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# CHAPTER 3

 Assumptions:
◦ Two countries: China and the United States
◦ Two goods: Cheese (C ) and Wine (W)
◦ In one labor-hour, China can produce either 6 units
of Cheese or 8 units of Wine.
◦ In one labor hour, the Unites States can produce
either 10 units of Cheese or 4 units of Wine.
  U.S has absolute advantage on producing
Cheese
  China has absolute advantage on
producing Wine
 Thus, U.S will specialize in production of Cheese
only.
 China will specialize in production of Wine
 Then, two countries exchange their goods, which
◦ For the U.S: 10 C > 4 W
◦ For China: 8W>6C
  condition for trade: 2/5 W < C < 4/3 W
  Exchange rate: 1 C = 1 W
 After trade, U.S benefits 12 C ; China benefits
8/3 W
  two countries benefit from international trade.
 The Theory of Absolute Advantage: a country can
benefit from international trade if it specializes in
producing and exporting the goods it has absolute
 EX2: In one labor-hour, the U.S can produce
either 8 units of Cheese or 6 units of Wine. China can
produce either 4 units of Cheese or 12 units of Wine.
How many units of products that every country
 EX 3: In the U.S, the number of labor hours needed to
produce one unit of Cheese is 4 and of Wine is 6. In
China , the number of labor-hour needed to make
one unit of Cheese is 8 and of Wine is 4. Calculate the
benefits of each country when having international
 However, the theory of absolute advantage
can not confirm whether a country can
benefit from trade if it has no absolute
  Theory of Comparative advantage can
 Assumptions:
◦ Two countries: China and the United States
◦ Two goods: Cheese (C ) and Wine (W)
◦ In one labor-hour, the U.S can produce either 10
units of Cheese or 8 units of Wine.
◦ In one labor hour, China can produce either 4 units
of Cheese or 6 units of Wine.
  China has comparative advantage on
producing Wine.
  The U.S has comparative advantage on
producing Cheese
 Thus, U.S will specialize in production of Cheese
only.
 China will specialize in production of Wine
 Then, two countries exchange their goods, which
◦ For the U.S: 10 C > 8 W
◦ For China: 6W>4C
  condition for trade: 0.8 W < C < 1.5 W
  exchange rate: 1 C = 1 W
 After trade, U.S benefits ----- C ; China benefits
------ W
  two countries benefit from international trade.
 Theory of comparative advantage: A country can
benefit from international trade if it specializes in
producing the good it has Comparative
 In the U.S: 10 C = 8 W
◦ It means that: to produce 10 C  sacrifice 8 W
◦ to produce 1 C  sacrifice 8/10 = 0.8 W
◦  the Opportunity Cost of 1 C = 0.8 W
 In China, the Opportunity Cost of 1 C = 1.5 W
  The U.S has comparative advantage on
producing Cheese because its opportunity cost is
lower than that in China (0.8 W < 1.5 W).
 The Theory of Comparative Advantage can be
said in another way: A country can benefit
from international trade if it specializes
producing and exporting the goods whose
opportunity cost is lower.
 In reality, to produce a good, producers need
two factors of production: Labor (L) and
Capital (K).
 One-factor world means we accept the
assumption: Labor is the only factor of
production.
 Assumptions:
◦ Two countries: Home and Foreign
Home:
aLC: labor-hours needed to produce 1 unit of C
aLW: labor-hours needed to produce 1 unit of W
L : total labor-hours in the Home country
Foreign:
a*LC: labor-hours needed to produce 1 unit of C
a*LW: labor-hours needed to produce 1 unit of W
L*: total labor-hours in the Foreign country
 For the Home country, we have :
 L = Qc. aLC + Qw.aLW
  Qw = L/aLW – aLC/aLW . Qc
  To produce one more unit of Cheese, we
have to give up aLC/aLW units of Wine
  The Opportunity Cost of one Cheese is
aLC/aLW
 Similarly, for the Foreign country, the
Opportunity cost of one Cheese is a*LC/a*LW
 If aLC/aLW < a*LC/a*LW , Home country
will have comparative advantage on Cheese.
on Wine.
 Graphical illustration of comparative
Qw = L/aLW – aLC/aLW . Qc
(PPF1)
Q*w = L*/a*LW – a*LC/a*LW . Q*c
(PPF2)
We also assume that: aLC/aLW < a*LC/a*LW
 EX1: Given
 Home country: L = 20 ; aLC = 2 ; aLW = 4
 Foreign country: L* = 40 ; a*LC = 6 ; a*LW=
1.5
◦ a Prove that two countries benefit from trade
◦ B. Graphically illustrate the benefits
 EX 2:
 Home country: L = 20 ; aLC = 2 ; aLW = 1
 Foreign country: L* = 20 ; a*LC = 2 ; a*LW= 2
◦ a Prove that two countries benefit from trade
◦ B. Graphically illustrate the benefits
 Concepts of absolute terms and relative terms
 Absolute prices : prices measured in terms of
USD.
