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International Trade (Chapter 20)
What is the law of
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1. What is the law of comparative advantage, and why is it important in international trade?Expert Answer
Comparative advantage refers to the situation where the ability of one country to produce goods and services less
The law of comparative advantage states that the country should produces the goods in which they have comparative advantage and export this for other goods. This would beneficial for both the good.
Comparative advantage theory explains how both the countries can gain though trade when the counties produce to the goods and services based on the comparative advantage. This is shown in the blow example.
Below table shows the consumption of two goods by two countries. Both the countries are producing both the goods by using 50% of the resources.
With the given resource, both the countries are producing equal amount of coconuts. Thus, there is no country has
Opportunity cost of producing coconut in Rich country can be calculated as follows.
Opportunity cost is 1.2.
Opportunity cost of producing coconut in Poor country can be calculated as follows.
Opportunity cost is 0.6.
Since the opportunity cost of producing coconut is lower in poor country. Thus, Poor country has comparative advantage in the production of coconut.
Opportunity cost of producing mango in Rich country can be calculated as follows.
Opportunity cost is 0.83.
Opportunity cost of producing mango in Poor country can be calculated as follows.
Opportunity cost is 1.67. Since the opportunity cost of producing mango is lower for zetobia, rich country has comparative advantage in the production of mango. Thus, Zetobia specialize in the production of mango.
Poor country has comparative advantage in the production of coconut. Thus, Poor country specialize in the production of coconut.
Now rich country can produces 120 units of mango (60*2) and Poor country produces 100 (50*2) units of coconut.
If poor country exports 50 coconuts for 50 units of mango to rich country, then rich country consumes 50 units of coconuts and 70 units of mango. Rich country consumes 10 units of mango higher now. Now poor country consumes 50 units of mango and 50 units of coconut. Poor country is consumes 20 units of mango higher. Thus, specialization results the same level of consumption for coconut and 30 units of mango higher than the previous situation. Thus, specialization is profitable for both the countries.
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