CHAPTER T W O
2
The Law of Comparative Advantage
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2014 John Wiley & Sons, Inc.
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Terms in Vietnamses
Mercantilism
Zero-Sum Game
Absolute Advantage
Invisible Hands
Wealth of Nations
Comparative Advantage
Labor Theory of Value
Opportunity Cost
Basic for Trade
Pattern of Trade
Gains from Trade
Complete Specialization
Mutually beneficial trade
Chủ nghĩa Trọng thương
Trò chơi tổng bằng không
Lợi thế tuyệt đối
Bàn tay vô hình
Sự thịnh vượng quốc gia
Lợi thế so sánh
Chi phí cơ hội
Lý thuyết Giá trị - Lao động
Cơ sở thương mại
Mô hình thương mại
Lợi ích thương mại
Chuyên môn hóa hoàn toàn
Thương mại cùng có lợi
Salvatore: International Economics, 10th Edition © 2009 John Wiley & Sons, Inc.
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In this chapter:
 Introduction
 The Mercantilists’ Views on Trade
 Trade Based on Absolute Advantage: Adam Smith
 Trade Based on Comparative Advantage: David
Ricardo
 Comparative Advantage and Opportunity Costs
 The Basis for and the Gains from Trade under
Constant Costs
 Empirical Tests of the Ricardian Model
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4
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The purpose of all these theories:
Why do nations trade?
 Why do nations trade different
products/services?
 Why are nations good at different
products/services in trade?

By knowing the answers to these questions, businesses
and governments should be able to compete in the global
market more effectively.
5
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Introduction
 Three basic questions:

What is the basis for trade?

What are gains from trade?

What is the pattern of trade?
 Assume two-nation, two-good world
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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The Mercantilists
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The Mercantilists’ Views on Trade
 Mercantilism

Economic philosophy in 17th and 18th centuries, in
England, Spain, France, Portugal and the
Netherlands.

Belief that nation could become rich and powerful
only by exporting more than it imported.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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Mercantilism
- A belief, popular in the 16th century, that national prosperity
results from maximising exports and minimising imports.
- The economic doctrine in which government intervention of
foreign trade is of paramount importance for ensuring the
prosperity and security of the state.
4/24/2023
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Hữu HUU
Lộc, UEH
NGUYEN
LOC
UEH
The Mercantilists’ Views on Trade
 Mercantilism



Export surpluses brought inflow of gold and silver.
Trade policy was to encourage exports and restrict
imports.
One nation gained only at the expense of another.
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The Mercantilists’ Views on Trade
 Mercantilists measured wealth of a nation by stock
of precious metals it possessed.
 Today, we measure wealth of a nation by its stock
of human, man-made and natural resources
available for producing goods and services.

The greater the stock of resources, the greater the flow
of goods and services to satisfy human wants, and the
higher the standard of living.
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The Mercantilists’ Views on Trade
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Exclusive Trade
4/24/2023
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S. Korea
v.s
N. Korea
GDP 2011
GDP
GDP per capita (PPP)
S. Korea
N. Korea
1,014 bil USD ; 13th
40 bil USD; 103th
28,800 USD
1,800 USD
(Source: Yonhap, Ria Novosti, 19/3/2013
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16
 Mercantilism demands a positive balance of trade

an economic philosophy advocating that countries should
simultaneously encourage exports and discourage imports

Trade surplus > trade deficit
 “…to sell more to strangers yearly than we consume of theirs
in value” (Mun, 1630)
 Mercantilist policies have included:







High tariffs, especially on manufactured goods
Export subsidies
Promoting manufacturing with research or direct subsidies
Exclusive trade with colonies
Forbidding trade to be carried in foreign ships
Banning all export of gold and silver
Maximizing the use of domestic resources
Restricting domestic consumption with non-tariff barriers to trade
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17
Neomercantilism
•
Today, some argue for neomercantilism—the
idea that a nation should run a trade surplus.
•
Supporters of neomercantilism include:
Labor unions (want to protect domestic jobs)
 Farmers (want to keep crop prices high)
 Some manufacturers (rely on exports)
 But is neomercantilism best for all?