◦ EX: Pc: price of Cheese ; Pw = price of Wine
Pc = 4 \$ ; Pw = 8 \$
Relative price: the price expressed in term of physical
amount of another good.
  Pw = 2Pc 
Pc/Pw = ½ : the relative price of Cheese:
means that 1 unit of C is equal just 0.5 units of W
Pw = 2 Pc : the relative price of Wine
Similarly, Qc/Qw : relative quantity of Cheese
Qw/ Qc: relative quantity of Wine
 Suppose that in the Home country: L, aLC,
aLW
 Pc : Price of Cheese
 Pw: Price of Wine
 If Pc/ Pw > aLC/aLW  Home country will
produce Cheese.
 If Pc/Pw < aLC /aLW  Home country will
produce Wine.
 Assume that : Pc/Pw : the relative price of
Cheese.
 aLC/aLW : the opportunity cost of Cheese in
the Home country
 a*LC/a*LW: the opportunity cost of Cheese in
the Foreign country
 aLC/aLW < a*LC/a*LW
 Qdc: quantity demanded of Cheese in Home
 Qdw: quantity demanded of wine in Home
country
 Q*dc: quantity demanded of Cheese in
Foreign country.
 Q*dw: quantity demanded of wine in Foreign
country
 The World’s Relative Demand function for
Cheese will be: Qwd = f(Pc/Pw)
 And the world’s relative quantity demanded:
 Qwd = (Qdc + Q*dc) / (Qdw + Q*dw)
 If Pc/Pw < aLC/aLW < a*LC/a*LW  both
countries will produce Wine. No Cheese will
be produced  No supply of Cheese.
 If Pc/Pw = aLC/aLW < a*LC/a*LW  Foreign
country produces Wine. Home Country may
produce Cheese or Wine and see no benefits
 If aLC/aLW < Pc/Pw < a*LC/a*LW  Home
will produce Cheese and Foreign will produce
Wine  international trade will happen
between the two countries.
 If aLC/aLW < Pc/Pw = a*LC/a*LW  Home
will produce Cheese and Foreign will produce
either Wine or Cheese  Foreign country sees
 If aLC/aLW < a*LC/a*LW < Pc/Pw  both
countries will produce Cheese. No countries
produce Wine  no Trade .
 Do exercises from 1 to 6, page 49 (or 52).
 Suppose that in one labor-hour:
◦ The U.S can produce either 3 units Cheese or 2
units of Wine.
◦ The U.K can produce either 2 units of Cheese or 1
unit of Wine.
◦ Wage rate in the U.S is 6 USD/ hour
◦ Wage rate in the U.K is 1 GBP /hour
◦ Prices of products are measured in terms of labor
hours.
◦ We can construct the table of product prices in two
countries.
 In the U.S: Pc = 2 USD and Pw = 3 USD
 In the U.K : Pc = o.5 GBP and Pw = 1 GBP.
 If the Exchange Rate is : GBP 1 = USD 2
◦  No Trade between two countries.
 If the Exchange Rate is : GBP 1 = USD 1
 If the Exchange Rate is: GBP 1 = USD 3.2
◦  There is international trade
  Conclusion: International Trade depends
not only on the Price of Goods but also on the
Exchange Rate of the two currencies.
 1. Through international trade, a country can
achieve the position outside the PPF curve
that it could not before trade  better –off
 2. Workers’ income increases in the
specializing sector.
 1.Free trade is beneficial only if a country is more
productive than foreign countries.
◦ No  because even if a country does not have advantages
in producing both goods, it can benefit from trade.
 2. Free trade with countries that pay low wages
hurts high wage countries.
◦ No  because international trade is based on differences of
productivity among the countries, not only on the wages.
Countries with low pay often face low productivity.
 3. Free trade exploits less productive country
◦ No  because without international trade, both consumers
and producers in the country can no be better.
 Suppose there are 5 goods produced in
the world:

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 The Ricardian model predicts that
countries should completely specialize
in production.
 But this rarely happens for primarily
3 reasons:
1. More than one factor of production reduces
the tendency of specialization (chapter 4)
2. Protectionism (chapters 8–11)
3. Transportation costs reduce or prevent
trade, which may cause each country to
produce the same good or service
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 Non-traded goods and services (e.g.,
haircuts and auto repairs) exist due to
high transportation costs.
◦ Countries tend to spend a large fraction of
national income on non-traded goods and
services.
◦ This fact has implications for the gravity model
and for models that consider how income