Basic Economic Concepts for
Understanding the Value of Trade
1.Specialization  Division of
Labor  Productivity  Standard
of Living
2.Comparative Advantage =
Specialization Among Nations
The Case of the Pin Maker
Hi, I am the only pin
maker in town. I cut
the wire, I sharpen the
end, I grind the top,
and I sell the finished
pin. I can make about
100 pins per day.
Town of about 100
people, only a few
of whom buy pins.
Production / Pins
700
Inputs: 1 Worker
Outputs: 100 Pins
Labor Productivity: 100 pins per worker
600
500
400
300
200
100
Labor
1
2
3
4
5
The Case of the Pin Maker
Now I need an
assistant. We both cut
the wire, sharpen the
end, and grind the top
of the finished pin. We
can make about 200
pins per day.
Town grows to 200
people.
Production / Pins
Inputs: 2 Workers
Outputs: 200 Pins
Labor Productivity: 100 pins per worker
Constant Returns to Scale
700
600
500
400
300
200
100
Labor
1
2
3
4
5
The Case of the Pin Maker
I hire another assistant.
We all cut the wire,
sharpen the end, and
grind the top of the
finished pin. We can
make about 300 pins
per day.
Town grows to 300
people.
Production / Pins
Inputs: 3 Workers
Outputs: 300 Pins
Labor Productivity: 100 pins per worker
Constant Returns to Scale
700
600
500
400
300
200
100
Labor
1
2
3
4
5
The Case of the Pin Maker
I hire another assistant.
One cuts the wire, two
sharpen the ends, I
grind the tops of the
finished pins. We can
make about 600 pins
per day.
Town grows to 400
people.
Production / Pins
700
600
500
Inputs: 4 Workers
Outputs: 600 Pins
Labor Productivity:
150 pins per worker
= Increasing Returns
to Scale
400
300
200
100
Labor
1
2
3
4
5
What Does This Story Tell Us?
• Dividing the labor process into steps allows
workers to specialize and thus produce more.
• The same number of workers can produce more
per worker than when each worker does not
specialize.
• Specialization thus makes each worker more
productive, which means that more goods can be
produced with the same number of inputs.
• Each worker can be paid more because they
produce more.
• But the division of labor is limited by the size of
the market: there is no need to specialize and
produce more if there are not more consumers to
buy the additional output.
The Case of the Bicycle Maker
Frame Makers
Wheel Makers
Final Assembly
Chain Makers
Each Figure = 10 Workers
Who is most productive?
Frame Makers
Wheel Makers
Final Assembly
Chain Makers
Each Figure = 10 Workers
Buy the wheels rather than make them
Rueda Wheel
Company
Frame Makers
Final Assembly
Chain Makers
Specialization and
thus productivity
are increased by
outsourcing
production of one
component to a
company in town.
Each Figure = 10 Workers
Buy all the parts rather than make them
Rueda Wheel
Company
Cuadro Frame Company
Final Assembly
Cadena Chain Company
Each Figure = 10 Workers
Specialization and
thus productivity
are increased by
outsourcing
production of all
components to
other companies.
One company is from another city
Rueda Wheel
Company
Cuadro Frame Company
Final Assembly
Cadena Chain Company
Welcome to Miami!
Each Figure = 10 Workers
Or from another state
Rueda Wheel
Company
Cuadro Frame Company
Final Assembly
Cadena Chain Company
Welcome to Michigan!
Each Figure = 10 Workers
Or from another country
Rueda Wheel
Company
Cuadro Frame Company
Final Assembly
Cadena Chain Company
Welcome to Mexico!
Each Figure = 10 Workers
What Does This Story Tell Us?
• International trade is really just another form
of specialization of labor.
• Outsourcing of production is done wherever
there are gains in productivity, whether that
means shifting production to another factory in
the same city, a factory in another city, or a
factory in another country.
• The mere presence of an international border
makes no difference to the underlying
argument.
Comparative Advantage
• English economist David Ricardo, 1817.
• The most important and most misunderstood
idea in the theory of trade.
• Essential arguments: (1) Two countries can
gain from trade with each other even if one of
them is better (more productive) at producing
everything than the other: absolute advantage
is less important than comparative advantage.
(2) Both countries can gain from trade even if
wages in those countries are very different. (3)
Trade allows specialization and economies of
scale.
Should England and Portugal
Engage in Trade?
