Economics (Trade-2)

GREASE THOSE WHEELS (ECONOMICS)


#2 ABSOLUTE and COMPARATIVE ADVANTAGE

• Principles of absolute and comparative advantage, and their  real-world limitations
• Other explanations/determinants of trade flows
• Opportunity cost concept allied to trade

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Trade and specialization is necessary for everyone to be better off...think about a world where there is no specialization and no trade between countries...then you will have to grow your own food, make [!] your own hairgels, you would ever have a feel of CK Jeans, Harley Davidsons would just remain to pictures and Toyota would have been localized to Japan only. I think you are starting to see the benefits of trade...=P!!
Some well known facts about trade are...

• Trade occurs only when both the parties are benefited.
• Trade involves importing and exporting of goods.

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Now lets move to the very important question that why do countries trade??

The answer is simple, nations trade so that they can get goods from other countries that are more expensive to produce at home and meanwhile focus their resources on good they specialize in and then sell them to the world.

So the boil down of the above mentioned reason is that nations trade because of specialization. Nations produce goods that they produce efficiently and trade them for goods that they are not good at producing [tongue twister, anyone? =P]. For example Kenya specializes in the production of tea by focusing its resources on it and then trades it with nations like France who are less efficient at producing tea for other goods like packaging machinery which they are not that efficient at producing.

So we can safely say that specialization is the heart and soul of international trade.

Moving on to the concept of absolute advantage.

It is defined as a country's ability to produce more of a good or service than another country.

Before we look at it we should see the system's assumptions first.

• Transportation costs are zero.
• There is no imposition of tariffs or custom duties on the import of that good.
• Prices are to remain constant.
• There are only two countries X and Y in the world.
• There are only two goods produced in the world.

For example we draw the PPFs of two countries Alpha and Beta and both of them produce two goods mangoes and oranges...

Before specialization...Alpha produces 10 mangoes and 15 oranges. While Beta produces 20 mangoes and only 10 oranges but afterwards both the countries specialize in the production of the fruit they are good at and so Alpha produces 25 oranges now and 0 mangoes while Beta produces 30 mangoes and 0 oranges and so we say that Alpha has an absolute advantage in the production of oranges while Beta has the absolute advantage in the production of mangoes.

Now let us look at the more complex comparative advantage.

It is defined as a country's ability to produce a good more efficiently or at a lower opportunity cost then other countries.

For example we again draw the PPFs of two countries Gamma and Bravo and, again both of them produce only two goods wheat and rice.

Before specialization...Gamma produces 5 tons of wheat and 10 tons of rice. While Bravo produces 20 tons of wheat and 60 tons of rice. Complex, eh? No scene of absolute advantage here so we resort to the good old concept of opportunity cost.

• Opportunity cost for Gamma on the production of a ton of wheat is (10/5) 2 tons of rice.
• While the opportunity cost for Bravo to produce a ton of wheat is (60/20) 3 tons of rice.

So Gamma has a comparative advantage on the production of wheat as it produces it more efficiently than Bravo, i.e, its opportunity cost of production of a ton of wheat is lower than that of bravo.

Now let us look at the opportunity costs for the production of a ton of rice for the two countries.

• Oppertunity cost for Gamma on the production of a ton of rice is (5/10) 1/2 tons of wheat.
• While the oppertunity cost for Bravo to produce a ton of rice is (20/60) 1/3 tons of wheat.

Here Bravo has a comparative advantage in the production of rice.
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Now let us look at it with the aid of graphs and we will then look at the advantages of specialization.

• The unbroken PPFs show the before trade scenario of production for the two countries. U.S has a comparative advantage in the production of food (as it has to give up 2 units of clothing in producing a unit of food compared to the 4 units of France). While France has a comparative advantage in the production of clothing as it has to forgo 1/4 unit of food in the production of a unit of clothing compared to the US's 1/2 unit of clothing.
• So by the law of comparative advantage France should specialize in and export clothing while the U.S should divert all its resources on the production of food and export it.
• After specialization, look at the intercepts of the PPF for the only good the country has chosen to produce. As we see U.S would make 500 units of food while France would produce 1200 units of clothing.
• Assume the terms of trade (average export price/average import price) for these goods in the international market will be 1 unit of food for 3 units of clothing (it should be less than 4, the before-trade relative price of the good so that France finds some benefit in trade) a further assumption is that a country sells all what it produces so by this France will have 1200/3 = 400 units of food (mind that 450 on the graph!...=P) more than the maximum of 300 it had before trade. While the US will have 500x3 = 1500 units of clothing, which is 500 more than the before trade, maximum quantity of that good. These changes are shown by the broken curves in the above figure, known as the consumption possibility curve.
• Look at the two graphs again, did you find out that the citizens of the two nations are better off after trade! The U.S citizens can now get 600 units of clothing along with 300 units of food (by exporting 200 units of food) which is better than the before trade situation when a U.S citizen would have gotten 600 units of clothing along with 200 units of food (by exporting 600 units of clothing). Same is the case for France.
• The imports are shown by the amount of goods a country consumes which it doesn't produce. It is 600 units of clothing for the U.S and 300 units of food for France.

From this stuff we can deduce that...

• After trade both countries will end up with more of each good.
• The terms of trade will fall between the before trade prices of the good in both the countries (it was 4 for France and 2 for the US, thus the TOT was 3).
• Total world output will increase.

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Although this theory looks quite good on paper, but in real world it has severla limitations...

• Existence of tariffs and transport costs reduces benefits from trade.
• Constant costs in real word are way to unrealistic. The more the production of a good the lower its cost should have been. So the negotiations of terms of trade gets a bit difficult.
• Governments cannot simply close down industries which they do not have a comparative advantage in due to political unrest.
• During periods of turmoil like war countries can suffer as foreign trade comes to a halt for that country as the country are too dependent on other countries after specialization.
• Some strategically important goods like weapons and steel should be produced by a country to support it during times of turmoil.
• Specialization is harmful at a great extent. For example, Saudi Arab is a country that is too dependent on oil for economic growth. Lower prices of oil can really put a halt to economic activities in  such countries so a little diversification should be there to cancel out such harmful build-ups.

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