Trade, Globalization, and Comparative Advantage Theory PDF

Trade, Globalization, and Comparative Advantage Theory  Economic Systems Modern economy is a market economy, which is an economic system based on private property and the markets in which, in principle, individuals decide how, what, and for whom to produce Markets work through a...

Trade, Globalization, and Comparative Advantage Theory  Economic Systems Modern economy is a market economy, which is an economic system based on private property and the markets in which, in principle, individuals decide how, what, and for whom to produce Markets work through a system of rewards and payments Individuals are free to do whatever they want as long as it is legal Fluctuations in prices play a central role in coordinating individuals’ wants in a market economy Most economists believe the market is a good way to coordinate economic activity  Capitalism and Socialism  Capitalism is an economic system based on the market in which the ownership of the means of production resides with a small group of individuals (called capitalists)  Socialism is an economic system based on individuals’ goodwill towards others, not on their own self-interest, and in which, in principle, society decides what, how, and for whom to produce  Capitalism and Socialism Socialism  Is where all people contribute what they can and get what they need  Is based on government ownership of the means of production with economic activity governed by central planning  China and Venezuela are often identified as socialistic in the news People today talk little about differences in economic systems; instead they talk about differences in institutions  Economic Institutions in a Market Economy GOODS MARKET INTERNATIONAL INTERNATIONAL CONNECTION CONNECTION GOVERNMENT BUSINESS HOUSEHOLDS (Consumption) (Production) FACTOR MARKET  The Production Possibilities Model  The production possibilities model can be presented both in a table and in a graph  A production possibility table is a table that lists the trade-offs between two choices An output is a result of an activity An input is what you put in a production process to achieve an output Application: A Production Possibilities Table History Economics Hrs of Study Grade Hrs of Study Grade 20 98% 0 40% 18 94% 2 46% 10 78% 10 70% What is the 4 66% 16 88% output? 0 58% 20 100% What is the input?  The Production Possibilities Model  A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs It gives you a visual picture of the tradeoff embodied in a decision A PPC is created from a production possibility table by mapping the table in a two-dimensional graph  Application: A Production Possibilities Curve Econ Grade 100 A PPC demonstrates: 16 hrs for Econ and 4 hrs for History There is a limit to what you 88 can achieve, given existing 10 hrs for each institutions, resources, and 70 History and Econ technology Every choice you make has PPC an opportunity cost 40 58 66 78 100 History grade  Trade and Comparative Advantage  The PPC is bowed outward because individuals specialize in the production of goods for which they have a comparative advantage  For a society to produce on its PPC, individuals must produce those goods for which they have a comparative advantage and trade for other goods  According to Adam Smith, humankind’s proclivity to trade leads to individuals using their comparative advantage  Increasing Opportunity Costs of the Trade-off The principle of increasing marginal opportunity Butter cost tells us that opportunity costs increase the more you concentrate on the activity A Slope is flat at A This means there is a low opportunity cost to produce more guns Slope is steep at B This means there is a high opportunity B cost to produce more guns Guns  Comparative Advantage  The reason we must give up more and more butter as we produce more guns is that some resources are relatively better suited to producing guns, while others are relatively better suited to producing butter.  A resource has a comparative advantage if it is better suited to the production of one good than to the production of another good  Efficiency Productive efficiency is achieving as Butter much output as possible from a given amount of inputs or resources A Points of efficiency D Unattainable with given amounts of inputs Point of inefficiency C B Guns  Efficiency and Technological Change Neutral technological increase Biased or an increase in resources technological increase A A B B  Distribution and Productive Efficiency  The productive possibility curve focuses on efficiency and ignores distribution  If a method of production will change income distribution we cannot determine if that method is efficient or not Efficiency has meaning when analyzing a particular goal  In our society, most people prefer more to less, and many policies have relatively small distribution effects The Production Opportunities Figure 1 The Production Possibilities Curve Copyright©2003 Southwestern/Thomson Learning Figure 1 The Production Possibilities Curve Copyright©2003 Southwestern/Thomson Learning The Gains from Trade: A Summary Figure 2 How Trade Expands the Set of Consumption Opportunities Copyright©2003 Southwestern/Thomson Learning Figure 2 How Trade Expands the Set of Consumption Opportunities Copyright © 2004 South-Western  Table 3 The Opportunity Cost of Meat and Potatoes Opportunity cost of: 1 kilogram of 1 kilogram of meat potatoes Gardener 4kg of potatoes 0.25kg of meat Farmer 2 kg of potatoes 0.5kg of meat  Markets, Specialization, and Growth Growth in per capita income during the past 2000 years $6,000 Income $5,000 $4,000 $3,000 $2,000 $1,000 Year 0 500 1000 1500 2020 What caused this growth?  The Benefits from Trade When people freely enter into trade, both parties can be expected to benefit from trade Textiles (yds) 5,000 Without trade, each country can only consume 4,000 those combinations of Pakistan goods along their PPCs 3,000 2,000 Belgium 1,000 1 2 3 4 5 Chocolate (tons)  The Benefits from Trade Textiles (yds) If each country specializes according to comparative advantage and trades, 5,000 they can consume beyond their “no-trade” PPCs 4,000 3,000 Pakistan Consumption Why should Pakistan with trade specialize in textiles 2,000 Belgium and Belgium specialize in chocolates? 1,000 1 2 3 4 5 Chocolate (tons)  Application: Textile Production and Trade  Two hundred years ago, the U.S. had a comparative advantage in textile production  Now, countries with cheaper labor or cotton production expertise (such as Pakistan, Bangladesh, etc.) have the comparative advantage in textiles  The gains from trade are higher wages for workers in Pakistan, Bangladesh, etc. and lower-priced cloth for U.S. consumers  Globalization and the Law of One Price Globalization  Globalization is the increasing integration of economies, cultures, and institutions across the world  A positive effect of globalization is that it provides larger markets than the domestic economy  The global economy increases the number of competitors and this increased competition can be a negative effect of globalization  Globalization and the Law of One Price Exchange Rates and Comparative Advantage  Comparative advantages can evolve over time.  The comparative advantage in innovation has resulted in higher wages in the developed countries.  As industries mature, they move to lower wage countries  Exchange rates and costs of production as automatic stabilizers.  Globalization and the Law of One Price The Law of One Price  The law of one price states that wages of workers in one country will not differ significantly from the wages of (equal) workers in another institutionally similar country  Chapter Summary  The production possibility curve illustrates maximum outputs from a given number of inputs  To get increasing amounts of something, we must give up ever-increasing quantities of something else  Trade allows people to use their comparative advantage and shift out society’s PPC  Efficient, inefficient, and unattainable points on the PPC  Through specialization and trade, countries can increase consumption