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Guide Models for Analyzing Comparative Advantage

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For example, it may be that the maximum output of cars produced by country A is only 20 million compared with 30 , and the maximum output of trucks produced by country B might only be 16 million instead of 21 million. Hence, the combined output from trade might only be 46 million units instead of the 51 million units initially predicted. Complete specialisation might create structural unemployment as some workers cannot transfer from one sector to another. Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage.

For example if the price of X rises relative to Y, the benefit of increasing output of X increases. Comparative advantage is not a static concept - it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade. Countries can develop new advantages, such as Vietnam and coffee production. Despite having a long history of coffee production it is only in the last 30 years that it has become a global player. Many countries strive for food security , meaning that even if they should specialise in non-food products, they still prefer to keep a minimum level of food production.

The real world is far more complex, with countries exporting and importing many different goods and services. According to influential US economist Paul Krugman , the continual application of economies of scale by global producers using new technology means that many countries, including China, can produce very cheaply, and export surpluses. This, along with an insatiable demand for choice and variety, means that countries typically produce a variety of products for the global market, rather than specialise in a narrow range of products, rendering the traditional theory of comparative advantage almost obsolete.

Modern approaches to explaining trade patterns and trade flows tend to use gravity theory - which explains trade in terms of the positive attractiveness between two national economies - based on economic size in a similar fashion as planets attracting each other based on their mass - and the 'economic distance' between two economies. Economic size attracts countries to trade, and economic distance makes trade harder.

Economic distance is increased by barriers to trade , and cultural, political and linguistic differences. Basic Business Statistics 5th edition. Business Analytics Mindtap Course List. Pocket World in Figures Naked Statistics Stripping the Dread from the Data. Managing for Quality and Performance Excellence 10th Edition.

A critical assessment of the theory of comparative advantage with reference to conditions of trade

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Remove From Wishlist Cancel. Only individual utility has a meaning. Moreover, they stress that utility has only ordinal meaning and not cardinal one [ 9 , 10 ]. One can say that he prefers A over B, but it is meaningless to say by how much. It should be stressed that this understanding was adopted by most modern schools of economics on this subject see Ref. The fact that two producers produce more of certain goods does not mean that they are better off.

The problem can easily be emphasised by the following example: Suppose one individual is expert in making bread, and the other one is expert in making mud pies. Should one conclude from the LA that they both have to focus on the product they are best in producing? Surely not. The mud pie is useless for both. In this case, they both need to be focusing on producing bread.

There is no point in wasting resources on producing mud pies. The erroneous conclusions are a direct result of the absence of any subjective utility analysis in the derivation of the LA.


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The problem is that the traditional Austrian analysis is based on verbal arguments or very basic preference schedule tables. Another discrepancy arises in the literature in connection to specialisation. It was stated very clearly by many economists and can easily be grasped by the layman that specialisation increases the productivity of every one of the merchants prior to trading.

Nevertheless, this effect is also neglected in the analysis or, at best, analysed separately from the benefits of trading.


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  8. See, for example, two contemporary economists pages 4 and 48 in Ref. It is the object of this chapter to fix these two problems and to analyse the LA with subjective preferences and with the effect of specialisation. Let there be two individuals 1 and 2 , both of them can produce two consumption commodities: A and B. Similarly, the maximum number of units of the same goods A and B that the second producer produces are A 2 and B 2 , respectively. Therefore, the first producer is constrained by the equation. These constrain equations are usually termed: the production possibility frontier PPF.

    In this case, it is clear that trading will be beneficial to both producers. It is easy to see that in this case, there is a common interest for the exchange. Clearly, the first producer would agree to this exchange provided the price, i. Otherwise, this producer can produce the commodity instead of buying it. Similarly, the second producer would agree to this exchange provided the price is larger than.

    Therefore, if inequality 3 holds, then there is a price regime in which they will both benefit from the exchange. This is the traditional LA. The reason for that is the producer is indifferent to its position on the PPF. Thus, any improvement in its status is achieved by advancing in the perpendicular direction to the production frontier. If after trading the first producer has a 1 units of A and b 1 units of B and the second producer has a 2 units of A and b 2 units of B, then the distances between their current status and their PPF which quantifies their production improvement are.

    However, clearly something is missing in these production analysis. It is clear that production in itself is not the economic goal. Hence, in what sense, the producer condition is better after the exchange than before it? One must assume that while the individuals have a comparative advantage in the production of one of the goods, they want or need both of them, and in the process of analysing the best option to act producing or a combination of producing and trading , the individual chooses the option, which yields the best combination of goods.

    But what is the best combination? An evaluation method is required. Historically, the tool for situation evaluation was the utility function. However, as was realised by the Austrian school of economics and was later accepted among most economists [ 11 ], the situation preference ranking cannot have a cardinal meaning as the utility function suggest but only ordinal one. The problem is, that creating a list, i. This may be the reason, that Rothbard, which used several times lists of preferences, used them only in relatively simple cases.

    In the problem under discussion, the actors are both producers and traders. Their decisions are based on two stages. Similarly, the states of the second producer are described by the equivalent parameter a 2 and b 2 , respectively.

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    Therefore, instead of presenting the scenarios as a single list, which includes all options, we present them with two two-dimensional matrices R 1 a 1 , b 1 and R 2 a 2 , b 2. In the limit where the units of the goods are arbitrarily small, the continuum limit can be used, in which case, Eq. The law of diminishing marginal utility LDMU is traditionally formulated by demanding a concave shape for the utility function. However, in the absence of a utility function, it is meaningless to apply this criterion on the preference ranking matrix.

    A better approach is to notice that the decline in the marginal utility of a certain good is actually manifested by the relative increase in the ranking of other goods. Therefore, the LDMU can be stated mathematically as. Similarly, Eq. Prior to trading the producer needs to produce the goods. The decision on the amount to produce depends on the ranking matrix under the relevant constrictions 1 and 2. In Figure 1 , such a two-dimensional ranking matrix is illustrated. For simplicity, we assume that the two producers have the same ranking, i.

    Comparative advantage - Wikipedia

    Two possible scenarios of trading. In the scenario on the left, the two producers temporally worsen their ranking, which decreases from 27 and 57 without trading to 16 and 24, respectively, to increase it to 40 and 68, respectively, after trading. On the right, the number of units, which exchange hands, was increased. As a result, the ranking of the first producer decreases to 28 but the ranking of the second producer increases to Since 0. In Figure 1 , two such options are presented. In both cases the producers decided to specialise in a single product, the one which they have a comparative advantage with.

    By specialising they knowingly decreases temporarily their preference ranking. The preference ranking of the first producer reduces temporarily from the maximum 27 to 16, and the ranking of the second producer reduces from the maximum value 57 to After trading, there is a substantial increase in the preference ranking. It is shown that if the second producer wishes to increase its preference ranking even further to 70, it must be on the account of a substantial reduction in the preference ranking of the first producer to 28 , albeit it is still higher than the pre-trading maximum ranking As was emphasised in Mises and Rothbard writings [ 9 , 10 ], the final state depends on the bargaining merits of the two producers now merchants.

    Comparative advantage specialization and gains from trade - Microeconomics - Khan Academy