Interdependence and Trade
Interdependence and
the Gains from Trade
Comparative Advantage
Herbert Stocker
Institute of International Studies
University of Ramkhamhaeng
Question: do you think, foreign trade
can hurt a country?
Under which circumstances do you think this could be
possible?
[Consider for example Thailand – China, Thailand –
USA]
In this chapter we will show that simple abstract
models can give crystal-clear and simple answers to
such complex questions!
Additionally, we will introduce some useful concepts
that will be helpful later.
You wake up to an alarm clock made in Korea.
You pour yourself some orange juice made from
oranges grown in Malaysia.
You put on some clothes made of cotton grown in
USA and sewn in factories in Vietnam.
You watch the morning news broadcast on your
TV made in Japan.
The bus you take is made of parts manufactured
in a half-dozen different countries.
Interdependence and Trade
Remember, economics is the study of how
societies produce and distribute goods in an
attempt to satisfy the wants and needs of its
members.
How do we satisfy our wants and needs in a global
economy?
We can be economically self-sufficient.
We can specialize and trade with others, leading to
economic interdependence.
Interdependence and Trade
The theory of ‘Comparative Advantage’
explains, why many economists are convinced,
that free trade is better for a country as a
whole than self-sufficiency!
This theory applies to countries as well as to
individuals or firms.
David Ricardo (1772 - 1823)
A successful business man and
brilliant economist with exceptional
abilities for abstract reasoning.
Main Work: “Principles of Political
Economy and Taxation” (1816)
“Ricardo conquered England as
completely as the Holy Inquisition
conquered Spain”
(Keynes 1936, S. 32)
Comparative Advantage
“. . . this deepest and most beautiful
result in all of economics.”
(Findlay 1988, S. 514)
Founder: David Ricardo
Comparative Advantage
“If there were an Economist’s Creed, it
would surely contain the affirmations ‘I
understand the Principle of
Comparative Advantage’ and ‘I
advocate free trade’.”
(Krugman 1987, p. 131)
Comparative Advantage
Comparative Advantage
Who are the winners and loosers of free trade?
Are ‘poor’ countries worse off when trading with
‘rich’ countries? (e.g. WTO-negotiations)
For understanding comparative advantage we need
some basic concepts, like . . .
Production possibilities frontier
Efficiency
Productivity
Opportunity cost
Thought experiment:
Imagine a lonely and beautiful island, maybe somewhere in the
south sea . . .
on this island, a lonely hunter . . .
this man can either hunt or fish
if he hunts the whole day (10 hours) he can get 10 kg
meat (M).
if he fishes the whole day (10 hours) he can catch 5 kg
fish.
Comparative Advantage
Production Possibilities Frontier
The hunter faces a trade-off:
Hunter (A):
Production possibilities:
F
Meat Fish
(M)
(F )
5
10
0.0
4
9
0.5
8
1.0
3
7
1.5
2
6
2.0
5
2.5
1
4
3.0
0
3
3.5
2
4.0
0 1 2 3 4 5 6 7 8 9 10M
b
b
b
b
b
b
F
5
effi
cie
nt,
ma
4
3
xim
al u
se
b
b
b
2
technical possible,
but not efficient!
b
b
1
0
4.5
5.0
F = 5 − 0.5M
1
0
0
1
2
3
4
5
of
reso
urc
es
6
7
(tim
e)
8
9 10 M
Definitions
Production Possibilities Frontier: a graph that
shows the combinations of output that the
economy can possibly produce given the available
factors of production and available production
possibilities (only for simplification we focus on
only two goods).
Efficiency: if it is not possible to increase
production of one good without producing less of
the other good.
Productivity: the amount of output produced
from one unit of input, e.g.
Labor productivity: the amount of output
produced from each hour of a worker’s time.
Productivity
(Labor-)Productivity (i.e. absolute cost advantage) is the decisive factor for the (material) standard of living!
Determinants of Productivity:
Physiscal Capital (machinery, etc.),
Human Capital & Know-how,
“Quality” of institutions and laws,
and many more . . .
The higher productivity, the more goods are
available (or people can work less, respectively)!
Productivity
The PPF lies further to the right, . . .
