StudySpace: Economics in Development, 6th Edition

Worked Example: Comparative Advantage and Gains from Trade

Figure 17–1 shows the production possibilities frontier (PPF) for Imara, a country that produces food (F) and clothing (C). In the absence of international trade, point A represents the combination of F and C that maximizes welfare and achieves the highest attainable social indifference curve (II). The slope of the PPF at point A (equal to –1/4) indicates the relative opportunity cost of the two goods: One more ton of F could be produced at the cost of giving up four bales of C, or one additional bale of C could be produced by forgoing 1/4 ton of F. In a market economy the slope at A would also equal the ratio of the product prices, since relative prices would reflect relative costs.

FIGURE 17-1

Suppose that on the world market the price of food is $1,000 per ton and the price of clothing is $2,000 per bale. One can trade 2F for 1C, or vice versa. By producing at A, Imara can attain any point along line TT through trade. Line TT shows the trade opportunities; its slope (–2) embodies the relative price ratio on the world markets, called the world terms of trade. Some points on TT (such as point A' ) clearly lie above indifference curve II, which is the best attainable welfare level in the absence of trade.

But Imara can do even better. For each 1 ton reduction in F output, the economy can produce four extra bales of C. In the world market the four extra bales of C can be sold for $8,000, which buys 8F. Giving up 1F to get back 8 is a good deal. In short, F can be “produced” more efficiently by shifting resources to C and trading. Imara has a comparative advantage in producing clothing.

As Imara reallocates resources toward producing more C and less F, the opportunity cost of C increases. At point B, the slope of the PPF equals –2. Up to this point, but no further, specialization and trade continue to be a good deal. With production at B, trade opportunities are given by line T'T'. Since T'T' is tangent to the PPF at B, no reallocation of domestic resources would provide more favorable trade opportunities. At B, Imara’s domestic price ratio corresponds to relative prices on the world market.

Compared to the best pretrade outcome at A, Imara obtains more C, more F, or more of both through specializing in producing C and trading along line T'T'.

The highest possible level of welfare is reached by producing at B and consuming at B' (where there is a tangency between line T'T' and a social indifference curve). The corresponding trade triangle involves exporting amount BD of clothing in exchange for amount DB' of imported food or other goods Imara could not produce on its own.

Exercises

1. It is your turn to analyze comparative advantage and gains from trade, along with some related issues.

a. El Desoto is a small agrarian country with land well suited to grow maize (M) and bananas (B), Figure 17–2 shows El Desoto’s production possibilities frontier (PPF).

(i) Most people in Desoto prefer eating maize. In the absence of trade, social welfare is maximized by producing and consuming at point A, where

M = thousand tons,

B = thousand tons.

(ii) The slope of the PPF at point A is equal to . (Hint: Calculate the slope of the tangent at A; the slope is an integer here.)

FIGURE 17-2

(iii) The value of the slope at A means that one extra ton of banana output has an opportunity cost equal to of maize. Similarly, the opportunity cost of one extra ton of maize is of bananas.

(iv) At the margin, one ton of maize trades for ton of bananas, so the relative price ratio in the domestic market is

PM /PB = .

b. On the world market maize sells for $2,000 per ton, while bananas sell for $6,000 per ton.

(i) Hence, on the world market one ton of maize trades for tons of bananas, and one ton of bananas trades for tons of maize.

(ii) Draw a line through point A showing the trade opportunities open to El Desoto when it produces at point A. Label this line TT.

(iii) The slope of TT is equal to .

(iv) El Desoto can benefit by reallocating resources (along its PPF) and trading. Specifically, the country can realize a net gain by reducing domestic production of maize by one ton in order to produce an extra ton of bananas.

(v) This extra banana output can be sold on the world market for $ , which then can be used to buy tons of maize.

(vi) In short, by reducing domestic maize output by one ton, El Desoto can obtain tons of maize indirectly through trade. El Desoto has a comparative advantage in producing .

c. As resources move to banana production, successive increments of output have increasingly high opportunity costs. At some point X on the PPF, further specialization no longer brings further gains from trade.

(i) Carefully identify point X in Figure 17–2. Draw a line T'T' showing the trade opportunities open to El Desoto when it produces at point X. (Hint: Lines T'T' and TT reflect the same world terms of trade, but T'T' is tangent to the PPF; point X involves nice round production numbers.)

(ii) At point X, El Desoto produces M = thousand tons,

B = thousand tons.

(iii) By producing at X and trading, El Desoto can attain exactly the same maize consumption it had enjoyed at point A, along with an extra

thousand tons of bananas.

Or the country can enjoy exactly the same banana consumption as at point A, along with an extra

thousand tons of maize.

(iv) Or it can enjoy more of both goods. Draw a point showing the latter outcome and label it X'.

(v) Draw in what the textbook calls the trade triangle for production at X and consumption at X'. Label clearly the corresponding volume of exports and imports.

d. The country as a whole unambiguously gains from trade. Is it possible, though, that some groups in El Desoto are hurt when the country is opened to free trade? Explain.

e.

(i) A decline in El Desoto’s terms of trade means that the world price of drops relative to the world price of .

(ii) How would declining terms of trade alter the position of the optimal production point X' and Desoto’s pattern of trade?

While working through the mechanics of this exercise, don’t lose sight of the vital lesson: Any country can gain from trade as long as relative prices in the world market differ from what the relative domestic prices would be in the absence of trade.

