Comparative Advantage and
Trade, Part 2
Terms of Trade
Graph the Following PPCs
Values represent all resources spent on one good
(the other value is 0)
1.
2.
3.
4.
5.
Shirts
Wheat
(millions)
(millions of bushels)
China
25
50
USA
50
200
Which country has an absolute advantage in shirts?
Which country has an absolute advantage in wheat?
What are the opportunity costs of each good for each country?
Which country has comparative advantage in shirts?
Which country has comparative advantage in wheat?
Shirts
1. The USA has an absolute
advantage in shirts
(millions)
2. The USA has an absolute
advantage in wheat
50
25
PPC USA
PPC China
0
100
200
Wheat
(millions of bushels)
3. Opportunity Costs
Shirts
China
USA
(50 wheat lost/25 shirts gained) =
Wheat
2 wheat
(200 wheat lost/50 shirts gained) =
4 wheat
(25 shirts lost/50 wheat gained) =
½ shirts
(50 shirts lost/200 wheat gained) =
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
¼ shirts
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.