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18
Foreign Exchange Reserve 2010
Rank
Country
Billion USD (end of month)
1
People's Republic of China
$ 2447,1 (March 2010)
2
Japan
$ 1019 (Jun 2009)
Eurozone
$ 716 (Oct 2009)
3
Russia
$ 456 (Apr 2010)
4
Republic of China (Taiwan)
$ 357.56 (Apr 2010)
5
India
$ 277.0 (Mar 26, 2010)
6
South Korea
$ 270.9 (Nov 2009)
7
Brazil
$ 250 (May 2010)
8
Hong Kong
$ 240 (Nov 2009)
9
Germany
$ 184 (Sep 2009)
10
Singapore
$ 182 (Sep 2009)
56
New Zealand
$18 (Mar 2011)
19
Source: Wikipedia
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Foreign Exchange Reserve 2016
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But, can you see the problem?



Trade-surplus country and trade-deficit country co-exist
 http://www.chinapost.com.tw/business/asia/bchina/2010/05/18/256963/Chinas-one-off.htm
Trade should NOT be a zero-sum game
“The approach of individual negotiating countries, both industrialised and
developing, has been to press for trade liberalisation in areas where their
own comparative advantages are the strongest, and to resist liberalisation in
areas where they are less competitive and fear that imports would replace
domestic production.” (Finnish Ministry of Finance)
file:///D:/How%20International%20Trade%20Works%201951%20%20YouTube.html
21
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Trade should be a positive-sum game
(Mutually beneficial trade)
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Absolute advantage (Adam Smith)

“a country has an absolute advantage in the production
of a product when it is more efficient than any other
country at producing it”
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Absolute Advantage Principle
A country should produce only those products in which it has absolute advantage
or those it can produce using fewer resources than another country.
(Factors of Production in units required for One Ton)
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Advocating Free Trade
The absence of restrictions to the
flow of goods and services among nations
Free trade is usually best because it leads to:





More and better choices for consumers and firms
Lower prices of goods for consumers and firms
Higher profits and better worker wages (because imported
input goods are usually cheaper)
Higher living standards for consumers (because their costs
are lower)
Greater prosperity in poor countries
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25
Trade Based on Absolute Advantage:
Adam Smith
 A nation has absolute advantage over another nation if
it can produce a commodity more efficiently.
 When one nation has absolute advantage in production
of a commodity, but an absolute disadvantage with
respect to the other nation in a second commodity, both
nations can gain by specializing in their absolute
advantage good and exchanging part of the output for
the commodity of its absolute disadvantage.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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Trade Based on Absolute Advantage:
Adam Smith
 Example:
 Canada is efficient in growing wheat, inefficient in
growing bananas.
 Nicaragua is efficient in growing bananas, inefficient
in growing wheat.
 Canada has absolute advantage in wheat, Nicaragua
has absolute advantage in bananas.
 Mutually beneficial trade can take place if both
countries specialize in their absolute advantage.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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Trade Based on Absolute Advantage:
Adam Smith
 Specialization and trade advantage both countries.
 Adam Smith and other classical economists
advocated policy of laissez-faire, or minimal
government interference with economic activity.
 Free trade would cause world resources to be utilized
most efficiently, maximizing world welfare.
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Trade Based on Absolute Advantage:
Adam Smith
Wheat (bushels/labor hour)
Cloth (yards/labor hour)
U.S.
6
4
U.K.
1
5
 U.S. has absolute advantage over U.K. in wheat.
 U.K. has absolute advantage over U.S. in cloth.
 Both nations can gain from specialization in
production and trade.
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Trade Pattern
US exports wheat
UK exports cloth
4/24/2023
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 A country should never produce goods at home that it
can buy at a lower cost from other countries.
 Trade is then a positive-sum game
The gain
from Trade
Cloth
US
UK
+2C
+ 24 C
31
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Trade Based on Absolute Advantage:
Adam Smith
No Trade
Specialization
Trade
Trade Gain
U.S.
U.K.
U.S.
U.K.
U.S.
U.K.
U.S.
U.K.
Wheat
6
1
12
0
6
5
-
5-1=4
Cloth
4
5
0
10
6
5
6-4=2
-
 Assuming each country has 2 unit labor hours and specialize on the
product that has Absolute Advantage
 US Specialize on Wheat then gain 2 additional Cloth
 UK Specialize on Cloth then gain 4 additional Wheat
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Trade Based on Comparative
Advantage: David Ricardo
Assumptions:
 Only two nations and two commodities
 Free trade
 Perfect mobility of labor within each nation but
immobility between the two nations
 Constant costs of production,
 No transportation costs
 No technical change, and
 The labor theory of value.
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Trade Based on Comparative Advantage:
David Ricardo
 Law of Comparative Advantage

