CHAPTER 3: WHY EVERYBODY TRADES:
COMPARATIVE ADVANTAGE AND FACTOR
PROPORTIONS.
 This chapter addresses the following questions:
1. What is the basis for trade?
2. What is the pattern of trade?
 We begin by discussing the mercantilist view of trade
then move to the theory of absolute advantage, then
comparative advantage, production possibility frontier
and community indifference curves and then discuss the
Heckscher-Ohlin theory of trade.
-Mercantilists view of trade
Proponents-merchants, bankers, govt officials,
philosophers
 Proponents of this view argued that the only way for a
nation to progress was to export more than it imported.
That it would then acquire lots of precious metals,
mainly gold and Silver which would make the country
stronger and richer.
They thus argued for government restriction on imports
1
especially of expensive consumer goods. Mercantilists:
Thus there would be benefits to both exporters and import
competing industries
 Thus trade was a zero sum game-One benefits at the
expense of the other nation
 It was further argued that since the amount of Silver and
Gold were fixed one nation would gain only at the
expense of the other.
 Wealth was by then measured in terms of stock of
precious metals. Acquisition of these enhanced a nation's
national power, stronger armies and more expansion of
territorial boundaries.
Although this has been criticized neo mercantilists argue
along the same lines. Argue that exports create
employment while imports create employment in foreign
countries.
Q. Why would countries voluntarily engage in trade if it is
not mutually advantageous?
-Trade based on absolute advantage.
2
 Adam Smith, father of modern economics, argued that
for two nations to voluntarily trade with one another,
both must gain from trade.
Absolute advantage- Occurs when one nation is more
efficient in the production of the good. Can produce more
with same amount of resources than the other nation.
 Countries will then trade when one has absolute
advantage in one good and not the other.
If this happens resources will be utilized more efficiently
and output will increase-This results in gains from trade
that will accrue to both nations.
 Consider Canada and Nicaragua. Canada has absolute
advantage in Wheat and Nicaragua in Bananas. Thus
Canada should specialize in wheat and export surplus to
Nicaragua in exchange for Bananas.
Adam Smith argued that for laizzez faire unlike the
mercantilists who argued for govt. intervention.
Thus free trade should lead to resources being used more
efficiently and consequently maximize welfare.
3
Exceptions it was argued was the protection of industries
that are crucial for a nation's defense.
Example on absolute advantage.
US
Wheat(bushels/ma 6
UK
1
n hr)
Cloth(yards/man
4
5
hr)
Q. Which country has absolute advantage in production of
Wheat? How about Cloth?
A.US, U.K.
Note that by specializing total world production will
increase. Consider for example if each country had 60 hrs
and w/o trade allocated have the time on Wheat and cloth
to with free trade outputs.
 Absolute advantage however fails to explain most trade
among nations especially among developed nations.
Please see also example in textbook p.38.
4
-Comparative advantage.
 David Ricardo in 1817 argued for this theory in his
book-The principles of political economy.
US
Rest of the world
0.25
1.0
0.5
0.67
Productivity
Yard of cloth per
labor hr
Bushels of Wheat
per labor hr
 In this case rest of the world has absolute disadvantage
in production of both goods. Comparative advantage
argues that the country should specialize and export the
commodity in which its absolute disadvantage is smaller
and import the commodity in which it has a higher
absolute disadvantage.
 Consider in aurtaky what the relative prices would be.
How much would I yard of cloth cost in terms of wheat?
5
(barter trade). A. 2 bushels of wheat. Note that this is
the opportunity cost of a yard of cloth.
 Opportunity cost defined as the amount of production
that you of the other product that you give up=loss/gain
or in this case 0.5/0.25: Note that in a two nation, twocommodity case one nation cannot have comparative
advantage in both commodities.
 Calculate opportunity costs for the above table.
 Is arbitrage possible assuming no transport costs? Buy
cloth in ROW at 0.67 bushels and sell it to US at 2
bushels and thus make arbitrage profit of 1.33 bushels
per yard of cloth. As more cloth goes to US price of
cloth in US declines in US and increases in ROW.
 International price with free trade will settle somewhere
between the two opportunity costs.
 Ricardos analysis is based on the concept of opportunity
cost
 Specialization and trade can then be explained in terms
of opportunity costs.
6
Another Example:
Production for given level of resources e.g. one hour:
US
UK
Wheat
3
1
Cloth
2
2
What is the opportunity cost of Wheat in US? How about
Cloth?
How about the UK?
Who has Comparative advantage in Wheat production?
Cloth?
Therefore based on opportunity cost the US should
specialize in Wheat production and the UK in cloth
production
 Basically a country specializes in the good in which it
has the least absolute disadvantage (or in which it has
the greatest relative advantage).
- We can show gains from Trade using PPC and assuming
constant costs. In this case the PPC will be linear. The PPC
shows combinations of outputs of different goods that an
economy can produce given its resources.
