CHAPTER 4
THE FOREIGN SECTOR
As per the checklist:
Why countries trade
Countries trade in order to gain goods that other countries can either supply
cheaper than they themselves can produce the item, or for items they do not
possess (such as crude oil or platinum that can only be found in some countries)
Define absolute advantage
An absolute advantage is with regards to ONE good that one can
produce faster/cheaper than another country
The example being Japan and Australia – Japan can produce video
cameras better, and Australia wool. They each trade what they make
best, and both countries benefit.
Define comparative advantage
The ability to produce a product at a lower opportunity cost than another person
or country.
A country has a comparative advantage over another if in producing a commodity it
can do so at a relatively lower opportunity cost in terms of the forgone alternative
commodities that could be produced.
Explain the law of comparative advantage
The law of comparative (or relative) advantage states that both countries
will benefit from trade if the opportunity costs of production (or relative
prices) differ between the two countries.
According to the theory each country will tend to specialise in and
export those goods for which it has a comparative advantage
Example – Germany can produce both wine and cars cheaper than in SA
(having an absolute advantage in both). However, when comparing the two
RELATIVELY, the outcome is less straightforward:
In one day:
o Germany = 2 cars or 8 barrels of wine
o South Africa = 1 car or 6 barrels of wine
Making CARS:
- One can see that Germany must give up less barrels of wine
(4) than SA (6) to produce one car
- Thus, it has a comparative advantage in producing cars
Making WINE
- SA: to make one barrel of wine SA has to give up 1/6 of a car
, - Germany: to make one barrel of wine, Germany has to give up
¼ of a car
- Thus, SA has the comparative advantage in producing wine
It now makes sense for SA to shift to producing wine, and Germany to shift to
cars (if trade at 5 barrels per one car, they each gain one barrel in the
exchange)
For this to work it MUST be advantageous to both
List the main sources of comparative advantage
The sources are found in those factors that determine the relative demands for
and the relative supplies of each of the goods produced
1. Technology
osuperior production processes (more output per unit of input)
o but this advantage can erode over time (e.g. Korea can copy Germany’s
technology, and as their labour costs are lower, Germany eventually
imports from Korea, and is known as the product life cycle theory of
international trade
1. Resource endowments (different countries have differing amounts, giving
them different advantages
a. The Heckscher-Ohlin theory: each country will tend to export those
goods that most intensively use the country’s relatively abundant
resources
2. Differences in tastes or demand (forces of demand are also important in
the determination of the country’s comparative advantage)
Calculations:
I can determine comparative advantage by calculating opportunity cost
The following statements are based on this information: Susan can knit 4 jerseys or
sew 8 dresses per week, while Jackie can knit 3 jerseys or sew 4 dresses per week.
Absolute cost is about who can produce more:
Susan has an absolute advantage in knitting jerseys (she can knit more
per week)
Susan has an absolute advantage in sewing dresses (she can knit more
per week)
Relative cost is about opportunity cost of specialising in production of one
product:
Jackie has a relative (or comparative) advantage in knitting jerseys.
Susan has a relative (or comparative) advantage in sewing dresses.
Jackie should specialise in knitting jerseys while Susan should
specialise in sewing dresses.
(To knit 1 jersey per week Susan has to sacrifice 2 dresses, whereas
Jackie sacrifices 1¼ dresses in order to produce a jersey. Jackie can knit
THE FOREIGN SECTOR
As per the checklist:
Why countries trade
Countries trade in order to gain goods that other countries can either supply
cheaper than they themselves can produce the item, or for items they do not
possess (such as crude oil or platinum that can only be found in some countries)
Define absolute advantage
An absolute advantage is with regards to ONE good that one can
produce faster/cheaper than another country
The example being Japan and Australia – Japan can produce video
cameras better, and Australia wool. They each trade what they make
best, and both countries benefit.
Define comparative advantage
The ability to produce a product at a lower opportunity cost than another person
or country.
A country has a comparative advantage over another if in producing a commodity it
can do so at a relatively lower opportunity cost in terms of the forgone alternative
commodities that could be produced.
Explain the law of comparative advantage
The law of comparative (or relative) advantage states that both countries
will benefit from trade if the opportunity costs of production (or relative
prices) differ between the two countries.
According to the theory each country will tend to specialise in and
export those goods for which it has a comparative advantage
Example – Germany can produce both wine and cars cheaper than in SA
(having an absolute advantage in both). However, when comparing the two
RELATIVELY, the outcome is less straightforward:
In one day:
o Germany = 2 cars or 8 barrels of wine
o South Africa = 1 car or 6 barrels of wine
Making CARS:
- One can see that Germany must give up less barrels of wine
(4) than SA (6) to produce one car
- Thus, it has a comparative advantage in producing cars
Making WINE
- SA: to make one barrel of wine SA has to give up 1/6 of a car
, - Germany: to make one barrel of wine, Germany has to give up
¼ of a car
- Thus, SA has the comparative advantage in producing wine
It now makes sense for SA to shift to producing wine, and Germany to shift to
cars (if trade at 5 barrels per one car, they each gain one barrel in the
exchange)
For this to work it MUST be advantageous to both
List the main sources of comparative advantage
The sources are found in those factors that determine the relative demands for
and the relative supplies of each of the goods produced
1. Technology
osuperior production processes (more output per unit of input)
o but this advantage can erode over time (e.g. Korea can copy Germany’s
technology, and as their labour costs are lower, Germany eventually
imports from Korea, and is known as the product life cycle theory of
international trade
1. Resource endowments (different countries have differing amounts, giving
them different advantages
a. The Heckscher-Ohlin theory: each country will tend to export those
goods that most intensively use the country’s relatively abundant
resources
2. Differences in tastes or demand (forces of demand are also important in
the determination of the country’s comparative advantage)
Calculations:
I can determine comparative advantage by calculating opportunity cost
The following statements are based on this information: Susan can knit 4 jerseys or
sew 8 dresses per week, while Jackie can knit 3 jerseys or sew 4 dresses per week.
Absolute cost is about who can produce more:
Susan has an absolute advantage in knitting jerseys (she can knit more
per week)
Susan has an absolute advantage in sewing dresses (she can knit more
per week)
Relative cost is about opportunity cost of specialising in production of one
product:
Jackie has a relative (or comparative) advantage in knitting jerseys.
Susan has a relative (or comparative) advantage in sewing dresses.
Jackie should specialise in knitting jerseys while Susan should
specialise in sewing dresses.
(To knit 1 jersey per week Susan has to sacrifice 2 dresses, whereas
Jackie sacrifices 1¼ dresses in order to produce a jersey. Jackie can knit
