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