Determining Absolute and Comparative Advantage

Why do nations stand to gain from trading with one another, and how should a nation determine the goods it should specialize in and which it should import? To answer these questions we must introduce some basic concepts of International Trade: absolute and comparative advantage. This lesson introduces these two concepts and uses a simple PPC model to determine how two countries should allocate their resources towards the production of a particular good to maximize the benefit they derive from trading with one another.

In the next lesson we’ll learn how to illustrate the potential gains from trade in the PPC diagram.

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The Gains from International Trade in the PPC Model

Now that we’ve established the difference between absolute and comparative advantage, we can proceed to how countries stand to gain from trade when they specialize in and produce the goods for which they have a comparative advantage. In this lesson we will explain how a “real exchange rate” can be determined between two goods and two countries that is mutually beneficial for both countries and then show how trade can increase the total possible level of consumption and effectively shift the PPC curve outwards.

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The Gains from International Trade in a Demand and Supply Diagram

International trade results in an increase in efficiency and total welfare among consumers and producer in the countries that participate in it. This is a thesis presented by advocates of free trade all the time. This lesson provides a simple illustration of the gains from trade experienced by an exporting and an importing nation, showing the increases in consumer and producer surplus and total welfare resulting from specialization based on comparative advantage.

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Protectionist Tariffs

While Economists generally agree that free trade creates more winners than loser, policymakers don’t always agree, and turn to protectionism to shelter domestic producers from foreign competition.

A tariff is one form of protectionism employed around the world by governments to shelter domestic firms from cheap imports. This lesson examines the impact tariffs have on the market for an imported good and evaluates their effect on different stakeholders, including consumers, producer and the government.


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Calculating the effects of protectionist subsidies – an IB HL exercise

Assume that the government of Bangladesh wishes to increase the production of leather by its domestic leather manufacturers, and simultaneously decrease the amount of leather products imported into the country. The government provides a subsidy of $2 per kilo of leather. The result is as follows:

  • Before the subsidy, the quantity of leather produced in Bangladesh was 10 million kilos, and 20 million kilos were imported at a price of $5 per kilo.
  • After the subsidy, the quantity of leather produced in Bangladesh is 15 million kilos, and only 15 million kilos are now imported. the price is still $5 per kilo.
  • Assume that at any price below $1, the domestic quantity supplied would be zero (in other words, the domestic supply curve begins at $1.
The video below explains how to illustrate the effects of a subsidy on the market for leather in Bangladesh. After watching the video, complete the questions that follow. (You will notice that the video does not answer the questions for you, because it does not calculate the various areas you are asked to calculate below).

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Determining Comparative Advantage using PPCs – Worked solutions to AP Free Response Questions

Free trade based on the principle of comparative advantage promises to maximize the efficiency with which the world’s resources are allocated. But how do we know whether a country has a comparative advantage in the production of one good over another compared to its potential trading partners?

In this lesson we will work our way through several Advanced Placement Free Response Questions and show how, using production data from a PPC or a production possibilities table, we can calculate opportunity costs for particular goods in different countries, and then determine how countries stand to gain from trade based on comparative advantage.

 

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