Absolute and Comparative Advantage

Principle of Absolute Advantage
-Absolute advantage: one country would have an absolute advantage over the other if it can produce same amount of goods with fewer resources

-This is then the ability of country to produce more goods than its competitors using same or less resources

Principle of Comparative Advantage
-A nation has comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than can a trading partner
-It is also the basis for all trade
-If the two nations specialize according to comparative advantage, then to get the other product, they must trade

Terms of Trade
-The rate of exchange of two products is be determined through negotiation
-The outcome is called the terms of trade
-Gains from trade are based on comparative advantage, not absolute advantage

Specialization and Trade
-Specialization based on comparative advantage improves global resource allocation
-Specialization and trade also increase productivity and the standard of living within a nation
-Because of specialization and trade, there will be a larger global output of goods and services

Input and Output Approach
-output problem approach: based on the most of an item producer can make if it specializes using a set amount of resources (apples per acre, widgets per hour)
-input problem approach: based on the least resources producer needs to make a set amount of an item (minutes per waffle, cups of flour per a dozen loaves)
-For output problems, you take B/A for comparative advantage and pick the highest amount for absolute advantage.
-For input problems, you do the opposite (A/B for comparative and pick lowest amount for absolute) - See more at: http://thekanishacorner.blogspot.com/2014/04/comparative-and-absolute-advantage.html?showComment=1400727389673#c5299564672104467699

Supply and Demand of Dollar

Supply of dollar comes from U.S citizens, banks, and industries wanting to purchase foreign goods investments assets and make transfer payments to foreigners.

Demand of dollar comes from foreigners, banks, and industries wanting to purchase U.S goods, investments, assets and make transfer payments to U.S.

Dollar Appreciates
Demand Increases
Supply  Decreases

Dollar Depreciates
Demand Decreases
Supply Increases


Fix Exchange rate- based on countries' willingness to distribute currency and control the amount (set by government).

Flexible or Floating exchange rate- based on supply and demand of the currency vs. other currencies (not government interventions based on market).

Five determinate of supply & demand in foreign exchange markets.

1. Change of buyer's taste
2. Change in relative income
3. Change in relative prices
4. Change in interest rates
5. Change in expectations

Unit 7

Specialization and Trade

• Specialization and international trade improve a producer's productivity and allow it to achieve greater output than it could otherwise
• Specialization- Occurs when productive agents (such as persons or nations) use their available resources to focus on producing one or a few products at which they are best suited.
• Economic resources needed to efficiently produce particular goods aren't evenly distributed among producers.
• Thus, some producers are better suited to produce certain items than others
• International Trade- Occurs when buyers and sellers in two nations exchange with one another
• A nation has a closed economy when it neither imports nor exports products (this is the situation represented by the basic market model)
• A nation has an open economy when it both imports and exports products.  By trading products they specialize in for those they don't, a nation with an open economy can obtain more of both
• Cost Ratios- Provide a method of comparing opportunity costs of producing certain items between producers
• The lower a nation's cost ratio, the lower its opportunity cost in producing certain items-in other words, the lower the cost ratio, the greater the cost advantage
• Like per-unit opportunity costs, cost ratios measures how much of one good must be surrendered for every unit of another good gained-opportunity costs compare different production possibilities within a single nation whereas cost ratios compare national production between nations
• Cost ratios can be compared between different nations for the same item OR between different items within the same nation
• Cost ratios can be calculated using output or input data-both approaches lead to the same results if done correctly
• In general, producers should specialize in making a product only when their cost ratio of doing so is less than that or their trading partners
• Output Problem Approach- Based on the most of an item each producer could make if it specializes using a set amount of resources (generally, all its resources)-these problems are stated in terms of output per resource unit (apples per acre, widgets per hour, etc.)
• Determine the maximum amount of each item each producer can make if they use all their resources and arrange the data in a table with the producers as rows and the products as columns

	Maximum sales per month
	LPs	8-tracks
Funkytown	90	30
Boogieland	160	40

• Divide each producer's output data in the following manner: Divide itsOUTPUT data of the OTHER item OVER the data for the one whose cost ratio you wish to find

Cost Ratio	Formula	Interpretation
Item A	Maximum output of item B Maximum output of item A	How much of item B must be lost for every unit of item A gained by this producer
Item B	Maximum output of item A Maximum output of item B	How much of item A must be lost for every unit of item B gained by this producer

• Reduce the fractions to the lowest common denominator
• Compare cost ratios for each product between the two producers and select the nation that has the lowest cost ratio for each product -- in general, divide across rows and compare up-and-down columns

	Cost Ratios
	LPs	8-tracks
Funkytown	1/3	*3
Boogieland	*¼	4

• Input Problem Approach- is based on the least resources each producer needs to make a set amount of an item (generally one unit) -- these problems are stated in terms of resources per output unit (minutes per waffle, cups of flour per dozen loaves, etc.)
• Determine the minimum amount of resources each producer needs to make on unit of an item if they specialize and list the data in a table with the producers as rows and the products as columns

