六、 Investment Tools: Economics: Global Economic Analysis
1.A: Gaining from International Trade
a: State the conditions under which a nation can gain from international trade.
Comparative advantage is the ability to produce a good at a lower opportunity cost than others can produce it. Relative cost determines comparative advantage. When trading partners specialize in producing products for which they have comparative advantage, costs are minimized, output is greater, and both trading partners benefit.
Absolute advantage is a situation in which a nation, as the result of its previous experience or natural endowments, can produce more output with the same resources than another nation.
Note the difference: Absolute advantage refers to using the fewest resources to produce a product. Comparative advantage refers to the lowest opportunity cost to produce a product.
According to the law of comparative advantage, trading partners are both better off if they specialize in the production of goods for which they are the low-opportunity cost producer and trade for those goods for which they are the high-opportunity cost producer.
How trade expands consumption possibilities: A country gains from international trade when it exports those goods for which it has a comparative advantage and imports those goods for which it does not. To see this more clearly, suppose that we can produce wheat at $2 per bushel. If the production cost is $3 in all other nations, it is to our advantage to produce more wheat and sell it on the world market.
Additional considerations on international trade:
1. It allows firms to realize economies of scale.
2. It benefits domestic consumers by allowing them to purchase from large scale producers abroad.
3. It promotes competition and allows consumers to purchase a wider variety of goods.
b: Discuss the effects of international trade on domestic supply and demand.
Assume the U.S. has a comparative advantage in the production of Product L. The following graph indicates that when the world price is allowed to prevail in the domestic market, the price and quantity supplied of Product L are both higher. As a result, domestic consumers are losers because of the higher price they must pay, and domestic producers are winners because of the higher price they receive and higher quantity they sell. However there is a secondary effect. To buy Product L from the U.S., foreign consumers must generate U.S. dollars. To do this, foreigners will export goods to the U.S. for which they have a competitive advantage. These goods are cheaper for U.S. consumers, which benefits the U.S. consumers at the expense of U.S. producers of those products. The net result is a benefit to the U.S. and world economies.