7
-
The straight line indicates that a constant opportunity
cost. The slope indicates the relative price of the good on
the horizontal axis. See Fig 3.1. Thus trade will result in an
equilibrium international price ratio that is in between the
two-non trade price ratios. Each country will specialize in
the good that it has comparative advantage. Each cou8ntry
is able to consume outside its PPF.
-
US has 100 hrs and productivity is 0.5 bushels of
wheat per hr and 0.25 yards of cloth per hr. The rest of the
world also has 100 hrs with productivity of 1 yard of cloth
and 0.4 bushes per labor hr. US specializes in Wheat and
Rest of the world in trade.
Before trade in the US is 2 bushels per yard. In the rest of
the world it will be 0.67 bushels per yard.
Without trade each country has to consume on or below the
PPC. With Free trade price of a yard of cloth will settle
between the two-pre trade. Assume trade price is 1.
And they exchange 20 bushels for 20 yards.
Who gains who benefits?
US: In exchange for 20 bushels what is the minimum
8
amount of cloth US is willing to accept. 2 bushels= 1 cloth.
Therefore Us was willing to accept 10C. It gains 10C
Rest of World: For 20 bushels what is the maximum cloth
they would have been willing to give up? Willing to give
up upto 1.5 yards per bushel. Therefore 30 yards. So they
also gain 10C
Note that with trade they are able to consume outside the
PPC.
Note that Rircardo assume constant marginal costs.
Assumption of homogenous factors of production.
We have so far we assumed that the PPF were linearconstant opportunity costs which assumes that inputs are
homogenous an
are used in fixed proportions.
 We consider the case of increasing opportunity costs. In
figure 3.2 shows increasing opportunity cost of Cloth as
we move left to right.
 Note that as move from right to left they're increasing
costs of wheat production.
9
Production possibility frontiers that reflect increasing
opportunity costs are concave.
.Why?
-Resources are not homogenous
-Resources are not used in fixed proportions. As we
produce more of that good a nation utilizes resources that
are less efficient in production of that commodity.
What point on the PPC is actually chosen. In free markets
the market price ratio will determine which production
point is chosen. Production will be driven to levels at
which the opportunity cost of producing another unit just
equals the price at which output can be sold. This reflects
tangency between the PPC and the price line. Consider
when price of cloth interms of wheat is 2 bushels per yard.
If the opportunity cost of producing another yard of cloth is
less than 2 bushels then produce more cloth and sell it for
wheat. If opportunity cost is more than then make less cloth
and more wheat. If it equals 2 then there is no incentive to
produce more cloth or less.
10
 .
Community indifference.
We move from production to demand side
 We can show tastes or demand preferences by use of
community indifference curves. These are analogous to
individual indifference curves and we assume they
satisfy same axioms as in individual indifference curves.
See figure 3.3. Convex and downward sloping indicating
that to consume more of good a nation has to give up
some of the other.
 We define marginal rate of substitution as the amount of
Y that a nation could give up for one extra unit of X and
still remain on the same indifference curve. This is given
as the absolute slope of community indifference curve
and declines as we move left to right.
 The actual point where the consumer ends will depend
on the budget constraint that the consumer faces.
 The slope of the budget contraint will be given by Pc/Pw.
 In figure 3.3 consumer maximizes utility by choosing
11
point D. We will apply the same technique to analyzing
a nation by assuming that the ICs provide information on
national well being and budget line represents national
budget.

Without trade a nation will be in equilibrium when it
reaches highest indifference given its PPC This is at point
S0. How about S1. Cloths are cheaper, higher DD for cloth
thus move down to S1.
When trade is opened in the two countries equilibrium
international price ratio is established that clears
international markets for the two goods. Production in each
country shits to the tangency with the new price line. Each
country trades along the price to the point determined by
tangency of the price line and the new community
Indifferrence curve.
Pre trade price of Cloth in US: 2 bushels of wheat per yard
Pre trade in the ROW 0.67 bushels per yard.
Both at S0. The international price will be between 0.67
bushels and 1 bushel. Free trade occurs at rate of 1 bushel
12
per yard of cloth.
Both end up at S1 US exporting wheat for Cloth. Exports
of cloth by ROW equals imports by US. Both consume at
C1 which is on a higher Community indifference curves
The right angle between production point and consumption
point is a trade triangle showing imports and exports for
each country. Note that at any other price of cloth say
below 1 imports will exceed exports.
Note that the distribution of gains from trade depends on
where the international price ends up. Suppose exchange
was 2 bushes per yard of cloth who gains? Looses if any
between US and ROW.
Country gains if price of exports is higher than that of
imports. The ration of the two is referred to as terms of
trade.
Effects on consumption and production
-Production increases for the good in which the country has
comparative advantage
 Import competing industry reduces production due to
imports
13