Even if one nation is less efficient than (has
absolute disadvantage with respect to) the other
nation in production of both commodities, there is
still a basis for mutually beneficial trade.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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Trade Based on Comparative Advantage:
David Ricardo
U.S.
U.K.
Wheat (bushels/labor hour)
6
1
Cloth (yards/labor hour)
4
2



U.K. has absolute disadvantage in both goods.
Since U.K. labor is half as productive in cloth but
six times less productive in wheat compared to
U.S., the U.K. has a comparative advantage in cloth.
U.S. has comparative advantage in wheat.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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Salvatore: International Economics, 10th Edition © 2009 John Wiley & Sons, Inc.
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An International Economics case study:
Trade and Economic Development
Ghana vs. South Korea


Ghana
Differences in government policy, and especially trade
policy, has seen very different outcomes for these two
countries
South Korea has grown and developed economically, while
Ghana has not
South
Korea
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Ghana
• 1970
South Korea
• 1970
GNP per capita
GNP per capita
• $250
• $260
So, what were the differences in trade policy in these countries?
Miracle Korea!
4/24/2023
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4-4
•
•
•
•
•
•
4/24/2023
1st British African colony to win independence (1957).
Nkrumah espoused pan African socialism.
High tariffs (Import Substituting policy)
Self-sufficiency
Returns to growers decreased export volume
Shift to subsistence agriculture
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• Kept lowering tariffs on manufactured goods.
• Created incentives to export and for the development of certain i
ndustries: steel (POSCO), telecomunication (SK TELECOM, Sa
msung)…(Case study Video)
• Reduced quotas.
• Reduced subsidies.
• Used foreign investment to gain technology.
• 1950s: 77% of employment in agriculture. Fell to 20%. Now 2.
9%
• Manufacturing GNP went from 10% to over 30%. Now 39.4%
4-3
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Ghana
 1992
 GNP per capita


1.5%
 Shift from productive uses




4/24/2023
 1992
 GNP per capita
$450
GNP Growth/year

South Korea
(cocoa) to unproductive uses
(subsistence agriculture).
2005 GNP pc $452
2009 GDP pc $695
2008 GDP pc (PPP) $1,500
agriculture: 56% industry:
15%
services: 29%


$6790
GNP Growth/year

9%
 Shift from non-comparative
advantage uses (agriculture) to
productive uses (labor-intensive
manufacturing).
 2008 GDP pc (PPP) $27,100
 agriculture: 2.9% industry:
39.4%
services: 57.7%
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Samsung 2017
 .
4/24/2023
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Class Discussion
 Key questions for discussion
1. Should a national government intervene to
protect the country’s domestic firms by:


taxing foreign goods entering the domestic market?
constructing other barriers against imports?
2. Should a national government directly help the
country’s domestic firms to increase their
foreign sales through:



4/24/2023
export subsidies?
government-to-government negotiations?
guaranteed loan programs?
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Class Exercise
1.
In groups of 3-4 design a political manifesto (aka
action plan for government) to drive economic
growth and development in your home country.
2.
How will your policies encourage investment by
multinational enterprises, development of local
firms while ensuring that the benefits are widely
distributed in the economy?
Consider:

trade, investment policies

government spending

industry policy
4/24/2023
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The gains from trade, Why 6W  6C
What is the range for mutually advantageous trade?
The gains from trade
Exchange Ratio
6W – 4C
6W – 5C
6W – 6C
6W – 7C
6W – 8C
6W – 9C
6W – 10C
6W – 11C
6W – 12C
4/24/2023
US
UK
The World
0C
1C
2C
3C
4C
5C
6C
7C
8C
8C
7C
6C
5C
4C
3C
2C
1C
0C
Non-trading
Win-win
8C
8C
Fifty-fifty
8C
8C
Win-win
Non-trading
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Comparative Advantage with Money
Country
4/24/2023
the wage rate
Norway
39 USD
(2007)
Germany
27,69 USD (2004)
The United State
15,78 USD (2004)
Thailand
1,29 USD (2004)
China
0,76 USD (2004)
Indonesia
0,55 USD (2004)
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Comparative Advantage with Money
Assumption:
the wage rate in the United States is 6 USD,
in England is 1 GBP
Price of one bushel of wheat Pw
Price of one yard of cloth Pc
4/24/2023
US
UK
$1.0
$1.5
1.0 GBP
0.5 GBP
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Comparative Advantage = f (exchange
rate)
R$/£
R1 = 2
Pw
Pc
4/24/2023
R2 = 3
R3 = 1
USD devaluation USD appreciation
US
UK
USø
UK
US
UK
1$
1,5 $
Ø
2 $
1 $
1$
1,5 $
3$
1,5 $
1$
1,5 $
1$
0,5 $
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Predicted top five economies by GDP per capita in 2050
In light of these trends which do you think will be the top 5 economies in 2050?
•
•
•
•
•
2012 by GDP
per capita
Singapore
56,532 $
Norway
51,226 $
US
45,511 $
Hong Kong 45,301 $
Switzerland 42,470 $
Predicted 2050





Singapore
Hong Kong
Taiwan
S Korea
US
137,710 $
116,639 $
114,093 $
107,752 $
100,802 $
(Source :Wealth 2012)
4/24/2023
•http://www.alliancetrusts.com/
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Class-Excercise
Labor Productivity of South Africa and Japan
(Products per hour of labor time)
South Africa
Japan
Bags of Wheat
55 W
18 W
DVD’s
11 D
72 D
550 ZAR
7200 JPY
Labor cost (per hour)
Determine:
 The Basic for Trade and the Pattern of Trade
 The range for mutually advantageous trade
 The exchange rate for South African Rand to Japanese Yen for
mutually advantageous trade
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Video: Review of Absolute advantage and
Comparative Advantage
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 Ricardo’s theory seems to make sense, however,
 The reality is far more complicated than a simple
theoretical model based on two countries.







More than 2 countries;
Transportation costs
Trade barriers: government intervention by protectionism
Different resources of countries, i.e. factor endowment
Too many products, and the unique features of services
Exchange rate and pricing
Globalisation of Production
 These are the limitations of early trade theories
52
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Globalisation of Production
 A qualitative shift in the world economy has seen the
emergence of an integrated international production
system (IIP) or a ‘global factory’ (Buckley & Ghauri,
2004)
 Eg. Ford ‘Global Car’



-Parts/components sourced worldwide
-Assembly in three strategic locations
-Sales worldwide
Video Clip:
The Globalization of the Automobile Industry http://jp.youtube.com/watch?v=7v_LLkEIYc0
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Example: Global Factory
4/24/2023

Global factory NOT limited to
manufacturing

Eg. Software development and
distribution for global banking
firms
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Example: Global Factory
4/24/2023
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4/24/2023
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A Case: Globalization of production:
Boeing in Vietnam
 Mitsubishi Heavy Industries (nhà cung cấp của Boeing) có
công ty con MHI Aerospace Vietnam Co., Ltd. (MHIVA),
chuyên sản xuất linh kiện máy, khánh thành nhà máy tại Hà
Nội, 9/2009.


