Power of Trade and Comparative Advantage

NOTE: INCOMPLETE. UPDATE WHEN REVIEW.

Advantages

Absolute advantage

The cost required for production for any given good is lower than that of another producer.

Comparative advantage

A producer has a comparative advantage in producing a good if the opportunity cost of producing that good is lower than that of another producer.

Consider goods $G_1,G_2$ , which takes costs $C$ to produce, or can be produced $U$ units in a period of time. The opportunity cost comparatively of producing G is given by:

OC_{G_1} = \frac{C_1}{C_2} = \frac{U_2}{U_1},\quad(G_2\text{ per }G_1)

Terms of trade (TOT)

The ratio at which one good can be exchanged for another, which determines the gains of each producer.

TOT = n

\begin{align*} \text{Gain from trade for producer of 1} &= C_1 - TOT^{-1} \cdot C_2\\ \text{Gain from trade for producer of 2} &= C_2 - TOT \cdot C_1\\ \end{align*}

The admissible $TOT$ is the range of values that trade will occur in: $TOT\in \{\min\{OC\},\max\{OC\}\}$

Note as TOT and OC are ratios, make sure they refer to the same good per unit.

Specialisation

Specialisation is the act of producing only one good, which can be done when a producer has a comparative advantage in producing that good.

Production possibilities

Production Possibilities Curve (PPC) - Individual

A plot of $G_1-G_2$ where $G_1$ is the quantity of Good 1 produced and $G_2$ is the quantity of Good 2 produced for a single producer.

Any points inside the curve are inefficient and any points outside the curve are unattainable. Points on the curve are efficient.

A PPC can be represented as:

G_1 = (-OC_2) \cdot G_2 + c

Where $OC_2$ (slope) is the opportunity cost of producing Good 2 and $c$ (y-intercept) the quantity of Good 1 produced when no Good 2 is produced.

Use the $PPC$ formula to find the amount of goods produced given amount of the other good by substitution.

To find the amount of goods produced, given a proportion constraint $p=G_1:G_2$ , plot $G_1 = p\cdot G_2$ and find the intersection with the PPC.

PPC of many producers

To construct the PPC of multiple producers, we arrange the curves from lowest to highest opportunity cost (slope) and connect each ends.

The curve will be concave due to the increasing opportunity cost of producing more of a good.

Economic growth

Economic growth is represented by an outward shift of the PPC.

Some factors that can cause this are:

Increase in productive resources (e.g. labour, capital)
Improvement in technology & education

World trade

World Terms of Trade

The world terms of trade can be given by the price of goods, or a ratio.

Consumption Possibilities Curve (CPC)

In a closed economy, $CPC = PPC$ as the economy can only consume what it produces.

In an open economy, $CPC > PPC$ as the economy can consume what it produces and what it imports.

Given a world economy of $ $p_1$ for $G_1$ and $ $p_2$ for $G_2$ , find the CPC by:

Find income by iterating through intersection points of PPCs and axes. Income is given by $I_i = p_1 G_{1i} + p_2 G_{2i}$
Choose highest income $I$
$CPC : G_1 = -\frac{p_2}{p_1} \cdot G_2 + I$

Use the $CPC$ formula to find the amount of goods consumed given amount of the other good by substitution in an open economy.