→ the better the economy is endowed with factors,
and
→ the higher is productivity.
F
Increase in labor
productivity in the
production of F only
M
Question
Our hunter can either hunt 10 kg meat or 5 kg fish per
day (10 hours).
What is the labor productivity if he hunts?
1 kg meat per working hour.
What is the labor productivity if he fishes?
0.5 kg fish per working hour.
Production Possibilities
Quiz: Which points are technical possible?
Y
bc
G
bc
D
bc
A
bc
E
H
bc
bc
bc
bc
Production Possibilities
Quiz: Which points are technical inefficient?
bc
bc
G
bc
D
A
bc
bc
bc
E
F
H
M
bc
bc
C
B
bc
bc
I
Solution: A,E,M,I
bc
A
K L X
bc
bc
bc
bc
G
bc
D
bc
N
bc
Quiz: Which points are technical impossible to realize?
J
bc
bc
K L X
Production Possibilities
bc
bc
N
bc
bc
I
Solution: B,D,F,H,K
Y
bc
bc
H
bc
M
bc
I
K L X
Solution: A,B,D,E,F,M,H,I,K
C
B
E
bc
J
bc
F
bc
N
bc
G
bc
D
bc
A
bc
M
bc
C
B
bc
bc
J
bc
F
bc
bc
Y
Quiz: Which points are technical efficient?
Y
C
B
bc
Production Possibilities
E
F
M
bc
H
bc
bc
I
Solution: C,G,J,N,L
J
bc
N
bc
bc
K L X
Opportunity Cost
Opportunity Cost
If we decide for one alternative, we have usually to
sacrifice other alternatives, since our resources
(e.g. time, money, . . . ) are scarce.
There is a trade-off between alternatives.
The Opportunity cost of one chosen alternative
are the cost of the next best alternative we had to
sacrifice.
If our lonely hunter wants one additional kg fish
he has to sacrifice 2 kg meat (i.e. he must fish
additional 2 hours instead of hunting!)
The opportunity cost of 1 kg fish is 2 kg meat.
If our lonely hunter wants an additional kg meat
he must sacrifice 0.5 kg fish (i.e. hunt 1 additional
hour instead of fishing!)
The opportunity cost of 1 kg meat is 0.5 kg fish.
Opportunity Cost . . .
Opportunity Cost
. . . is the slope of the production possibilities frontier!
F
F = 5 − 0.5M or M = 10 − 2F
5
∆M
∆M = −2
4
∆F
∆F
∆M
∆F = +1
3
= −2
= −0.5
∆M = +1
∆F = −0.5
2
0
1
2
3
4
5
6
7
8
9
The slope is the derivative of a function
F = 5 − 0.5M
Opportunity cost of Meat:
dF
= −0.5
dM
1
0
The slope of the production possibilities
frontier measures the opportunity cost!
10 M
M = 10 − 2F
Opportunity cost of Fish:
dM
= −2
dF
Opportunity cost of fish is the reciprocal of
opportunity cost of meat.
Slope and Angle
Opportunity Cost
H
yp
o
te
nu
se
The slope of a linear function can also be calculated as
the tangent of an angle:
Opposite
leg
α
tan α =
Opposite leg
Adjacent
Opportunity cost of
meat:
F
5
4
3
2
1
0
= Slope
F = 5 − 0.5M
dF
= −0.5
dM
tan α =
α
Opposite leg
Adjacent
0 1 2 3 4 5 6 7 8 9 10M
=
5
= 0.5
10
Adjacent
One kg meat “costs” the lonely hunter 0.5 kg fish!
Opportunity Cost
Opportunity Cost
Opportunity cost of
fish:
F
5
4 β
3
2
1
0
0 1 2 3 4 5 6 7 8 9 10M
M = 10 − 2F
dM
= −2
dF
tan β =
Opposite leg
Adjacent
10
=
=2
5
One kg fish “costs” the lonely hunter 2 kg meat!
Fish (F )
4
F
3
β
tan α
2
M
1
0
Production possibility frontier of Mr.
