Gain from Trade: The Theory of Comparative Advantage originally advanced by the 19th-century The theory of comparative advantage economist David Ricardo as an explanation for why nations trade with one another. The theory claims that economic well-being is enhanced if cach country's citizens produce that which they have a comparative advantage in producing relative to the citi- zens of other countries, and then trade products. Underlying the theory are the assump- tions of free trade between nations and that the factors of production (land, labor, technology, and capital) are relatively immobile. Consider the example described in Exhibit A.1 as a vehicle for explaining the theory. Exhibit A.1 assumes two countries, A and B, which each produce only food and textiles, but they do not trade with one another. Country A and B each have 60,000,000 units of input. Each country presently allocates 40,000,000 units to the production of food and 20,000,000 units to the production of textiles. Examination of the exhibit shows that Country A can produce five pounds of food with one unit of production or three yards of textiles. Country B has an absolute advantage over Country A in the production of both food and textiles. Country B can produce 15 pounds of food or four yards of textiles with one unit of production. When all units of production are employed, Country A can produce 200,000,000 pounds of food and 60,000,000 yards of textiles. Country B can produce 600,000,000 pounds of food and 80,000,000 yards of textiles. Total output is 800,000,000 pounds of food and 140,000,000 yards of tex- tiles. Without trade, each nation's citizens can consume only what they produce. While it is clear from the examination of Exhibit A.1 that Country B has an absolute advantage in the production of food and textiles, it is not so clear that Country A (B) has a relative advantage over Country B (A) in producing textiles (food). Note that in using units of production, Country A can "trade off" one unit of production needed1 produce five pounds of food for three yards of textiles. Thus, a yard of textiles has an opportunity cost of 5/3= 1.67 pounds of food, or a pound of food has an opportunity cost of 3/5 60 yards of textiles. Analogously, Country B has an opportunity cost of 15/4 3.75 pounds of food per yard of textiles, or 4/15 .27 yards of textiles per pound of food.. When viewed in terms of opportunity costs it is clear that Country A was Country Total A B Units of input (000,000) Food Textiles Output per unit of input (bs. or yards) Food Textiles Total output (lbs. or yards) (000,000) I. 40 40 20 20 5 15 3 4 II. 200 600 80 800 140 Food 60 Textiles IV. Consumption (Ibs. or yards) (000,000) 200 60 600 80 800 Food Textiles 140 L Country Total A Units of input (000,000) Food Textiles 50 10 20 40 15 Output per unit of input (lbs. or yards) 5 3 II Food Textiles Total output (lbs. or yards) (000,000) Food Textiles IV. Consumption (lbs. or yards) (000,000) Food Textiles 4 850 160 100 120 750 40 625 90 850 160 225 70 is relatively more efficient in producing textiles and Country B is relatively more effi- cient in producing food. That is, Country A's (B's) opportunity cost for producing textiles (food) is less than Country B's (A's). A relative efficiency that shows up via a lower opportunity cost is referred to as a comparative advantage. Exhibit A.2 shows that when there are no restrictions or impediments to free trade, such as import quotas, import tariffs, or costly transportation, the economic well-being of the citizens of both countries is enhanced through trade. Exhibit A.2 shows that Country A has shifted 20,000,000 units from the production of food to the production of textiles where it has a comparative advantage and that Country B has shifted 10,000,000 units from the production of textiles to the production of food where it has a comparative advantage. Total output is now 850,000,000 pounds of food and 160,000,000 yards of textiles. Suppose that Country A and Country B agree on a price of 2.50 pounds of food for one yard of textiles, and that Country A sells Country B 50,000,000 yards of textiles for 125,000,000 pounds of food. With free trade, Exhibit A.2 makes it clear that the citizens of each country have increased their consumption of food by 25,000,000 pounds and textiles by 10.000,000 yards. 1. Country C can produce seven pounds of food or four yards of textiles per unit of input. Compute the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of producing textiles instead of food. 2. Consider the no-trade input/output situation presented in the following table for countries X and Y. Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries. Country Y Total Units of input (000,000) Food Textiles II Output per unit of input (bs. or yards) Food Textiles II. 70 40 60 30 17 5 Total output (lbs. or yards) (000,000) Food Textiles IV Consumption (bs. or yards) (000,000) Food Textiles 2 1,190 200 300 60 1,490 260 1,190 200 300 60 1,490 260 Gain from Trade: The Theory of Comparative Advantage originally advanced by the 19th-century The theory of comparative advantage economist David Ricardo as an explanation for why nations trade with one another. The theory claims that economic well-being is enhanced if cach country's citizens produce that which they have a comparative advantage in producing relative to the citi- zens of other countries, and then trade products. Underlying the theory are the assump- tions of free trade between nations and that the factors of production (land, labor, technology, and capital) are relatively immobile. Consider the example described in Exhibit A.1 as a vehicle for explaining the theory. Exhibit A.1 assumes two countries, A and B, which each produce only food and textiles, but they do not trade with one another. Country A and B each have 60,000,000 units of input. Each country presently allocates 40,000,000 units to the production of food and 20,000,000 units to the production of textiles. Examination of the exhibit shows that Country A can produce five pounds of food with one unit of production or three yards of textiles. Country B has an absolute advantage over Country A in the production of both food and textiles. Country B can produce 15 pounds of food or four yards of textiles with one unit of production. When all units of production are employed, Country A can produce 200,000,000 pounds of food and 60,000,000 yards of textiles. Country B can produce 600,000,000 pounds of food and 80,000,000 yards of textiles. Total output is 800,000,000 pounds of food and 140,000,000 yards of tex- tiles. Without trade, each nation's citizens can consume only what they produce. While it is clear from the examination of Exhibit A.1 that Country B has an absolute advantage in the production of food and textiles, it is not so clear that Country A (B) has a relative advantage over Country B (A) in producing textiles (food). Note that in using units of production, Country A can "trade off" one unit of production needed1 produce five pounds of food for three yards of textiles. Thus, a yard of textiles has an opportunity cost of 5/3= 1.67 pounds of food, or a pound of food has an opportunity cost of 3/5 60 yards of textiles. Analogously, Country B has an opportunity cost of 15/4 3.75 pounds of food per yard of textiles, or 4/15 .27 yards of textiles per pound of food.. When viewed in terms of opportunity costs it is clear that Country A was Country Total A B Units of input (000,000) Food Textiles Output per unit of input (bs. or yards) Food Textiles Total output (lbs. or yards) (000,000) I. 40 40 20 20 5 15 3 4 II. 200 600 80 800 140 Food 60 Textiles IV. Consumption (Ibs. or yards) (000,000) 200 60 600 80 800 Food Textiles 140 L Country Total A Units of input (000,000) Food Textiles 50 10 20 40 15 Output per unit of input (lbs. or yards) 5 3 II Food Textiles Total output (lbs. or yards) (000,000) Food Textiles IV. Consumption (lbs. or yards) (000,000) Food Textiles 4 850 160 100 120 750 40 625 90 850 160 225 70 is relatively more efficient in producing textiles and Country B is relatively more effi- cient in producing food. That is, Country A's (B's) opportunity cost for producing textiles (food) is less than Country B's (A's). A relative efficiency that shows up via a lower opportunity cost is referred to as a comparative advantage. Exhibit A.2 shows that when there are no restrictions or impediments to free trade, such as import quotas, import tariffs, or costly transportation, the economic well-being of the citizens of both countries is enhanced through trade. Exhibit A.2 shows that Country A has shifted 20,000,000 units from the production of food to the production of textiles where it has a comparative advantage and that Country B has shifted 10,000,000 units from the production of textiles to the production of food where it has a comparative advantage. Total output is now 850,000,000 pounds of food and 160,000,000 yards of textiles. Suppose that Country A and Country B agree on a price of 2.50 pounds of food for one yard of textiles, and that Country A sells Country B 50,000,000 yards of textiles for 125,000,000 pounds of food. With free trade, Exhibit A.2 makes it clear that the citizens of each country have increased their consumption of food by 25,000,000 pounds and textiles by 10.000,000 yards. 1. Country C can produce seven pounds of food or four yards of textiles per unit of input. Compute the opportunity cost of producing food instead of textiles. Similarly, compute the opportunity cost of producing textiles instead of food. 2. Consider the no-trade input/output situation presented in the following table for countries X and Y. Assuming that free trade is allowed, develop a scenario that will benefit the citizens of both countries. Country Y Total Units of input (000,000) Food Textiles II Output per unit of input (bs. or yards) Food Textiles II. 70 40 60 30 17 5 Total output (lbs. or yards) (000,000) Food Textiles IV Consumption (bs. or yards) (000,000) Food Textiles 2 1,190 200 300 60 1,490 260 1,190 200 300 60 1,490 260