Microeconomics Study Guide: Trade, Comparative Advantage, and Demand

Trade and Comparative Advantage

Overview of Production Possibilities

The concept of production possibilities illustrates the trade-offs countries face due to limited resources. The Production Possibilities Frontier (PPF) is a model showing the maximum combinations of goods a country can produce.

• Scarcity: Resources are limited, so choices must be made, leading to opportunity costs.

• Opportunity Cost: The value of the next best alternative forgone when making a decision.

• Concave PPF: The PPF is typically concave, reflecting increasing opportunity costs as production shifts between goods.

Example: Allocating land between wheat and corn increases the opportunity cost of producing one as more of the other is produced.

Comparative Advantage and Trade

Comparative Advantage refers to the ability of a country to produce a good at a lower opportunity cost than another country. Trade allows countries to specialize according to their comparative advantages, increasing overall welfare.

• Trade benefits both countries when they specialize according to comparative advantage.

• Specialization leads to more efficient resource allocation.

Example: A farmer must decide how much land to allocate to wheat versus corn, considering the opportunity cost of each.

Trends in Global Trade

Global trade has generally increased over the past 70 years, with technological advancements lowering trade costs and improving communication and transportation.

• Trade increases consumption possibilities and living standards.

• Smaller countries often rely more on imports due to limited resources.

David Ricardo and Trade Philosophy

David Ricardo was a British economist who advocated for free trade in the early 1800s. He argued that countries benefit from trade even if one has an absolute advantage in all goods.

• Trade should be based on comparative advantage, not absolute advantage.

• Tariffs and trade barriers often reduce overall welfare.

Key Concepts: Absolute vs. Comparative Advantage

• Absolute Advantage: The ability to produce more of a good with the same resources compared to another country.

• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another country.

Example: The U.S. may have an absolute advantage in both wheat and clothing, but should specialize in the good where its opportunity cost is lower.

Comparative Advantage in Practice

Countries should produce goods where their opportunity cost is lowest, even if they have an absolute advantage in multiple goods.

• Specialization increases total output and efficiency.

• Trade allows countries to consume beyond their production possibilities.

Summary of Influential Economists

• Adam Smith: Early proponent of free trade.

• David Ricardo: Developed the concept of comparative advantage.

Country/Region	Trade Specialization (%)
United States	20% - 40%
European Countries	Higher due to smaller size

Comparative Advantage and Trade

Understanding Absolute vs. Comparative Advantage

Absolute advantage refers to producing more of a good with the same amount of resources. Comparative advantage focuses on opportunity cost, determining which good a country should specialize in.

• Opportunity Cost: What a country must give up to produce one more unit of a good.

Example: If Japan makes cars, the opportunity cost is the value of other products they could be producing instead.

Trade Example: US and Mexico

• Autarky: Countries are self-sufficient and do not trade.

• US Production: 5 units of clothing, 6 units of wheat.

• Mexico Production: 4 units of clothing, 3 units of wheat.

Absolute Advantage

• The US has an absolute advantage in both clothing and wheat production.

• However, absolute advantage does not mean the US should not trade with Mexico.

Calculating Comparative Advantage

To determine comparative advantage, calculate the opportunity cost for each country.

Country	Opportunity Cost of 1 Clothing	Opportunity Cost of 1 Wheat
US	$1.185$ Wheat	$1.25$ Clothing
Mexico	$0.75$ Wheat	$1.33$ Clothing

• Wheat: The US has a lower opportunity cost ($0.833$ clothing) compared to Mexico ($1.33$ clothing), so the US has a comparative advantage in wheat.

Specialization and Trade

• Countries should specialize in goods for which they have a comparative advantage.

• US Specialization: Produces only wheat (12 units).

• Mexico Specialization: Produces only clothing (8 units).

Trade Ratios

• Example trade ratio: 6 wheat for 6 clothing.

• US Benefits: By trading 6 wheat, the US receives 6 clothing, which is better than producing 5 clothing on its own.

• Mexico Benefits: By trading 6 clothing, Mexico receives 6 wheat, allowing them to consume more than they could without trade.

Consumption Possibilities

• Through trade, both countries can consume beyond their PPF.

• US Consumption After Trade: 6 clothing and 6 wheat.

• Mexico Consumption After Trade: 2 clothing and 6 wheat.

Trade Benefits and Drawbacks

• Overall Benefits: Trade increases the standard of living by allowing specialization and efficient resource use.

• Individual Drawbacks: Not everyone benefits equally; some may lose jobs due to competition.

Trade Barriers and Free Trade

Trade Barriers

• Purpose: Protect domestic jobs and industries.

• Import Taxes (Tariffs): Can lead to higher prices for consumers.

• Foreign Subsidies: Tariffs may be justified by foreign subsidies, but can reduce consumer welfare.

• Downstream Job Losses: Protecting one industry can lead to job losses in related industries.

National Security and Trade

• Trade restrictions may be justified for national security reasons.

• Concerns include protecting critical industries and resources.

Dumping Allegations

• Dumping: Selling goods below cost to gain market share, often leading to trade disputes.

• Example: Allegations of dumping by foreign producers in the US market.

Labor and Environmental Concerns

• Countries may restrict imports based on labor or environmental standards.

• Example: Bans on imports produced with child labor or poor environmental practices.

Demand and Price Effects

Law of Demand

The law of demand states that, holding other factors constant (ceteris paribus), as the price of a good increases, the quantity demanded decreases.

• Demand curves typically slope downward.

• Exceptions exist, such as Giffen goods or Veblen goods.

Factors Influencing Demand

• Income: Higher income increases demand for normal goods, decreases demand for inferior goods.

• Prices of Related Goods: Substitutes and complements affect demand.

• Weather/Conditions: Can increase or decrease demand for certain goods.

Price Change Effects on Consumption

• When prices fall, consumers can buy more for the same amount of money, increasing their real income.

Example: If pizza costs half as much, consumers can buy the same amount for less money or buy more pizza.

Demand Curve and Demand Shifts

• Movement Along the Demand Curve: Caused by a change in the price of the good.

• Shifts in Demand: Caused by changes in factors other than price (income, tastes, prices of related goods).

Demand Shifters

• Normal Goods: Demand increases as income rises.

• Inferior Goods: Demand decreases as income rises.

• Substitutes: An increase in the price of one good increases demand for its substitute.

• Complements: An increase in the price of one good decreases demand for its complement.

Example: If the price of peanut butter rises, demand for jelly (a complement) may decrease.

Formulas and Equations

• Opportunity Cost: $\text{Opportunity Cost of Good A} = \frac{\text{Units of Good B foregone}}{\text{Units of Good A gained}}$

• Law of Demand: $Q_d = f(P)$, where $Q_d$ is quantity demanded and $P$ is price.

Conclusion

Understanding trade, comparative advantage, and demand is essential for analyzing how countries and individuals make economic decisions. These concepts form the foundation of microeconomics and help explain the benefits and drawbacks of trade, specialization, and market interactions.