Fisher from the neighboring island:
tan β
α
0
1Meat (M)
= 4 − 4M,
=
Opposite leg
Adjacent
=
= 1 − 0.25F ,
=
Opposite leg
Adjacent
=
dF
= −4
dM
4
=4
1
dM
= −0.25
dF
1
= 0.25
4
Productivity
Opportunity Cost
Labor productivity in the production of . . .
Fish
Meat
Hunter 0.5 kg Fish/Hour
1 kg Meat/Hour
0.1 kg Meat/Hour
Fisher 0.4 kg Fish/Hour
⇒ The hunter is more productive in hunting and
fishing! (and has therefore probably a higher standard of living)
Should the fisher and hunter trade with each other???
Opportunity Cost – Comparative Adv.
Opportunity
Meat
Hunter 0.5 kg Fish
Fisher 4 kg Fish
Cost of
Fish
2 kg Meat
0.25 kg Meat
The hunter has lower opportunity costs in
producing meat (for one additional kg meat the
hunter has to sacrifice 0.5 kg fish, the fisher has
to sacrifice 4 kg fish for one additional kg meat).
It follows automatically, that the fisher has lower
opportunity costs in producing fish!
Labor productivity in the production of . . .
Fish
Meat
Hunter 0.5 kg Fish/Hour
1 kg Meat/Hour
0.1 kg Meat/Hour
Fisher 0.4 kg Fish/Hour
Hunter
Fisher
Opportunity Cost of
Fish
Meat
0.5 kg Fish/Hour
1 kg Meat/Hour =
1 kg Meat/Hour
2 kg Meat
0.5 kg Fish/Hour = 1 kg Fish
0.1 kg Meat/Hour
kg Meat
= 0.25
0.4 kg Fish/Hour
1 kg Fish
0.4 kg Fish/Hour
0.1 kg Meat/Hour
=
Comparative Advantage
Example: Opportunity Cost of Meat of Fish
Fish
γ
4
3
2 δ
1
α
β
0
0 1 2 3 4 5 6 7 8 9 Meat
Meat:
α<β
⇒
Hunter
Fish:
δ<γ
⇒ Fisher
0.5 kg Fish
1 kg Meat
4 kg Fish
1 kg Meat
Two Kinds of Cost
Opportunity Cost – Comparative Adv.
For the gains from trade is not productivity (or
absolute cost) relevant, but only opportunity
cost!
Absolute Cost: how many hours are needed to
produce one unit of a good.
Absolute Advantage: the country with the
higher productivity has an absolute advantage!
Opportunity Cost: which alternatives we have
to give up to produce one more unit of a good
(i.e. how many units of the other good have to be
sacrificed to produce this one more unit)?
Comparative Advantage: the country with the
lower opportunity cost has an comparative
advantage!
Example
Everyone should specialize in the production of
the good, where he or she has the lower
opportunity cost!!!
Since opportunity cost is the slope of the
production possibilities frontier, both parties will
gain as long as the exchange ratio is between the
slopes of the individual production possibilities
frontiers!
Comparative Advantage
Example: Autarky (no trade):
Autarkie (no trade):
Consumption possibilities = Production possibilities
Production
Hunter 6 kg Meat
2 kg Fish
Fisher 2 kg Fish
0.5 kg Meat
Trade
0
0
0
0
Consumption
6 kg Meat
2 kg Fish
2 kg Fish
0.5 kg Meat
Fish
bc
4
3
2
1
0
bc
Production and
Consumption
under autarky
bc
(Any other point on
the PPF is possible
as well.)
0 1 2 3 4 5 6 7 8 9 Meat
Example
Comparative Advantage
With Trade:
for simplicity we assume an exchange ratio 1:1
Example: Trade with an exchange ratio 1:1
(assumption)
Consumption possibilities > Production possibilities
Production
Hunter 10 kg Meat
0 kg Fish
Fisher 4 kg Fish
0 kg Meat
Gains from Trade:
Trade
– 2 kg Meat
+ 2 kg Fish
– 2 kg Fish
+ 2 kg Meat
Hunter:
Fisher:
Consumption
8 kg Meat
2 kg Fish
2 kg Fish
2 kg Meat
+ 2 kg Meat
+ 1.5 kg Meat
Result
Not the location of the production
possibilities frontier (productivity) is
decisive whether trade is advantageous,
but the slope of the production
possibilities frontier (i.e. Opportunity
Cost)!
