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Countries with
lower pre-trade price
are potential exporters.
1
‘conditions are favourable’ for production
Trade on the basis of natural advantage
Leaders in world exports (2020) • Climate / Natural resource
Selected commodities • Acquired skill
commodities 3 Leading exporters Combined
Share of world
exports
(approx)
Coffee Brazil, Switzerland, Germany 35%
Tea China, Sri Lanka, Kenya 58%
Cinnamon China, Vietnam, Sri Lanka 72%
Perfumes France, Spain, Germany 47%
Pepper India, Vietnam, China 61%
Clocks and Switzerland, Hong Kong, China 67%
watches
Wine from France, Italy, Spain 59%
fresh grapes
2
A shift from a regime of self sufficiency to one of free trade is
associated with
- more competition for domestic firms
- close down of some domestic industries
- price adjustments
- old skills becoming irrelevant to the market
- workers trying to acquire of new skills
- market being flooded with varieties of imported goods
3
• A policy shift from protected market (autarky) to free trade is a
political decision.
• It benefits some, while others incur costs.
It raises
consumption possibilities
beyond
production possibilities.
4
Absolute advantage:
• Argument:
If free trade is allowed between countries with natural or acquired
advantage,
(1) world’s productive efficiency will increase.
Due to Adam Smith • Through honing of existing skills
• Development of more effective work methods
• Most importantly, through a better allocation of resources
between sectors (industries)
(2) Consumption possibilities increase
5
Absolute advantage : lower price.
7
Say, the cost difference is solely due to productivity differences.
• Let the countries be identical in all respect except labour productivity
• Let the total number of labour available in each country = 100
• Market structure – perfectly competitive (P = MC)
• Production subject to Constant returns to scale (AC = MC)
• Identical wages in both countries
8
coffee Pepper
India 20 5
Brazil 10 25
9
coffee Pepper Production possibility frontiers
India 20 5 India’s PPF equation: L(i) = Lci.Qc + Lpi.Qp
Brazil 10 25 => Qp = L(i)/Lpi - Lci/Lpi . Qc
Labour available in each => Qp = 100/5 – 20/5.Qc
country: 100
India 20 5 India 5 0
or
Brazil 10 25 0 20
India
Maximum
coffee Pepper
production
possible in Brazil Brazil 10 0 Labour available in
using the entire each country: 100
labour resource or
Brazil 0 4
11
Production possibility frontiers
pepper
India’s PPF equation:
20
Qp = 100/5 – 20/5.Qc
5 10
coffee
12
Relative prices and what do they signify….
In autarky,
Relative price ratio
= Pc/Pp = relative labour requirement
= L used in 1 unit of Coffee/ L used in 1 unit of Pepper
= slope of PPF
13
Production possibility frontiers
pepper
20
India’s consumption ,
production in absence
of trade Coffee: Pepper = 60L: 40L
Brazil’s consumption ,
production in absence
4 of trade Coffee: Pepper = 50L: 50L
5 10
coffee
14
In absence of trade:
Say, India uses 60L in coffee and 40L in
pepper
coffee Pepper coffee Pepper
India 20 5 India 3 8
15
coffee Pepper
India 20 5
Brazil 10 25 • Once trade is allowed, consumers buy products from the cheaper source
Post trade prices
Price of Pepper rises in India due to increased demand from Brazil
falls in Brazil due to increased supply from India
Price for coffee should increase for Brazil and decrease for India and settle
between 5 and 25 say at 20
16
Workers’ pre trade wage coffee Pepper
This makes the two countries completely specialise in the two products.
Wage in both countries rise.
In Brazil it rises to 1.5 from 1. In India it rises to 4 from 1. 17
Under free trade:
Indian specialises in pepper and uses 100L
in pepper
coffee Pepper
coffee Pepper
India 20 5 India 0 20
Brazil 10 0
world 10 20
18
Gains from trade:
coffee Pepper
Total world production world 10 20
after trade
Total world production world 8 10
before trade
• Unemployment:
Note the assumption that all that is produced is sold. There is enough
demand. Rather a questionable assumption.
19
Prices and possibility of consumption gain
Relative prices
Pc/Pp fall in India, rise in Brazil relative to the autarky level.
20
Production and consumption possibility frontiers
pepper Pre-trade Post-trade
Pc/Pp Pc/Pp
20 India 4 0.75
Possibility of
consumption
gain
5 10
coffee
21
Production and consumption possibility frontiers
pepper Pre-trade Post-trade
Pc/Pp Pc/Pp
20 Brazil 0.4 0.75
Possibility of
consumption
gain
4
5 10
coffee
22
Terms of Trade
For India,
TOT = price of pepper / price of coffee
TOT rises from 5/20 to 20/15
Or from 0.25 to 1.33
For Brazil,
TOT = price of coffee / price of pepper
TOT rises from 10/25 to 15/20
Or from 0.4 to 0.75
23
Possible Consumption Gain due to
24
So, is trade all beneficial?
Is there no problem?
25
Implicit assumptions:
26
Reading
27
Exercise
Consider the framework of absolute advantage, among two countries A and B. Each country
can produce goods X and Y.
Labour needed for unit Labour needed for unit Total labour
production of good X production of good Y supply
A 10 22 1000
B 20 8 100
Total labour supply [1000] = labour used in X [10 X Qx] + labour used in Y [22 X Qy]
And Qx = Qy
Find out how much labour was used in X and Y
29
Exercise
Following table shows the transport costs and pre-trade prices in India and
Mexico of 5 commodities. Markets for all commodities are competitive and
production subject to constant returns to scale.