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NSS Exploring Economics 6

Chapter 11

International trade (I) — free trade and principle of comparative advantage

Questions

p.124

Think it over

The photos show some of the imported goods we consume. Why does Hong Kong import

them rather than produce them domestically?

p.126

Discuss

11.1

If Country A has a higher productivity than Country B in the production of all goods, should

Country A produce all the goods itself? Should Country B produce nothing?

11.2

Country A has an absolute advantage in the production of all goods. Does Country A also

have a comparative advantage in the production of all goods?

p.127

Discuss

11.3

What determines international specialisation and trade? Absolute advantage or comparative

advantage?

p.130

Test yourself

11.1

Use the above example about Country A and Country B to illustrate that absolute advantage

and comparative advantage are unrelated.

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p.132 Test yourself 11.2 Refer to Section 11.3 above. What is the terms of trade of
p.132
Test yourself
11.2
Refer to Section 11.3 above. What is the terms of trade of 1C? What are the gains of two
countries from trade? Show your answers by completing Fig. 11.3.
Discuss
11.4

Refer to Table 11.2. Will Country A and Country B trade food with each other under the

following situations?

  • a. The terms of trade is 1F to 0.5C.

  • b. The terms of trade is 1F to 0.8C.

  • c. The terms of trade is 1F to 2.5C.

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pp. 143-146

Exercises Multiple Choice Questions

1.

Which of the following descriptions about absolute advantage and comparative advantage

is INCORRECT?

  • A. A country has an absolute advantage over another country in producing a good if it can produce a larger amount of the good than the other country with the same amount of resources.

  • B. A country has an absolute disadvantage over another country in producing a good if it has a lower productivity in the production of the good than the other country.

  • C. A country has a comparative advantage over another country in producing a good if it can forgo a smaller amount of another good than the other country in producing the same amount of the good.

  • D. A country has a comparative disadvantage over another country in the production of a good if it can produce the good at a lower opportunity cost than the other country.

2*.

Suppose Country A and Country B produce Good X and Good Y only. If Country A has a comparative advantage in producing Good X over Country B,

  • A. Country A produces a larger amount of Good X than Country B with the same amount of resources.

  • B. Country A produces Good X at a lower opportunity cost than Good Y.

  • C. Country A produces Good Y at a higher opportunity cost than Country B.

  • D. Country A also has an absolute disadvantage in producing Good Y over Country B.

3.

The following table shows the output of Good X and Good Y per unit of resources in Country

A and Country B.

 

Country A

Country B

Good X (units)

8

10

Good Y (units)

2

6

Which of the following descriptions is correct?

  • A. Country A has an absolute advantage in producing Good X.

  • B. Country B has an absolute disadvantage in producing Good Y.

  • C. Country A has a comparative disadvantage in producing Good X.

  • D. Country B has a comparative advantage in producing Good Y.

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4*.

The following table shows the output of Good X and Good Y per unit of resources in Country A and Country B.

 

Good X (units)

Good Y (units)

Country A

8

10

 

Country B

2

6

Which terms of trade is mutually beneficial to the two countries?

A.

1X = 1Y

B.

2X = 5Y

C.

3X = 9Y

D.

4X = 15Y

5*.

The following table shows the output of computers and watches per unit of resources in Country A and Country B.

 

Computers (units)

Watches (units)

Country A

2

10

 

Country B

4

8

Suppose the exchange ratio is 1 unit of computers to 4 units of watches. Which of the following is correct?

A.

Country A gains 2 units of watches per unit of computers imported.

B.

Country B gains 0.25 units of computers per unit of watches exported.

C.

The total gain from trade per unit of computers transacted is 2 units of watches.

D.

If the total transaction cost per unit of watches is 0.5 units of computers, there will be no trade in watches.

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6**.

The following table shows the number of man-hours required by Countries A, B and C in the production of consumer goods and producer goods.

   

1 unit of

1 unit of

consumer goods

producer goods

Country A

 

1 man-hour

  • 5 man-hours

Country B

2

man-hours

  • 4 man-hours

Country C

3

man-hours

  • 3 man-hours

If 1 unit of consumer goods can be exchanged for 0.6 units of producer goods,

  • A. Country A will export consumer goods and import producer goods.