2010, MHIVA sản xuất cánh tà cho 2 - 4 máy bay/tháng, từ
2011 sản xuất cho 10 máy bay/tháng với linh kiện được cung
cấp từ nước ngoài, và MHIVA sẽ mở rộng việc mua sắm tại
VN.
Boeing thành lập các nhà máy sản xuất linh kiện máy bay tại
VN; giúp VN đào tạo kỹ sư, chuyên viên hàng không.
4/24/2023
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4/24/2023
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Comparative Advantage and
Opportunity Costs
 The original idea of comparative advantage was
based on the labor theory of value:

The value or price of a commodity depends exclusively
on the amount of labor used to produce it.
 Can use the opportunity cost theory to explain
comparative advantage:

The cost of a commodity is the amount of a second
commodity that must be given up to release just enough
resources to produce one additional unit of the first
commodity.
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Using the opportunity cost theory
to explain comparative advantage
U.S.
U.K.
Wheat (bushels/labor hour)
6
1
Cloth (yards/labor hour)
4
2
U.S.


U.K.
Wheat
UK has higher opportunity cost than US
in Wheat production
Cloth
US has higher opportunity cost than UK
in Cloth production
the U.K. has a comparative advantage in cloth.
U.S. has comparative advantage in wheat.
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Comparative Advantage and
Opportunity Costs
 Production Possibilities Frontier
 A curve that shows alternative combinations of the two
commodities a nation can produce by fully using all
resources with best available technology.
 Constant opportunity costs arise when:
1. Resources are either perfect substitutes for each other
or used in fixed proportion in production of both
commodities, and
2. All units of the same factor are homogeneous.
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The Production Possibility Frontiers of the United State
Wheat
Cloth
180
150
120
90
60
30
0
0
20
40
60
80
100
120
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The Production Possibility Frontiers of the United Kingdom
Wheat
Cloth
60
50
40
30
20
10
0
0
20
40
60
80
100
120
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Opportunity costs and Relative Commodity Prices
4/24/2023
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The Basis for and the Gains from Trade under
Constant Costs
 In the absence of trade, a nation’s production
possibilities frontier also represents its
consumption frontier.
 Increased output resulting from specialization and
trade represents nations’ gains from trade,
allowing nations to consume outside production
possibilities frontier.
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FIGURE 2-2 The Gains from Trade.
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The Basis for and the Gains from Trade
under Constant Costs
 Under constant cost conditions, nations will
completely specialize in their comparative
advantage .
 With complete specialization in both nations, the
equilibrium-relative commodity price of each
commodity lies between the pretrade relative
commodity price in each nation.
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Nguyễn Hữu Lộc, UEH
FIGURE 2-3 Equilibrium-Relative Commodity Prices with Demand and Supply.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Nguyễn Hữu Lộc, UEH
Empirical Tests of the Ricardian Model
 McDougall (1951 and 1952)
 Argued that costs of production would be lower in the
U.S. in industries where U.S. labor was more than twice
as productive as U.K. labor.
 Found positive relationship between labor productivity
and exports; industries with relatively productive labor
in U.S. have higher ratios of U.S. to U.K. exports,
supporting Ricardian theory of comparative advantage.
 Results supported by Balassa, Stern and Golub in later
studies.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Nguyễn Hữu Lộc, UEH
FIGURE 2-4 Relative Labor Productivities and Comparative
Advantage–United States and United Kingdom.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Nguyễn Hữu Lộc, UEH
Empirical Tests of the Ricardian Model
2.8
Output per JPN Worker/
Output per KOR Worker
2.6
Precision Machinery.
2.4
2.2
Transport Machinery
Metal
2.0
General Machinery
Paper
1.8
Chemical
Electric Machinery
1.6
y = 0.2129x + 1.3368
2
R = 0.4598
Wood
1.4
Food
1.2
Textiles
Fuel
1.0
0.0
Basic Iron
Office Machinery
1.0
Non-metal
2.0
3.0
4.0
5.0
6.0
JPN Exports/KOR Exports
FIGURE 2-4-K Relative Labor Productivities and Comparative Advantage–
Korea and Japan.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Nguyễn Hữu Lộc, UEH
Case Study: Relative Exports and Relative Unit
labor Costs– United States and Japan.
FIGURE 2-5 Relative Exports and Relative Unit Costs–
United States and Japan.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Nguyễn Hữu Lộc, UEH
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4/24/2023
Nguyễn Hữu Lộc, UEH