 

2. Review the terms-of-trade formulas in the textbook before starting this exercise. Table 17–1 provides data on trade, factor productivity, and exchange rates in Colombia and Malawi for 1980 and 1990. Each figure is an index number defined to equal 100 for 1980. The 1990 values reflect the relative changes between 1980 and 1990. For example, the number 69 in the top row says that Colombia’s average export price in 1990 was 69 percent as high as a decade earlier; the average price dropped by 31 percent over this time period. Malawi’s average export price also fell but only by 20 percent. Notice in row 5 that GDP growth for the decade was nearly the same in the two countries—40 percent in Colombia versus 36 percent in Malawi. Terms-of-trade measures also are expressed as index numbers. For all of the index measures in this exercise, you have to adjust the units so that the value for 1980 equals 100.

Click here for Table 17-1

a. What was the value of net barter terms of trade for 1990?

For Colombia: Tn = . For Malawi: Tn .

You should find that the two countries experienced nearly identical declines in net barter terms of trade.

b.

(i) Calculate the income terms of trade for 1990.

For Colombia, Ti = .

For Malawi, Ti = .

(ii) For both countries the income terms of trade index for 1990 is higher than the net barter terms of trade index. Why?

(iii) How is it possible for Ti to exceed 100 for Colombia in 1990, when Tn fell so much during the 1980s?

c.

(i) Calculate the single factoral terms of trade index for 1990 (again with 1980 = 100).

For Colombia, Ts = .

For Malawi, Ts = .

(ii) Although both countries faced similar declines in Tn between 1980 and 1990, the values of Ts were quite different. For Colombia, Ts was virtually unchanged for the decade, but for Malawi, Ts fell. Explain the meaning of these different outcomes for Ts.

d. Overall, how did the two countries fare in terms of their capacity to earn foreign exchange, as purchasing power to buy imports? Explain.

e. A key difference between the two countries was that Colombia’s export volume grew much more rapidly. Perhaps this was due to exchange-rate policies.

(i) From the data in lines 6, 7, and 8 of Table 17–1, calculate the real exchange rate in 1990.

For Colombia, RER = .

For Malawi, RER = .

Again use 1980 = 100 as the base for computing the index number.

(ii) Which country managed its exchange rate in a manner most conducive to stimulating export growth? Explain.

3. This exercise studies the curse of resource riches, also known as Dutch disease. Until recently, the economy of Bounty was based on exporting marbles and producing rice for domestic consumption. The government budget was balanced, and there was little inflation, little unemployment, and a very moderate foreign debt.

Then, in 1995, bonanza! An enormous lode of diamonds was discovered in Bounty. Abruptly, export earnings tripled. A large fraction of the new revenue accrued to government in the form of royalties paid by foreign diamond-mining companies. It sounds idyllic, but...

a. The rapid increase in supply of foreign exchange caused the home currency (shillings) to appreciate dramatically: from Sh1 = $1 in 1994 to Sh0.4 = $1 in 1995.

(i) The world price of marbles is $5 per box. At the 1994 exchange rate, marble exporters earned Sh per box. At the 1995 exchange rate, marble exporters received only Sh per box.

(ii) Assuming the supply curve for marble production has a normal shape, what happened to the volume of marble exports following appreciation of the shilling due to the diamond bonanza?

b.

(i) The world price of rice is $200 per ton. At the 1994 exchange rate, the home-currency price of imported rice was Sh per ton. At the exchange rate prevailing after the bonanza, the price in Bounty for imported rice was Sh per ton.

(ii) Assuming the supply curve for domestic rice production has a normal shape, what happened to domestic rice output when the shilling appreciated due to the diamond bonanza?

(iii) The rice and marble sectors are very labor intensive, whereas the diamond industry is very capital intensive. How did the diamond bonanza affect employment and real wages in Bounty? Why?

c. The mining royalties paid by diamond companies caused government revenues to swell. The government decided to spend most of this revenue bonanza on domestic services. Since diamond royalties accrued in dollars, the government had to convert the funds to shillings at the central bank.

(i) When the government converted the huge influx of dollars into shillings and then spent the shillings locally, what happened to the domestic money supply in circulation?

(ii) With the government spending its foreign exchange bonanza in this manner, what happened to the domestic price level for nontradables?

d. Over the following year, the government of Bounty held the exchange rate fixed at Sh0.4 = $1. Meanwhile, the domestic price level jumped by 40 percent while world market prices rose just 2 percent.

(i) Did Bounty’s real exchange rate appreciate or depreciate between 1995 and 1996? How much? (Give an exact numerical answer, letting 1995 = 100.)

(ii) Although the official exchange rate remained fixed in 1996, how did the change in the real exchange rate affect output in the domestic marble and rice sectors? Explain briefly, with reference to profitability.

e. Recalling the case of Nigeria after the oil boom, explain how Bounty might end up with a large government budget deficit and a large national debt as a result of its diamond bonanza.

f. The textbook points out that the adverse effects of Dutch disease can be avoided if the government responds prudently to the sudden flood of revenues.

(i) What should the government of Bounty do to prevent the diamond boom from causing high unemployment and inflation? Explain.

(ii) What should the government do to convert the diamond windfall into a sound foundation for sustained development? Explain.

 

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