With 1 unit of
labor
Portugal
England
Wine
Cloth
1 unit
1 unit
2 units
4 units
England has an absolute advantage in both Wine and Cloth. That is, 1
unit of labor in England can produce 2 units of Wine or 4 units of Cloth.
In Portugal, 1 unit of labor can produce only 1 unit of Wine or 1 unit of
Cloth. English workers are more productive than Portuguese workers
and probably get paid more because they produce more. England is
probably a richer country because it is more productive.
Comparative versus Absolute
Advantage: Opportunity Cost
With 1 unit of
labor
Portugal
England
Wine
Cloth
1 unit
1 unit
2 units
4 units
Ricardo argued that opportunity cost was the key to gains from trade.
The opportunity cost of an item is what we have to give up to get that
item. So, the opportunity cost of 1 unit of Wine in Portugal is 1 unit of
Cloth. The opportunity cost of 1 unit of Wine in England is 2 units of
Cloth. The opportunity cost of 1 unit of Cloth in England is ½ unit of
Wine. The opportunity cost of 1 unit of Cloth in Portugal is 1 unit of
Wine.
Comparative versus Absolute
Advantage: Opportunity Cost
With 1 unit of
labor
Portugal
England
Wine
Cloth
1 unit
1 unit
2 units
4 units
Comparative advantage says that countries will export those goods for
which they have a lower opportunity cost:
• 1 unit of Wine in Portugal is 1 unit of Cloth.
• 1 unit of Wine in England is 2 units of Cloth.
• 1 unit of Cloth in England is ½ unit of Wine.
• 1 unit of Cloth in Portugal is 1 unit of Wine.
Comparative versus Absolute
Advantage: Opportunity Cost
With 1 unit of
labor
Portugal
England
Wine
Cloth
1 unit
1 unit
2 units
4 units
Because the opportunity cost of producing Wine in Portugal is less than
in England (loss of 1 unit of cloth versus 2 units of Cloth), Portugal
should specialize in producing Wine which it will then export to England.
And because the opportunity cost of producing Cloth in England is less
than in Portugal (½ unit of Wine versus 1 unit of Wine), England should
specialize in producing Cloth which it will then export to Portugal.
Comparative versus Absolute
Advantage: Opportunity Cost
With 10
units of
labor
Wine
Cloth
Portugal England
5 units
5 units
World
Total
10 units 15 units
20 units 25 units
In a pre-trade world, both countries will attempt to produce both goods, which means
that they have to divide their labor force (10 units of labor) between industries: 5 units
of labor for Wine and 5 units of labor for Cloth. In Portugal, 5 units of labor can
produce 5 units of Wine and 5 units of Cloth. In England, the more productive country,
5 units of labor can produce 10 units of Wine and 20 units of Cloth. Total global
output is 15 units of Wine and 25 units of Cloth.
Comparative versus Absolute
Advantage: Opportunity Cost
With 10
units of
labor
Portugal England
World
Total
Wine 10 units 5 units 15 units
Cloth 0 units 35 units 35 units
In a world with trade, both countries specialize in the product in which they have a
comparative advantage. This means that Portugal shifts its labor force to producing
Wine: 10 units of labor now produce 10 units of Wine. England shifts part of its labor
force to making Cloth: 7.5 units of labor now produce 35 units of Cloth. The other 2.5
units of English labor produce 5 units of Wine. Total global output is 15 units of Wine,
just as before trade, and 35 units of Cloth, 10 more than before trade. Total global
output has increased from 40 units to 50 units.
Comparative versus Absolute
Advantage: Opportunity Cost
With 10
units of
labor
Wine
Cloth
Portugal England
World
5 units traded
Total
5 units 10 units 15 units
5 units 30 units 35 units
In a world with trade, Portugal can now trade 5 units of Wine to England, so that both
countries get to consume the same amount of Wine as before trade (5 units in
Portugal; 10 units in England). England, which now produces even more Cloth than
before, can consume even more than before trade (when it consumed 20 units) and
export 5 units (or more) to Portugal, which can now consume at least as much as
before trade (when it consumed 5 units). Specialization thus increases aggregate
welfare.
Comparative Advantage:
Implications
1. Free trade is beneficial even if a country
suffers from an absolute disadvantage in the
production of everything. The relative cost of
producing a good is more important for trade
than the absolute cost. Higher productivity is
no guarantee that an industry can compete,
since the opportunity cost of producing that
good may be higher than in another country.