Fish
4
3
2
1
0
bc
rs
rs
bc
ut
bc
ut
ut
rs
Production and
Consumption
under autarky
Production
with trade
Consumption
with trade
0 1 2 3 4 5 6 7 8 9 Meat
Question
Should George Clooney iron
his shirts himself, even if he
should be a world champion
in ironing?
Comparative Advantage
Without trade production possibilities determine
consumption possibilities!
Without Trade:
Production possibilities = Consumption
possibilities
Trade allows to increase consumption possibilities!
With Trade:
Consumption possibilities > Production
possibilities
Free trade makes both parties better off, since
trade allows to make a more efficient use of the
available resources!!!
Absolute vs. Comparative Advantage
Summing up . . .
Whenever the opportunity cost of two trading
partners differ both parties will profit from trade!
A country could have an absolute disadvantage in
the production of all goods, but it is logically
impossible that a country has an comparative
disadvantage in the production of all goods!
For the gains from trade only comparative
advantages are relevant, absolute advantage is
irrelevant!
Comparative Advantage: Example
An Example
Productivities:
Amount produced
in one hour
Cheese
Bread
England
40
20
Spain
30
5
Endowment with labor:
England: 10 hours
Spain:
England’s production possibility frontier is
B = 200 − 0.5 C
Spain’s production possibility frontier is
B = 100 − 1/6 C
Why?
20 hours
Comparative Advantage: Example
Productivities:
Amount produced
in one hour
Cheese
Bread
England
40
20
Spain
30
5
B
Endowment with labor:
England: 10 hours
Spain:
20 hours
Engl.: B = 200 − 1/2 C
Spain: B = 100 − 1/6 C
200
100
0
0 100 200 300 400 500 600 C
Comparative Advantage: Example
PPF England:
B = 200 − 1/2 C or
C = 400 − 2B
Opportunity cost of
Cheese in England:
20B/h
40C /h
200B
=
400C
dB
= −
dC
= 1/2 B/C
OCC =
PPF Spain:
B = 100 − 1/6 C or
C = 600 − 6B
Opportunity cost of
Cheese in Spain:
5B/h
30C /h
100B
=
600C
dB
= −
dC
= 1/6 B/C
OCC =
Comparative Advantage: Example
PPF England:
B = 200 − 1/2 C or
C = 400 − 2B
Opportunity cost of
Bread in England:
40C /h
20B/h
400C
=
200B
dC
= −
dB
= 2C /B
OCB =
PPF Spain:
B = 100 − 1/6 C or
C = 600 − 6B
Opportunity cost of
Bread in Spain:
30C /h
5B/h
600C
=
100B
dC
= −
dB
= 6C /B
OCB =
Comparative Advantage: Example
England has lower opportunity cost in the
production of bread, and should therefore
specialize in the production of bread.
Spain has lower opportunity cost in the production
of cheese, and should therefore specialize in the
production of cheese.
Trade will make the world a better place, since
England and Spain as countries are better of by
specializing and trading.
However, British cheese maker and Spanish baker
will not be amused!
Summary
Free trade can increase welfare of all trading
partners, since free trade allows a more
efficient allocation of resources!
By a more efficient allocation of resources it is
usually possible to produce more of both goods!
However, some groups may loose, though the
gains of the Winners will generally exceed to
losses of the losers; more on this later
Comparative Advantage
Nonlinear PPF
Production possibilities frontier are often bowed
outward. One reason for this is, that opportunity cost
often increase as more resources go in the production
of one good.
F
Opportunity cost are
measured as the slope
of a tangent in the
relevant point!
M
Sources of Comparative Advantage
International Trade:
Example of David Ricardo: England and Portugal
trade cloth for wine.
Specialization necessitates structural change!
People have to change jobs, and if they are not
mobile between industries many will loose their
jobs!!!
Structural change implies adjustment costs in the
short run, but can increase welfare in the long run!
International differences in climate and natural
resources.
Technology.
Factor endowments: The relationship between
comparative advantage and factor availability is
found in an influential model of international
trade, the Heckscher-Ohlin model.