  • B. Country B will import both consumer goods and producer goods.

  • C. Country C will export both consumer goods and producer goods.

  • D. We cannot determine the pattern of trade in a three-country case.

Short Questions

1.

  • a. Define absolute advantage and comparative advantage.

(4 marks)

b**. ‘A country can have an absolute advantage in the production of all goods but it cannot

have a comparative advantage in the production of all goods.’ Do you agree? Explain. (6 marks)

2.

a.

State the principle of comparative advantage.

(2 marks)

b*.

‘Specialisation raises the total world output while trade distributes the increased output

between trading partners.’ Do you agree? Explain.

(6 marks)

3*.

‘Comparative advantage determines the direction of trade, the terms of trade, the volume of

trade and the gains from trade.’ Do you agree? Explain.

(6 marks)

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Structured Questions

1*.

Suppose the amount of resources in Country X is double that in Country Y and both use ALL their resources in production. Their maximum output in a year is shown below.

 

Consumer goods

Producer goods

(units)

(units)

Country X

100

OR

100

Country Y

30

OR

45

a.

Which country has an absolute advantage in the production of consumer goods and

producer goods, respectively? Explain.

 

(4 marks)

b.

Which country has a comparative advantage in the production of consumer goods and

producer goods, respectively? Explain.

 

(6 marks)

c.

If 1 unit of consumer goods can be exchanged for 1.25 units of producer goods, what are

the gains for Country X and Country Y for each unit of consumer goods transacted?

 

(4 marks)

d.

Determine the range of terms of trade of consumer goods and producer goods which is

mutually beneficial to both countries.

 

(2 marks)

2*.

The following table shows the amount of labour required to produce one unit of Good X and one unit of Good Y in Country A and Country B, respectively.

 

Good X

Good Y

Country A

 

1

3

 

Country B

2

4

a.

Which country has an absolute advantage in the production of Good X and Good Y,

respectively? Explain.

 

(4 marks)

b.

Which country has a comparative advantage in the production of Good X and Good Y,

respectively? Explain.

 

(6 marks)

c.

If the terms of trade is 1X = 0.4Y, what are the gains for Country A and Country B for

each unit of Good Y transacted?

 

(5 marks)

d.

What will the minimum transport cost of Good Y be for trading not to be beneficial? (2 marks)

e.

Suppose the transport cost of 1Y is 0.4X and is shared equally between the two countries. What is the range of the terms of trade of 1Y for trade to be mutually beneficial?

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Answers
Answers

P.124

Think it over

Hong Kong cannot produce them or other countries can produce them at a lower cost.

P.126

Discuss 11.1 Although Country A has a higher productivity than Country B in the production of all goods, Country A’s productivity in food production is 3.33 times (= 10F ÷ 3F) that of Country B but its productivity in clothing production is only 1.33 times (= 8C ÷ 6C) that of Country B.

If Country A uses its resources to produce clothing, it cannot use the same resources to produce food. Hence, Country A should not produce all goods in which it has an absolute advantage. Instead, it should allocate its resources to produce the good in which it has a comparative advantage so that its resources can be used more efficiently.

On the other hand, although Country B has a lower productivity than Country A in the production of all goods, if it produces nothing, it has nothing to consume. Among all the goods in which it has an absolute disadvantage, it should produce the good in which it has a comparative advantage.

Discuss 11.2 No, Country A does not have comparative advantages in the production of all goods. (For a numerical illustration, refer to the section below. For a mathematical proof, refer to Extension Corner Section 1.)

P.127

Discuss 11.3 It is comparative advantage, rather than absolute advantage, that determines international specialisation and trade. This is because absolute advantage tells nothing about which good is more beneficial for a country to produce, whereas comparative advantage does. This is explained in Extension Corner Section 2.

