Comparative Advantage and Trade, Part 2

Terms of Trade

Graph the Following PPCs

Shirts(millions)

Wheat(millions of bushels)

China 25 50

USA 50 200

Values represent all resources spent on one good(the other value is 0)

1. Which country has an absolute advantage in shirts?2. Which country has an absolute advantage in wheat?3. What are the opportunity costs of each good for each country?4. Which country has comparative advantage in shirts?5. Which country has comparative advantage in wheat?

Shirts(millions)

Wheat(millions of bushels)

0200100

25

50

PPC China

PPC USA

1. The USA has an absolute advantage in shirts

2. The USA has an absolute advantage in wheat

3. Opportunity CostsShirts Wheat

China (50 wheat lost/25 shirts gained) = 2 wheat (25 shirts lost/50 wheat gained) = ½ shirts

USA (200 wheat lost/50 shirts gained) = 4 wheat (50 shirts lost/200 wheat gained) = ¼ shirts

4. China has a smaller opportunity cost and thus a comparative advantage in shirts

5. The USA has a smaller opportunity cost and thus a comparative advantage in wheat

Terms of Trade

• What if the USA proposes to trade 20 million bushels of wheat to China in exchange for 7.5 million shirts?

• Will the trade benefit both sides?

• How do we know?

Terms of Trade

• The “price” in terms of one good for another should fall between the opportunity costs for both countries

• Price of a shirt: (20 wheat/7.5 shirts) = 2.66 wheat

• This falls between China’s opportunity cost of 2 wheat and the USA’s opportunity cost of 4 wheat

Homework Example

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day.

Before we can answer the question, we need to convert to production per worker:

Automobiles Washing Machines

Italy (8 workers = 1 auto) or 1/8 auto (3 workers = 1 wm) or 1/3 wm

USA (6 workers = 1 auto) or 1/6 auto (2 workers = 1 wm) or 1/2 wm

Homework Example

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day.

a. Which country has an absolute advantage in the production of automobiles? In washing machines?

Automobiles Washing Machines

Italy (8 workers = 1 auto) or 1/8 auto (3 workers = 1 wm) or 1/3 wm

USA (6 workers = 1 auto) or 1/6 auto (2 workers = 1 wm) or 1/2 wm

The USA has an absolute advantage in both goods, because in each case it takes fewer workers to make the good.

Homework Example

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day.

b. Which country has a comparative advantage in the production of automobiles? In washing machines?

Automobiles Washing Machines

Italy (1/3 wm / 1/8 auto) = 2 2/3 wm (1/8 auto / 1/3 wm) = 3/8 auto

USA (1/2 wm / 1/6 auto) = 3 wm (1/6 auto / 1/2 wm) = 1/3 auto

The USA has a comparative advantage in washing machines, while Italy has a comparative advantage in automobiles.

Homework Example

In Italy, an automobile can be produced by 8 workers in one day and a washing machine by 3 workers in one day. In the USA, an automobile can be produced by 6 workers in one day, and a washing machine by 2 workers in one day.

c. What type of specialization results in the greatest gains from trade between the two countries?

The USA will specialize in washing machines, while Italy will specialize in automobiles.

Work Together on Handout

1. Assume USA is left graph and England is right graph

2. Assume that “normal” production levels are represented by given points on graphs (with dashed lines)

3. Assume that specializing leads to production of only one good.