistan. Pakistan has this table of production possibilities and if it wants to operate by itself without trade, it's got to choose some point on this line and that be its consumption. So let's suppose that Pakistan chooses this point right here, which would be at 15 and 10. I'm going to imagine that Pakistan chooses to produce and consume 10 bushels of rice and to produce and consume 15 bushels of wheat.
So the black dots in each of these diagrams represent the pattern of production and consumption when the two economies operation independently of each other. Now, let's show how, by cooperating, Pakistan and Malaysia can improve their situation, how, by cooperating, Pakistan and Malaysia can produce more wheat and more rice than they are producing operating independently.
First, let's notice how much that they are producing together when they're operating independently. Malaysia's producing 20 bushels of wheat, Pakistan is producing 15, for a total wheat production of 35 bushels. Malaysia is producing 20 bushels of rice, Pakistan 10, for a total rice production of 30 bushels. Let's see now how, by cooperating, specializing and trading, we can increase the quantity of agricultural goods that the two countries have available. Let's look at an example.
In Malaysia, the opportunity cost of one bushel of rice is two bushels of wheat. The same amount of labor that will produce these two bushels of wheat would otherwise produce this one-bushel of rice. So the opportunity cost can be represented by this ratio: one bushel of rice always costs two bushels of wheat in Malaysia. In Pakistan, on the other hand, one bushel of rice costs only one and one-half bushel of wheat. Or we could write this a different way: the opportunity costs of two bushels of rice in Pakistan is three bushels of wheat. The same labor that could produce three bushels of wheat would otherwise be producing two bushels of rice. Now, we can show here that there is a possibility of gain from trade. Notice that the opportunity cost of producing two bushels of rice, for instance, is lower in Pakistan than it is in Malaysia. If Malaysia wants to produce two bushels of rice, it's going to be giving up four bushels of wheat. The opportunity cost in Malaysia is two bushels of wheat for one bushel of rice. In Pakistan, on the other hand, if Pakistan wants to produce two bushels of rice, it's only giving up three bushels of wheat. The opportunity cost of rice in Pakistan is lower than it is in Malaysia; therefore we know by definition that Pakistan has a comparative advantage in the production of rice, because it can produce rice at a lower opportunity cost than can Malaysia. These are the numbers that are in the production possibilities frontier equation. Malaysia's slope is -2; that is, two bushels of wheat for every bushel of rice. Pakistan's slope is -; that is, one and a half bushels of wheat for every bushel of rice.
Now that we know that Pakistan has a comparative advantage in the production of rice, we can tell a story whereby Malaysia and Pakistan cooperate to increase their wealth. Here's the way the story works. Since Pakistan has a comparative advantage in the production of rice, Malaysia is going to try to find some way to get Pakistan to want to produce rice and send it to Malaysia instead. Malaysia wants to specialize in the direction of wheat; Pakistan would specialize in the direction of rice. Here's a story that I think will make this comparative advantage comparison clear.
Let's suppose that Malaysia wants to try to make things good for itself. What it will do then is it will cut back its production of rice by two units. So get these two bushels of rice off of the board and replace it with four bushels of wheat. That's what Malaysia can produce instead. Now, Pakistan down here is producing three bushels of wheat, but remember Pakistan has a comparative advantage in rice, so anything that allows Pakistan to reduce its wheat production is going to increase wealth for these two economies operating together.
So let's have Malaysia send these three bushels of wheat down to Pakistan, which then allows Pakistan not to have to produce these three bushels of wheat. Instead, Pakistan can devote its labor to rice production and increase its rice output by two units. So now that Pakistan has someone else producing wheat for it, Pakistan can produce two extra bushels of rice, which it then sends to Malaysia. Notice now we're back where we started. Pakistan has three bushels of wheat, which now Malaysia is producing and sending to it. Malaysia has two bushels of rice, which it got from Pakistan, but we now have one extra bushel of wheat. This extra bushel of wheat was created by specialization and trade. This bushel of wheat did not exist before. We're back where we started with one extra bushel of wheat. That's what happens when two countries specialize in trade.
Let's suppose now that, since Pakistan has a comparative advantage in the production of rice, we have Pakistan produce all of the rice for the two economies. And let's suppose that, in addition, that we have Malaysia produce 12 bushels of rice and spend its remaining labor on wheat. With this particular production of specialization and trade, we can now see that both countries can be better off. Let's look back at our diagram.
Here we have Pakistan, specialized according to its comparative advantage, producing 20 bushels of rice. Now, these 20 bushels of rice are available for trade, so Malaysia can now change its pattern of production and specialize in the direction of wheat. We're going to have Malaysia cut back its production to 12 bushels of rice and that leaves 12 2 is 24, subtracted from 60, is 36 bushels of wheat that Malaysia can produce. So here's a new point on Malaysia's production possibilities frontier. If Malaysia produces here at this orange point and Pakistan produces here at this orange point, we can see that they have created more wheat and more rice for their combined economy. Let's add up the totals.
Pakistan is producing 20 bushels of rice; Malaysia is producing 12 bushels of rice, for a total of 32 bushels of rice. They were only producing 30 bushels before, that's two extra bushels of rice created by trade. Let's look at wheat production. Well, Pakistan is not producing any wheat and Malaysia is producing 36 bushels of wheat. 36 is one more bushel than we were producing before, when the economies were operating independently and producing only 35 bushels of wheat. Aha! By specialization according to comparative advantage, we have created an additional two bushels of rice and an additional one-bushel of wheat. These two economies now can agree to trade in such a way that both of them are better off. They can find some ratio of trading rice for wheat that makes them both better off than they were before. Those extra two bushels of rice and extra one bushel of wheat are available to be divided between Malaysia and Pakistan. And the rate of trade that they will agree on is somewhere between the slopes of their production possibilities frontier. Pakistan is quite happy to trade with any terms of trade that give it more than one and a half bushels of wheat per bushel of rice. Malaysia is happy to trade with any terms of trade that give it less than two bushels of wheat per bushel of rice. So the two economies can now agree upon a particular price of wheat, in terms of rice, that will allow them both to be better off. By specializing, they have created more wheat and rice together than they could have created separately. And this is the basis of their gains from trade. Notice that each country produced more of the good in which they had comparative advantage, more of the product for which its opportunity cost was relatively low.
Introduction to Economic Thinking
Comparitative Advantage
Analyzing an International Trade Using Comparitive Advantage Page [5 of 5]

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