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P.130

Test Yourself 11.1

Refer to Table 11.3. Country A has an absolute advantage in both food production and

clothing production, while it has a comparative advantage in the former but a comparative disadvantage in the latter. Moreover, Country A has a comparative advantage as well as an absolute advantage in food production, while Country B has a comparative advantage but an absolute disadvantage in clothing production. Hence, absolute advantage and comparative advantage are unrelated.

P.132

Test Yourself 11.2

P.130 Test Yourself 11.1 Refer to Table 11.3. Country A has an absolute advantage in both

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P.132

Discuss 11.4

  • a. When the terms of trade is 1F to 0.5C, the international price of food is lower than the production costs in both countries (0.8C and 2C). Both would want to import food from the world market. However, without sellers, no trade can take place.

  • b. When the terms of trade is 1F to 0.8C, the international price of food is equal to the production cost in Country A. As Country A cannot benefit from trade, it may refuse to trade. In that case, no trade occurs as only one participant (Country B) exists.

  • c. When the terms of trade is 1F to 2.5C, the international price of food is higher than the production costs in both countries (0.8C and 2C). Both would want to export food to the world market. However, without buyers, no trade occurs.

P.143-146

Exercises Multiple Choice Questions

  • 1. D Option D: A country has a comparative disadvantage over another country in the production of a good if it produces the good at a higher opportunity cost than the other country.

  • 2. C Option A is incorrect. It implies that Country A has an absolute advantage (rather than a comparative advantage) over Country B in the production of Good X. Option B is incorrect. In a two-good case, the production cost of Good X is in terms of Good Y while that of Good Y is in terms of Good X. The two production costs cannot be compared. Moreover, comparative advantage concerns the production costs of a good in two different countries, instead of the production costs of two goods in one country. Option C is correct. Since Country A has a comparative advantage (a lower opportunity cost) over Country B in the production of Good X, Country A must have a comparative disadvantage over Country B in the production of the other good (Good Y). Option D is incorrect. Comparative advantage or disadvantage are unrelated to absolute advantage or disadvantage.

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3.

D

Options A and B: Country A can produce 8X or 2Y per unit of resources, while Country

B can produce 10X or 6Y. Both are smaller in A than in B. Hence, Country A (B) has an absolute disadvantage (advantage) over the other country in the production of both Good

X

and Good Y.

Options C and D: The production cost of 1X is 0.25Y (= 2Y ÷ 8) in Country A and 0.6Y

(= 10Y ÷ 6) in Country B. Hence, Country A (B) has a comparative advantage (disadvantage) over the other country in the production of Good X. This also implies that Country A (B) has a comparative disadvantage (advantage) over the other country in the production of Good Y.

  • 4. B The production cost of 1X is 1.25Y (= 10Y ÷ 8) in Country A and 3Y (= 6Y ÷ 2) in Country B. For option A, both would want to import Good X. Without a seller, no trade can take place. For option B, the terms of trade is 2X = 5Y or 1X = 2.5Y and Country A will be the exporter while Country B will be the importer. Trade is mutually beneficial. For option C, the terms of trade is 3X = 9Y or 1X = 3Y and Country B would have no gain from trade. It may refuse to trade. For option D, the terms of trade is 4X = 15Y or 1X = 3.75Y and both would want to export Good X. Without a buyer, no trade can take place.

  • 5. D

Let C be computers and W be watches. Option A is incorrect. The production cost of 1C is 5W (= 10W ÷ 2) in Country A and 2W (= 8W ÷ 4) in Country B. If the exchange ratio is 1C = 4W, Country A would import computers and gain 1W (= 5W − 4W) per unit of computers imported, while Country B would export computers and gain 2W (= 4W − 2W) per unit of computers exported. Option B is incorrect. The production cost of 1W is 0.2C (= 2C ÷ 10) in Country A and 0.5C (= 4C ÷ 8) in Country B. If the exchange ratio is 1W = 0.25C (= 1C ÷ 4), Country A would export watches and gain 0.05C (= 0.25C − 0.2C) per unit of watches exported, while Country B would import watches and gain 0.25C (= 0.5C − 0.25C) per unit of watches imported. Option C is incorrect. The total gain from trade per unit of computers transacted is 3W (= 5W − 2W = 1W + 2W). Option D is correct. The total gain from trade per unit of watches transacted at zero transport and transaction costs is 0.3C (= 0.5C − 0.2C). As the total gain is smaller than the total transaction cost of 0.5C, there will be no trade in watches.

