Chapter 3 Comparative Advantage and Factor
Proportions
Link to syllabus
Adam Smith:
The Wealth of Nations 1776
In a free market society,
individuals, acting out of their own
self interest, will be guided, as if by
an invisible hand, to make socially
beneficial economic decisions.
Chapter 3. Comparative advantage –why
countries can gain from trade, and who will
trade which product. Questionable example
page 36. Book’s example. My example.
PPcurve. Opportunity cost.
Demonstration of who has comp. adv.
Demonstration of gains from trade.
Adam Smith: Individuals acting out of their
own self interest, will be guided, as if by an
invisible hand, to make socially beneficial
economic decisions.
Also: benefits of free trade, criticism of
mercantilism.
David Ricardo. 1772-1823
Born in London; father was a stockbroker.
In addition to major contributions in
Economics, he was a member of the British
Parliament, a businessman and financier.
Said to have become interested in economics
at the age of 27, after reading Adam Smith,
while on vacation.
Was friends with James Mill, Bentham,
Malthus, and other classical economists.
Also, benefits of free trade, and criticism of
mercantilism.
David Ricardo. 1772-1823
Born in London; father was a strockbroker.
In addition to major contributions in
Economics, was a member of the British
Parliament, a businessman and financier.
Said to have become interested in econ
at the age of 27, after reading Adam Smith, while on
vacation. Was friends with James Mill, Bentham, Malthus,
and other classical economists.
Smith talked about benefits of trade, using argument of absolute
advantage. Argued against mercantilism.
Mercantilism: trade is source of growth (through exports). Imports
were to be minimized. Emphasis on generating employment.
Accumulate gold (balance of payments surplus). Book states
that mercantilists viewed trade is a zero sum game.
Ricardo: labor theory of value. Comp. advantage.
Book’s example of Ricardian model (p. 37):
2
Labor hours to make one unit of
Cloth
Wheat
U.S. R.o.W.
4.0 1.0
2.0 1.5
Labor Productivity (units of cloth per hour): [inverse of labor hours
US R.o.w.
Cloth/labor
.25 1.0
Wheat/labor
0.5 0.66
Ricardian example of comparative advantage. Page 37
Pre- trade Prices, in Ricardo’s Example p. 38
Ricardian model of comparative
advantage.
Data on Page 36.
Typos for R.o.W.
Also, question of notation on p. 38
R.o.W. has absolute advantage in both goods. Maybe US would
fear trade in either good.
Let’s look at comparative advantage. Where are goods relatively
cheaper?
Calculation of opportunity costs:
In U.S., one unit of cloth requires 4 units of labor, which could
have produced 2 units of wheat. So the opportunity cost of
cloth in terms of wheat in the US is 2.
In R.o.W., one unit of cloth requires 1 unit of labor which could
have produced 2/3 unit of wheat. So cloth’s opportunity cost
in terms of wheat in R.o.W. is 2/3. It is cheaper there.
Pre-trade Relative prices:
U.S.
R.o.W.
Pcl/Pwh
2bu/yard 0.67 bu/yard
3
Other relative prices are the inverses:
Pwh/Pcl
.5
1.5
Benefits from trade. Have to construct the PPcurve.
Figure 3.1 page 39
Gains from trade: constant cost case
My example.
Labor Input:
Figure 3.1 page 41.
PPC drawn with 100 units of labor in each
country.
Labor hours to make one unit of:
U.S. R.o.W.
Cloth
4.0 1.0
Wheat
2.0 1.5
Country A
B
gr
0.5 0.33
ma
1
0.25
Opportunity cost of grain in terms of machines
In A: 1 unit of grain needs 0.5 units of labor, which could have
produced 0.5 units of machines
In B: 1 unit of grain needs 0.33 units of labor, which could have
produced 0.33/0.25 =1.33 units of ma. So grain is cheaper in A.
Absolute Advantage Does Matter p. 43
Absolute Advantage Does Matter p. 41
Handouts
Description of argument of comparative advantage
Numerical example of comparative advantage
Handouts on comparative advantage
What determines comparative advantage?
Demand or supply
If supply, wages, productivity
(technology), existence of raw materials.
4
Let awh be the amount of labor used for a unit of wheat in the US,
and acl the amount of labor for a unit of cloth. Let Pwh and Pcl be
the prices of the two goods, and their levels of output or
consumption be Wh and Cl.
First, what is the slope of the PPC in the US?
The PPC is also the budget line for the US, and the formula for the
budget line is Pwh · Wh + Pcl · Cl = Budget (some level).
With prices fixed, a movement along the PPC or the budget line
involves a change in Wh (ΔWh) counterbalanced by a change in
Cl (ΔCl). So we have:
Pwh · ΔWh + Pcl · ΔCl = ΔBudget = 0.
The PPC as drawn in our text has wheat on the vertical axis, so its
slope is ΔWh / ΔCl , which from this formula is - Pcl / Pwh .
Note that if labor is the only cost (Ricardian world), we can
express the prices in terms of the labor inputs. If labor is paid
‘wage’, and it takes awh of labor to produce one unit of wheat,
then Pwh = awh· wage. Similarly Pcl = acl ·wage.
So the ratio Pcl / Pwh = acl / awh .
In other words, the ratio of prices is the direct ratio of labor inputs.
To determine which country has the lower pre-trade prices, just
look at the ratio of the labor inputs.
The common sense interpretation of this is that the (relative) price
of a good will be lower if that good uses (relatively) less labor.
The above derivation hints of calculus. A simpler story is simply
the following. For a given level of the labor force L, the vertical
height of the PPC is L/ awh , and the horizontal distance is L/ acl .
So the ratio of height to length is (L/ awh )/ (L/ acl), or acl / awh .
Chapter 3 p. 45. Question #8