2020 Fall

1. Learning Unit 3
Gain from Trade and Empirical Evidence
ECON452
International Economics

2. Objectives
1. Explain and measure gains from trade and its source
2. Determine a relative price that all countries will benefit from trade
3. Describe the concept of specialization, trade, and gains from trade
on diagram
4. Examine empirical evidence of comparative advantage and trade
5. Identify revealed comparative advantage in real world

3. Gains from Specialization and Trade
The trade benefits a country in many ways
• Trade is considered as an indirect method of production – let other countries
who can produce more efficiently and cheaply to produce them, so it can save
scarce resources and allocate them to production of the goods that the country
can produce efficiently and cheaply.
• Trade enlarges a country’s consumption possibilities – gains from specialization
and trade can be measured as extra goods and services that a country can
consume as a result of specialization and trade.

4. Gains from Specialization and Trade -
Example
Home
• Unit labor requirement to produce
one pound of cheese = 1 labor hour
• Unit labor requirement to produce
one gallon of wine = 2 labor hours
• Total labor supply = 1,000 hours
• Maximum quantity of cheese
produced = 1,000 pounds
• Maximum quantity of wine produced
= 500 gallons
Foreign
• Unit labor requirement to produce
one pound of cheese = 6 labor hour
• Unit labor requirement to produce
one gallon of wine = 3 labor hours
• Total labor supply = 3,000 hours
• Maximum quantity of cheese
produced = 500 pounds
• Maximum quantity of wine produced
= 1,000 gallons

5. Gains from Specialization and Trade –
Example (cont.)
Autarky: Economy is self-sufficient – No international trade.
• Home assigns 500 hours of labor to cheese production and 500 hours of labor to wine
production.
→ Home produces and consumes 500 units of cheese and 250 units of wine.
• Foreign assigns 1,500 hours of labor to cheese production and 1,500 hours of labor to
wine production.
→ Then, Foreign produces and consumes 250 units of cheese and 500 units of wine.
• In total, two countries produce and consume 750 units of cheese and 750 units of wine.

6. Gains from Specialization and Trade –
Example (cont.)
• Slope of PPF of Home = ½
• Slope of PPF of Foreign = 2
• A steeper PPF of Foreign
indicates a higher opportunity
cost to produce cheese in
Foreign.
• Home should specialize to
produce cheese and Foreign
should specialize to produce
wine.
500
5001,000
1,000
250
250500
500

7. Gains from Specialization and Trade –
Example (cont.)
Specialization (Production):
• Home assigns all 1,000 hours of
labor to produce 1,000 units of
cheese (F).
• Foreign assigns all 3,000 hours of
labor to produce 1,000 units of wine
(F*).
• In total, two countries produce 1,000
units of cheese and 1,000 units of
wine.
– 250 more units of cheese and
wine than the autarky.
500
5001,000
1,000
250
250500
500

8. Gains from Specialization and Trade –
Example (cont.)
Trade
• Home exports 350 units of cheese
to Foreign and imports 350 units of
wine from Foreign.
Consumption
• Home consumes 650 units of
cheese and 350 units of wine.
• Foreign consumes 350 units of
cheese and 650 units of wine.
350
1,000
1,000650
650
350
350
350
350
350

9. Gains from Specialization and Trade –
Example (cont.)
Gain from specialization and trade:
• Home consumes 150 more units of
cheese and 100 more units of wine.
• Foreign consumes 100 more units of
cheese and 150 more units of wine.
Gains are measured by comparing
consumption under trade (C) with
consumption under the autarky (A).350
1,000
1,000650
650
350
500
250500
250
v
v
v
v
100
100
150
150

10. Gains from Trade - Example
Home Foreign
Cheese Wine Cheese Wine
Autarky
Production (A) 500 250 250 500
Consumption (A) 500 250 250 500
Spec. & Trade
Production (F) 1,000 0 0 1,000
Trade -350 +350 +350 -350
Consumption (C) 650 350 350 650
Gains from Spec. & Trade +150 +100 +100 +150
When countries
specialize in production
in which they have a
comparative advantage
and trade them, more
goods and services can
be produced and
consumed.

11. Equilibrium Relative Price
Under autarky, the relative price of cheese is lower in Home than Foreign
(and the relative price of wine is lower in Foreign than Home).
Then, a trade occurs between Home and Foreign.
• Because the relative price of cheese is cheaper in Home, Foreign wants to
purchase cheese from Home. As demand for cheese increases, its price rises in
Home.
• Because the relative price of wine is cheaper in Foreign, Home wants to purchase
wine from Foreign. As demand for wine increases, its price rises in Foreign and
the relative price of cheese falls in Foreign.
• Eventually, their relative prices are equal at equilibrium.