  • 6. A

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The production costs of consumer goods (C) and producer goods (P) in the three countries are listed in the table below.

 

Production cost of 1 unit of

Production cost of 1 unit of

consumer goods

producer goods

Country A

0.2P (= 1 man-hour ÷

5C (= 5 man-hours ÷

  • 5 man-hours × 1P)

  • 1 man-hour × 1C)

Country B

0.5P (= 2 man-hours ÷

2C (= 4 man-hours ÷

  • 4 man-hours × 1P)

  • 2 man-hours × 1C)

Country C

1P (= 3 man-hours ÷

1C (= 3 man-hours ÷

  • 3 man-hours × 1P)

  • 3 man-hours × 1C)

If the exchange ratio is 1C = 0.6P or 1.67C = 1P, the pattern of trade is shown in the table below.

 

Consumer goods

Producer goods

Country A

Export

Import

[Cost (0.2P) < Price (0.6P)]

[Cost (5C) > Price (1.67C)]

Country B

Export

Import

[Cost (0.5P) < Price (0.6P)]

[Cost (2C) > Price (1.67C)]

Country C

Import

Export

[Cost (1P) > Price (0.6P)]

[Cost (1C) < Price (1.67C)]

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P. 145

Short Questions

1.

  • a. A country has an absolute advantage over another country in the production of a good if it can produce a larger amount of the good than the other country with the same amount of resources. (2 marks) (Alternative definition of absolute advantage: A country has an absolute advantage over another country in the production of a good if it can use a smaller amount of resources to produce the same amount of the good.) A country has a comparative advantage over another country in the production of a good if it can forgo a smaller amount of another good than the other country in producing the same amount of the good. (2 marks)

  • b. Yes. With the help of advanced equipment and technology or better human capital, it is possible that a country has a higher productivity or an absolute advantage in the production of all goods. (1 mark) However, in the case of two countries (A and B) and two goods (X and Y), if a country (Country A) has a comparative advantage (i.e. with a lower opportunity cost) over another country (Country B) in the production of Good X, Country A must have a comparative disadvantage over B in the production of Good Y. Hence, it is impossible for a country to have a comparative advantage over the other country in all goods. (2 marks) Proof: Suppose Country A has a comparative advantage over Country B in the production of X, and Country A’s production cost of 1X is αY and that of Country B is βY, then αY < βY (i.e. α < β). From the production cost of X, we can derive the

 

1

production cost of Y. Country A’s production cost of 1Y is

 

x

and Country B’s

 
  • 1 1

1

 

production cost of 1Y is

. Since α < β,

  • x >

x

  • x . Hence, Country A must

have a comparative disadvantage over Country B in producing Y. (3 marks)

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2.

  • a. The principle of comparative advantage states that if each country specialises in producing the good in which it has a comparative advantage (or lower opportunity cost), the total world output will increase. (2 marks)

  • b. Yes. According to the principle of comparative advantage, each country should specialise in producing the good which it has a lower opportunity cost than that of other countries. By allocating the production of a good (say Good X) from a high- cost country to a low-cost country, the total output of the alternative good (say Good Y) can be increased, and the increase in output is equal to the difference in production costs between the two countries. Thus, the total world output increases with specialisation. (3 marks) If the terms of trade of the two goods lies between the production costs of the two countries, both the exporting and importing countries can benefit. Each country’s gain is equal to the difference between the terms of trade and its production cost. Hence, the gain from specialisation is distributed among countries through trade. (3 marks)

3.

No. Comparative advantage determines the direction of trade. The country with a lower production cost is the exporter while the country with a higher production cost is the importer. (2 marks) However, the terms of trade and the volume of trade is determined by the market demand and market supply of the good in the international market, rather than determined by comparative advantage. (2 marks) The unit gains from trade are equal to the difference between the terms of trade and the production costs of the trading countries. They are not determined by comparative advantage. (2 marks)

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Structured Questions

1.