Comparative Advantage:
Implications
2. Lower wages in another country do not mean
that it will take all the jobs away from a
higher-wage country (pauper labor
argument). It would not make sense to shift
all production of both Wine and Cloth to
Portugal even if Portugal has lower wages
than England. Instead, both countries gain by
shifting workers to industries in which they
have a relative unit labor cost advantage.
Comparative Advantage:
Implications
3. Low-wage workers in low-wage
countries can benefit from trade
by specializing in low-wage work
that is then exported to higherwage countries. This may look
like exploitation, but it beats the
alternative of producing less.
Comparative Advantage: Caveats
(things that might not work out in
the real world)
1. The strongest outcomes from comparative
advantage occur when there is perfect
occupational mobility: that is, workers from
one industry can move effortlessly into all
other industries. Obviously, this is not true
in the real world: workers who sew clothing
cannot effortlessly become computer
programmers.
Comparative Advantage: Caveats
(things that might not work out in
the real world)
2. If workers cannot move effortlessly between
industries, then workers in import-competing
sectors will lose under trade while workers in
export industries will gain. Trade may raise
overall welfare, but it will produce winners
and losers.
Comparative Advantage: Caveats
(things that might not work out in
the real world)
3. Theoretically, the winners might be taxed and
their gains from trade could be redistributed
to the losers, which means that everyone
could still gain from trade. However, in the
real world, such transfers may be politically
impractical.
Comparative Advantage: Caveats
(things that might not work out in
the real world)
4. This model assumes that business owners will
not resist the structural changes that follow
from trade. Wine growers in England may
not want to lose out to imports from Portugal
and may seek protection (tariffs, quotas) to
keep Portuguese wine from destroying their
English businesses.
Comparative Advantage: Caveats
(things that might not work out in
the real world)
5. If consumption of cloth does not increase,
then there may be no need for additional
workers in the English cloth industry. This
means that trade could lead to
unemployment, unless the government of
England does something (macroeconomic
policy) to encourage more consumption and
thus boost the need for labor.
Comparative versus Absolute
Advantage: Opportunity Cost
With 10
units of
labor
Wine
Cloth
Portugal England
World
5 units traded
Total
5 units 10 units 15 units
5 units 30 units 35 units
In a world with trade, Portugal can now trade 5 units of Wine to England, so that both
countries get to consume the same amount of Wine as before trade (5 units in
Portugal; 10 units in England). England, which now produces even more Cloth than
before, can consume even more than before trade (when it consumed 20 units) and
export 5 units (or more) to Portugal, which can now consume at least as much as
before trade (when it consumed 5 units). Specialization thus increases aggregate
welfare.
Pre-Trade Production and Consumption
With 10
units of
labor
Portugal England
World
Total
Wine 5 units 10 units 15 units
Cloth 5 units 20 units 25 units
Total
30 units 40 units
Consumption 10 units
Pre-trade, England consumes 20 units of Cloth produced by 5
units of labor.
Post-Trade Production and Consumption
With 10
units of
labor
Portugal England
World
Total
Wine 5 units 10 units 15 units
Cloth 5 units 30 units 35 units
Total
40 units 50 units
Consumption 10 units
Post-trade, let’s assume that more Cloth is consumed in England (30
units). Workers produce more through specialization and trade, so
more can be consumed.
Post-Trade Production and Consumption
With 10
units of
labor
Portugal England
World
Total
Wine 5 units 10 units 15 units
Cloth 5 units 20 units 25 units
Total
30 units 40 units
Consumption 10 units
Post-trade, let’s assume that no more Cloth is consumed in England
(back to 20 units consumed, just as in the pre-trade era). That means
that we do not need 7.5 units of labor to produce 30 units of Cloth.
Instead, we only need 5 units of labor to produce 20 units of Cloth. That
means that we will have 2.5 units of unemployed labor.
Post-Trade Production and Consumption
With 10
units of
labor
Portugal England
World
Total
Wine 5 units 10 units 15 units
Cloth 5 units 30 units 35 units
Total
40 units 50 units
Consumption 10 units
In the parlance of economists, we have “freed up those workers to
pursue other productive activities.” This can be interpreted as either
wishful thinking, willful blindness, or a call for macroeconomic
intervention to boost consumption and thus the need for labor.