	Minutes per sale
	LPs	8-tracks
Funkytown	8	12
Boogieland	2	6

• Divide each producer's input data in the following manner: Divide the INPUTdata of the other item INTO (i.e., place it beneath the line as a denominator) the data for the item whose cost ratio you INTEND to find

Cost Ratio	Formula	Interpretation
Item A	Resources needed for item A Resources needed for item B	How much of item A will be gained for every unit of item B lost by this producer
Item B	Resources needed for item B Resources needed for item A	How much of item B will be gained for every unit of item A lost by this producer

• Reduce the fractions to the lowest common denominator
• Compare cost ratios for each product between the two nations and select the nation that has the lowest cost ratio for each product

	Cost Ratios
	LPs	8-tracks
Funkytown	2/3	*3/2
Boogieland	*1/3	3

Specialization and Trade 2

• Rules of Specialization- these hold true for both input and output problems
• In general, producers should specialize in making a product only when their cost ratio of doing so is less than that of their trading partners
• the no advantage rule states that nations should not specialize or trade if neither trading parner possesses a cost advantage in producing either product

	Sales per week
	LPs	8-tracks
Funkytown	40	20
Boogieland	50	25

	Cost Ratios
	LPs	8-tracks
Funkytown	1/2	2
Boogieland	1/2	2

• Though Funkytown produces greater total output, neither has an advantage when cost ratios are compared
• The absolute advantage rule (Adam Smith) states that two countries should specialize and trade when each partner has an output advantage over the other

	Sales per Week
	LPs	8-tracks
Funkytown	40	*20
Boogieland	*45	15

	Cost Ratios
	LPs	8-tracks
Funkytown	1/2	*2
Boogieland	*1/3	3

• This rule is not always a reliable guide because having an output advantage does not guarantee a cost advantage (in terms of cost ratios)
• The comparative advantage rule (David Ricardo) states that two countries should specialize and trade, even if one produces more output of both products, as long as each partner has a cost advantage over the other
• Example:

	Sales per Week
	LPs	8-tracks
Funkytown	40	20
Boogieland	*75	*25

	Cost Ratios
	LPs	8-tracks
Funkytown	1/2	*2
Boogieland	*1/3	3

• Though Boogieland has an absolute advantage in both products, each nation still enjoys a cost advantage over the other and therefore should specialize and trade
• Trade possibilities curves provide an alternative way of solving output problems
• The trade possibilities curve (TPC) shows the amount of two items a country can obtain by specializing in one and trading for the other
• The production possibilities curve (PPC) assumes a closed economy where trade-offs must be made in how a nation uses its own resources
• The TPC assumes an open economy where a nation is free to specialize its own production and trade with other nations
• Comparing the TPCs of different economies reveals their absolute and comparative advantage
• The slope of the trade possibilities curve, which may be found using the slope formula (y1-y0)/(x1-x0), provides the opportunity cost of producing one more unit of a particular good
• The nation with the lower opportunity cost has a comparative advantage in that particular item

Terms of Trade

• Terms of Trade- determine the rate at which one country is willing to trade one item for another item on the world market
• Trade terms may be expressed in either monetary or bartering vocabulary
• As a monetary expression, terms of trade are stated as a world price, the subject of upcoming discussions
• When viewed from a bartering standpoint, trade terms refer to the amount of certain items two countries are willing to exchange with one another
• Trade terms are influenced by economic and non-economic factors and must be negotiated through a political process
• There is no unique set of optimal trade terms between two countries
• A range of acceptable trade solutions exists from which the countries must select through trade agreements
• Knowing how a country benefits from specializing can help us determine how it may benefit from trade -- shifts its PPC outward
• Solving terms of trade problems
• If necessary, construct an output table using the data for two nations -- this represents their production possibilities before trade

	Item A	Item B
Nation C	100	200
Nation D	40	200

• Determine the cost ratios and comparative advantage of each nation

	Item A	Item B
Nation C	2*	1/2
Nation D	5	1/5*

• Select one product as a reference and use its cost ratio to determine its per-unit opportunity cost for each nation
• Nation C: 1A = 2B  Nation C not willing to trade As for less than 2 Bs a piece
• Nation D: 1A = 5B  Nation D not willing to trade As for more than 5 Bs a piece
• Set a term of trade somewhere between the two boundaries
• 1A = XB where 2 < X < 5
• Say 1A = 3B is negotaited as a trade term
• Calculate the maximum amount of each item each nation can gain through trade
• Nation whose cost advantage is item A should MULTIPLY its output of that item by the term of trade
• Nation whose cost advantage is item B should DIVIDE its output of that item by the term of trade
• Nation C: 100A x (3B per A) = 300B
• Nation D: 200B / (3B per A) = 66 2/3 A