  • a. Transform the table given in the question to a table that shows the output of the two countries with the same amount of resources (by dividing the outputs of Country X by 2).

 

Consumer goods

Producer goods

(units)

(units)

Country X

50 (= 100 ÷ 2)

OR

50 (= 100 ÷ 2)

Country Y

30

OR

45

Since Country X can produce a larger amount of both consumer goods and producer goods than Country Y with the same amount of resources, Country X has absolute advantages over Country Y in the production of consumer goods and producer goods. (4 marks)

  • b. Let C be consumer goods and P be producer goods.

 

Cost of 1C

Cost of 1P

Country X

1P (= 50P ÷ 50)

1C (= 50C ÷ 50)

Country Y

1.5P (= 45P ÷ 30)

0.67C (= 30C ÷ 45)

Since 1P < 1.5P, Country X has a comparative advantage over Country Y in the production of consumer goods. (3 marks) Since 0.67C < 1C, Country Y has a comparative advantage over Country X in the production of producer goods. (3 marks)

  • c. In Country X, the production cost of 1C (= 1P) is lower than its price (= 1.25P). Hence, Country X would export consumer goods and gain 0.25P (= 1.25P − 1P) per unit of consumer goods exported. (2 marks) In Country Y, the production cost of 1C (= 1.5P) is higher than its price (= 1.25P). Hence, Country Y would import consumer goods and gain 0.25P (= 1.5P − 1.25P) per unit of consumer goods imported. (2 marks)

  • d. For mutually beneficial trade, the terms of trade (TOT) should lie between the production costs of the two countries. Hence, the range of the terms of trade of 1 unit of consumer goods is 1.5P > TOT > 1P, while that of 1 unit of producer goods is 1C > TOT > 0.67C. (2 marks)

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2.

a.

To produce one unit of Good X, Country A needs 1 unit of labour (L) while

b.

Country B needs 2L. Since 1L < 2L, Country A (requires fewer resources to produce one unit of Good X) has an absolute advantage over Country B in the production of Good X. (2 marks) To produce one unit of Good Y, Country A needs 3L while Country B needs 4L. Since 3L < 4L, Country A also has an absolute advantage over Country B in the production of Good Y. (2 marks)

 

Cost of 1X

Cost of 1Y

 

Country A

0.33Y (= 1 ÷ 3)

3X (= 3 ÷ 1)

 

Country B

0.5Y (= 2 ÷ 4)

2X (= 4 ÷ 2)

Since 0.33Y < 0.5Y, Country A has a comparative advantage over Country B in the production of Good X. (3 marks) Since 2X < 3X, Country B has a comparative advantage over Country A in the production of Good Y. (3 marks)

 

c.

The terms of trade is 1X = 0.4Y or 2.5X = 1Y. (1 mark) In Country A, the production cost of 1Y (= 3X) is higher than its price (= 2.5X). Hence, Country A would import Good Y and gain 0.5X (= 3X − 2.5X) per unit of Good Y imported. (2 marks) In Country B, the production cost of 1Y (= 2X) is lower than its price (= 2.5X). Hence, Country B would export Good Y and gain 0.5X (= 2.5X − 2X) per unit of Good Y exported. (2 marks)

d.

Since the gain from trade per unit of Good Y transacted is 1X (= difference in production costs = 3X – 2X), trade would not be beneficial if the minimum transport cost per unit of Good Y was 1X. This would offset the entire gain. (2 marks)

e.

Without transport costs, the range of mutually beneficial terms of trade (TOT) of 1Y is 3X > TOT > 2X. With the equally shared transport cost of 0.4X, the maximum price offered by the importing country (A) is 3X – 0.2X, while the minimum price asked by the exporting country (B) is 2X + 0.2X. Hence, the new range becomes 2.8X > TOT > 2.2X (= 3X – 0.2X > TOT > 2X + 0.2X). (2 marks)

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