Foundations of
Modern Trade Theory:
Comparative Advantage
Chapter 2
Mercantilists
o popular from 1500-1800 in Europe
o assumption that a trade surplus (exports >
imports) would lead to a nation obtaining more
gold which would lead to increased domestic
production and employment
o policy implication was for domestic
government to limit trade through tariffs, import
quotas, and other methods
Price-Specie-Flow Doctrine
o David Hume
o counter argument to mercantilism
o trade surplus possible only in short run
o inflow of gold or other form of wealth will
lead to an increase in the price of domestic
goods
o higher prices for domestic goods will
eventually lead to increased imports and
decreased exports
Absolute Advantage
o Adam Smith – Wealth of Nations
o cost differences determine the patterns of
international trade
o based on natural and acquired resources
o labor theory of value – amount of labor
required determines the cost of any good
o principle of absolute advantage – trade is
beneficial when each country is a least cost
producer of one of the goods being traded
Absolute Advantage - Example
Since the U.S. can produce more cloth, we should
produce cloth and trade it to the U.K. for wine, for
which the U.K. has greater capacity.
Comparative Advantage
o David Ricardo
o trade as mutually beneficial even if one
country is more efficient than another
o principle of comparative advantage –
each nation should specialize in production
of those goods for which it is relatively more
efficient with a lower opportunity cost
o not possible for one country to have a
comparative advantage in everything
Comparative Advantage - Example
The U.S. can produce twice as much wine as the
U.K. but four times as much cloth. Therefore the U.S.
should specialize in producing cloth while the U.K.
specializes in producing wine.
Production Possibilities Schedule (PPS)
PPS - various
combinations
of two goods
that a nation
can produce
using all
available factor
inputs
Marginal Rate of Transformation (MRT)
o amount of one good a country must sacrifice to
get one more unit of another good
o synonymous with opportunity cost
o equal to the absolute value of the slope of the
production possibilities schedule
∆ good Y
o MRT =
∆ good X
MRT (cont.)
In this graph
the MRT
equals 0.5
because wheat
output falls by
20 when auto
rises by 40
Basis for Trade
o The MRT or opportunity cost for each nation
will indicate the direction of trade.
o The MRT or opportunity cost can also indicate
the potential gains from trade.
o We begin with an assumption of constant
opportunity costs.
o Benefits will be measured in terms of both
improved production and consumption.
Gains from Specialization
1 additional auto in the U.S. => loss of 0.5 bushel of wheat
1 additional auto in Canada => loss of 2 bushels of wheat
Gains from Specialization (cont.)
Since the U.S. has a lower opportunity cost of auto production,
it will be mutually beneficial for the U.S. to produce autos and
trade them to Canada for wheat.
Production Gains
o Without trade or specialization, world production is
80 autos and 120 bushels of wheat.
o If both nations specialized based on their
comparative advantages, world production would
increase to 120 autos and 160 bushels of wheat.
Consumption Gains
o If the U.S. trades 60 autos for 60 bushels of wheat,
then consumption will increase in each country.
Consumption Gains (cont.)
Graphically consumption could increase from A to C
for the U.S. and A
to C for Canada or
elsewhere along the Trading Possibilities Lines.
Distributing Gains from Trade
o comparative advantage => only outer limits for the
terms of trade
o based on
domestic cost
ratios
o form no-trade
boundaries and
region of
mutually
beneficial trade
Equilibrium Terms of Trade
John Stuart Mill – Theory of Reciprocal Demand
o terms of trade determined by the relative
strength of each nation’s demand for the other
nation’s product
o nations of roughly equal size => gains from
trade distributed roughly equally
o one nation larger => smaller nation attains
most of the gains from trade because trade
occurs closer to the larger nation’s existing price
ratio – “importance of being unimportant”
Terms of Trade Estimates
export price index
o terms of trade =
× 100
import price index
o prices of
exports rise in
relation to
imports shows
improvement
o 2017 terms of
trade data using
2000 as the
base year
Dynamic Gains from Trade
1) increased income leads to increased savings
which leads to increased investment
2) greater options in supply chain
3) increased output level can lead to benefits
from economies of scale
4) improved competition can lead to lower prices
for consumers and a greater variety of
products offered to consumers
Changes in Comparative Advantage
o Thus far our analysis has assumed comparative
advantage did not change.
o However, if productivity changed at different rates,
comparative advantage could shift from one nation
to another.
Many Products
1) Various products have different comparative
costs resulting in different degrees of
comparative advantage.
2) Each nation will produce and export the
goods for which it has the greatest
comparative advantage subject to supply and
demand constraints.
Many Countries
1) multilateral trade
2) implies bilateral trade balance is unlikely
result
Outsourcing – Pros & Cons
Pros
1) reduced costs and increased competitiveness
for domestic companies
2) increased exports to countries in which new
jobs are created
3) higher level of repatriated earnings
reinvested into domestic economy
Cons
1) reduced employment in specific industries
2) lower wages, particularly for unskilled workers