2. A Model of Comparative Advantage

Question 1

What are some reasons why countries trade with another?

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2.
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4.

Answer 1

• larger variety of goods
• lower cost via increased production quantities
• lower prices via increased competition via larger markets
• more innovation due to exchange of ideas/ knowledge

VCPI

Question 2

David Ricardo | Key facts

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2.
3.

Answer 2

• introduced to stock market by 14 and became rich
• published model of comparative advantage
• elected in UK parliament and fought for free trade there

Question 3

Whats the Production Possibility Frontier (PPF)? Whats an efficient output? What happens over time?

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Answer 3

• shows possible output combinations of (two goods in our case, to keep it simple) an economy can produce given its production factors and technology
• output combination is called efficient if there is no possiblity to produce more of one good without producing less of the other (ie A if efficient, B not)
• over time, economic growth and technological developments can shift the PPF outwards

Question 4

Opportunity Costs (OC) | Definition

How does it connect to the PPF?

Answer 4

• OC of a good is equal to what you need to let go in order to get the good
• the slope of the PPF represents the OC of one good in terms of the other good
• eg OC of car and laptop:
  OC Car: nr of laptops that need to be given up / 1 car
  OC laptop: nr of laptops that need to be given up/ 1 laptop

Question 5

Why is the PPF bowed outwards?
Wha does this imply for the OC?

Answer 5

• concave, because production factors are not equally suited for the production of both goods -> if youre good at building cars, you dont need to be a good laptop builder at the same time
• the more is produced of one good, the higher the OC for this good gets
• eg from C to A, the OC of 100 additional cars are 200 laptops, but from D to E, its 900 laptops

In our case, we assume a linear PPF!!!!!

Question 6

Absolute Advantage | Definition

Answer 6

• refers to situation where a producer needs less inputs to produce a good than another producer
• eg when for all goods, your unit labor requirements are lower
• this producer can however STILL benefit from trade

Question 7

Comparative Advantage | Definition

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2.

Answer 7

• refers to one producer of a good having a lower opportunity cost of a good than another producer
• even if a producer has an absolute disadvantage in the production of both goods, the producer always needs o have a comparative advantage in the production of one of them

Question 8

How can specialization use comparative advantage and result in benefits for both rading partners?
Whats the condition for the trade to occur?

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Answer 8

• the producers could specialize in the production of he good in which they have a comparative advantage
• this will increase overall ouput and thus, via trade both can consume more of both goods
• for the trade to occur, the trading price has to be in between the OC of the two trading partners

Question 9

Whats the Ricardian Model?

Answer 9

• very simple model that yields strong conclusions such as that countries will completely specialize on goods where they have a comparative advantage

Question 10

Why do countries not fully specialize in the real world?

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Answer 10

• no perfect substitutability of production factors (eg a perfect car worker may simply be unable to become a shoe worker
• transportation costs (remember: distance in the gravity model)
• resilience/ independence (remember: geographic instability)
• protectionism

Question 11

Countries tend to export goods where…

Answer 11

… they have comparative advantage (even though they might have an absolute disadvantage)