Terms of trade and the gains from trade. Input approach to determining comparative advantage. When there aren't gains from trade. Comparative advantage worked example. Consider the example of trade in two goods, shoes and refrigerators, between the United States and Mexico.
These goods are homogeneous, meaning that consumers and producers cannot differentiate between shoes from Mexico and shoes from the U. From Table 1, we can see that it takes four U. It takes one U.
The United States has an absolute advantage in producing both shoes and refrigerators; that is, it takes fewer workers in the United States than in Mexico to produce both a given number of shoes and a given number of refrigerators.
Absolute advantage simply compares the productivity of a worker between countries. The United States can produce 1, shoes with four-fifths as many workers as Mexico four versus five , but it can produce 1, refrigerators with only one-quarter as many workers one versus four.
When nations increase production in their area of comparative advantage and trade with each other, both countries can benefit. The production possibilities frontier is a useful tool to visualize this benefit. Recall from earlier readings that the production possibilities frontier shows the maximum amount that each country can produce given its limited resources, in this case workers. Consider a situation where the United States and Mexico each have 40 workers. For example, as Table 2 shows, if the United States divides its labor so that 40 workers are making shoes, then, since it takes four workers in the United States to make 1, shoes, a total of 10, shoes will be produced.
If four workers can make 1, shoes, then 40 workers will make 10, shoes. If the 40 workers in the United States are making refrigerators, and each worker can produce 1, refrigerators, then a total of 40, refrigerators will be produced. As always, the slope of the production possibility frontier for each country is the opportunity cost of one refrigerator in terms of foregone shoe production—when labor is transferred from producing the latter to producing the former see Figure 1.
Figure 1. Production Possibility Frontiers. All other points on the production possibility line are possible combinations of the two goods that can be produced given current resources.
Point A on both graphs is where the countries start producing and consuming before trade. Point B is where they end up after trade. Table 3 shows the output of each good for each country and the total output for the two countries. Continuing with this scenario, each country transfers some amount of labor toward its area of comparative advantage. For example, the United States transfers six workers away from shoes and toward producing refrigerators. As a result, U.
Mexico also moves production toward its area of comparative advantage, transferring 10 workers away from refrigerators and toward production of shoes. Notice that when both countries shift production toward each of their comparative advantages what they are relatively better at , their combined production of both goods rises, as shown in Table 4. The reduction of shoe production by 1, pairs in the United States is more than offset by the gain of 2, pairs of shoes in Mexico, while the reduction of 2, refrigerators in Mexico is more than offset by the additional 6, refrigerators produced in the United States.
It induces the producers to expand the scale of production, volume of investment and employment. Consequently, the production frontiers in the trading countries can continuously be expanded. As the demand for the home produced goods increases due to international trade, there is strong impetus to investment. The growth of export sector leads to the expansion of several allied ancillary industries creating more and more opportunities for investment. There is also substantial increase in foreign direct investments in the export sector of the economy.
International trade paves the way for more efficient use of productive resources. The exploitation and use of the resources, previously considered economically non-viable, becomes economically viable due to increased demand in the foreign markets. Production for exports and increased imports of goods bring about a series of adjustments within the economic system that ultimately have stimulating effect upon the overall growth in the trading countries. Trade not only induces the growth of export industries, but also promotes the growth of infrastructure and services sector.
New ways of producing and organising production are spread to the local economy through trade and the competitive force of trade stimulates adoption of cost saving techniques. Trade also makes possible economical local production of many goods that would be prohibitive to produce locally. International Economics , Trade , Gains from Trade. Article Shared by. Related Articles. Globalisation Economic Processes Economics. Term Paper on International Trade Economics.
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Comparative advantage worked example. Lesson summary: Comparative advantage and gains from trade. Practice: Comparative advantage and the gains from trade.
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