CHAPTER T W O
2
International
Economics
Tenth Edition
The Law of Comparative Advantage
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
Introduction
 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.
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.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
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.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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
Salvatore: International Economics, 10th Edition © 2009 John Wiley & Sons, Inc.
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.
Trade Based on Comparative Advantage:
David Ricardo
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
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.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 2-1 The Production Possibility Frontiers of the
United States and the United Kingdom.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 2-2 The Gains from Trade.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
FIGURE 2-3 Equilibrium-Relative Commodity Prices with
Demand and Supply.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
FIGURE 2-4 Relative Labor Productivities and Comparative
Advantage–United States and United Kingdom.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.
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.
FIGURE 2-5 Relative Exports and Relative Unit Costs–
United States and Japan.
Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.