12. Equilibrium Relative Price (cont.)
Under autarky
Pc/Pw < Pc*/Pw*
Price adjustment through trade
Pc/Pw  < Pc*/Pw* ↓
Eventually, at equilibrium (balanced trade)
Pc/Pw = Pc*/Pw*

13. Equilibrium Relative Price (cont.)
Under trade, the relative price of cheese must be equal in both Home
and Foreign.
– The equilibrium relative price must be between aLC/aLW and aLC
*/aLW
*.
– If it is lower than aLC/aLW, then neither country will produce cheese.
– If it is higher than aLC
*/aLW
*, then both countries produce only cheese, but
wine.
The world relative price of cheese is equal to the slope of TF line (F*T*
line) on PPF diagrams.
*
,
*
LC C LC
LW W Lw
a P a
a P a
 

14. Equilibrium Relative Price - Example
• Opportunity cost of cheese in Home (ac/aw) = 1/2 under autarky
• Opportunity cost of cheese in Foreign (ac
*/aw
*) = 2 under autarky
• World relative of cheese (Pc/Pw) must be between 1/2 and 2 under trade.
½ ≤ Pc/Pw ≤ 2
• A slope of TF line is 1 (= 350/350), which is between ½ and 2.
*1
2
2 *
LC LC
LW LW
a a
a a
  

15. Comparative Advantage vs. Absolute
Advantage
Under absolute advantage, two countries will trade and gain from trade, when
aLC < aLC
* and aLW > aLW
*,
but not aLC < aLC
* and aLW < aLW
*.
Under comparative advantage, two countries will trade and gain from trade, when
aLC/aLW < aLC
*/aLW
*, which
is always true when aLC < aLC
* and aLW > aLW
*,
may occur when aLC < aLC
* and aLW < aLW
*.
But not aLC/aLW = aLC
*/aLW
*.
Gains from trade comes from being able to purchase goods from other country
at lower (relative) price than its (relative) cost to produce domestically.

16. Rate of Exchange
• Rate of exchange: ratio of one good to another in exchange =
Equilibrium relative price under trade.
• Rate of exchange between two countries must be equal to the
equilibrium relative price because under assumption of balanced
trade.
• Balanced trade: the total value of export is equal to the total value
of import in each country.

17. Rate of Exchange (cont.)
• Home exports Qc units of cheese to Foreign and imports Qw units of
wine from Foreign.
• The world prices of cheese and wine are Pc and Pw, respectively.
• Balanced budget means Pc x Qc = Pw x Qw.
• Then, Pc/Pw = Qw/Qc, the equilibrium relative price is equal to a rate
of exchange – quantity of wine imported for each unit of cheese
exported.

18. Rate of Exchange - Example
• Opportunity cost of cheese in Home (aLC/aLW) = 1/2 under autarky
• Opportunity cost of cheese in Foreign (aLC
*/aLW
*) = 2 under autarky
• Home exports 350 units of cheese and imports 350 units of wine from Foreign.
• Rate of exchange, Qw/Qc = 350/350 =1 which is between 1/2 and 2.

19. Empirical Evidence
• Do countries export those goods in which their productivity is
relatively high?
• The main implications of the Ricardian model are well supported by
empirical evidence:
– productivity differences play an important role in international trade
– comparative advantage (not absolute advantage) matters for trade

20. Empirical Evidence (Developed Countries)
• The ratio of U.S. to British exports in 1951
compared to the ratio of U.S. to British labor
productivity in 26 manufacturing industries
suggests yes.
• At this time the U.S. had an absolute
advantage in all 26 industries, yet the ratio of
exports was low in the least productive
sectors of the U.S.

21. Empirical Evidence (Developing Countries)
• A very poor country like Bangladesh can have comparative advantage in clothing
despite being less productive in clothing than other countries such as China
because it is even less productive compared to China in other sectors.
– Productivity (output per worker) in Bangladesh is only 28 percent of China’s
on average.
– In apparel, productivity in Bangladesh was about 77 percent of China’s,
creating strong comparative advantage in apparel for Bangladesh.

22. Revealed Comparative Advantage
• Revealed comparative advantage is measured by the excess in the
percentage of total exports over the percentage of total imports in
each major commodity group for each country.
– If a nation has a comparative advantage in production of a good, then it
should export that good in large amount and import that good in small
quantity (so, its percentage of total export should be large and its percentage
of total import should be small).
– If a nation has a comparative dis-advantage in production of a good, then it
should import that good in large amount and export that good in small
quantity (so, its percentage of total import should be large and its percentage
of total export should be small).

23. Revealed Comparative Advantage (cont.)
In 2004, comparing with Japan,
• The U.S. has a revealed comparative
advantage in
– “Food” (EX=7.3% > IM=4.4%)
– “Chemicals” (EX=13.8% > IM=7.6%)
• The U.S. has a revealed comparative
disadvantage in
– “Fuels” (EX=4.6% < IM=16.2%)
– “Automotive products”
(EX=9.3% < IM=12.9%)

24. Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University
Disclaimer
Please do not copy, modify, or distribute
this presentation
without author’s consent.
This presentation was created and owned
by
Dr. Ryoichi Sakano
North Carolina A&T State University