Trade lecture 1

Introduction to Comparative Advantage

• Focus on the principle of comparative advantage, gains from trade, and how trade benefits both countries.

• Example used: Two countries (Zambia and Malawi) producing two products (maize and meat).

• Acknowledgment of simplicity but effectiveness in illustrating key economic principles.

Production Capabilities of Countries

• Zambia's Production:

  • Can produce either 30 units of maize or 30 units of meat.

  • Possible linear combinations of maize and meat.

• Malawi's Production:

  • Can produce 20 units of meat or 10 units of maize.

  • Also possible linear combinations of the two products.

Production Possibility Frontier (PPF)

• Graphical representation of production capabilities of Zambia and Malawi.

• Zambia's PPF is less steep and further from the origin, indicating it can produce more of both products relative to Malawi.

• Assumption made that resources are equally suited for producing maize and meat, leading to constant opportunity costs.

Standard of Living Comparison

• Zambia has a higher standard of living because it can produce more of both products compared to Malawi.

• Absolute Advantage:

  • Zambia has absolute advantage in both maize and meat production.

  • It can produce more of both than Malawi.

Opportunity Costs and Specialization

• Zambia's Opportunity Cost:

  • 1 unit of maize = 1 unit of meat.

• Malawi's Opportunity Cost:

  • 1 unit of maize = 2 units of meat.

• Conclusion:

  • Maize is relatively more expensive in Malawi, while it is cheaper in Zambia.

  • Zambia should specialize in maize production and Malawi in meat production due to their respective comparative advantages.

Gains from Trade

• Both countries can benefit from specialization in the product where they hold a comparative advantage.

• Zambia Specialization: Produces and exports maize.

• Malawi Specialization: Produces and exports meat.

• By trading, Zambia and Malawi can consume more than they would be able to without trade.

Trading Ratio and World Output Before Trade

• Before trade, Zambia produces:

  • 18 units of maize and 12 units of meat.

• Before trade, Malawi produces:

  • 8 units of maize and 4 units of meat.

• Total world output without trade:

  • Maize = 26 units; Meat = 16 units.

Specialization and Trade Benefits

• Zambia's Specialization Output:

  • 30 units of maize and 0 units of meat.

• Malawi's Specialization Output:

  • 0 units of maize and 20 units of meat.

• Post-specialization, world output increases:

  • Maize = 30 units; Meat = 20 units.

• Trade example:

  • Zambia gives 10 units of maize for 15 units of meat from Malawi.

  • Each country's consumption patterns improve post-trade.

Gains from Trade Comparison

• Zambia Gains:

  • 2 additional units of maize, 3 additional units of meat.

• Malawi Gains:

  • 2 additional units of maize, 1 additional unit of meat.

• World overall gain after trade: 4 units of maize and 4 units of meat.

Understanding Opportunity Costs

• Importance of understanding opportunity costs to determine specialization.

• Opportunity cost impacts whether trade is beneficial or not.

International Terms of Trade

• Countries need to establish terms of trade to trade profitably.

• The proposed exchange ratio (1 maize = 1.5 meat) should provide mutual benefits.

Mutual Benefits from Trade

• If the exchange ratio is unfavorable, it may not be beneficial for either country (e.g., Zambia won't trade for less than 1 unit of meat for 1 unit of maize).

• Optimal trade must exceed domestic opportunity costs for both countries to benefit.

Conclusion on Trade and Specialization

• Trade and specialization allow countries to consume more than they could in isolation.

• Effective negotiation of terms of trade is crucial in maximizing benefits from trade.