CHAPTER 2

THE LAW OF COMPARATIVE

ADVANTAGE
Prepared by:
Dr. Siti Badariah Saiful Nathan
 LEARNING GOALS

After reading this chapter, students should be able to:

 Understand the doctrine of Mercantilism, the theory of
absolute advantage & the law of comparative advantage.
 Understand the relationship between opportunity costs
& relative commodity prices.
 Explain the basis for trade and show the gains from
trade under constant costs conditions.

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 2.1 INTRODUCTION

Questions to be answered:
1. What is the basis of trade & what are the gains from
trade? How are gains from trade generated? How
large are the gains & how they are divided among
trading nations.
2. What is the pattern of trade? What commodities are
traded & which commodities are exported & imported
by each nation?

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Doctrines & theories to be discussed:
1) Mercantilism
2) Theory of absolute advantage – Adam Smith
3) Law of comparative advantage – David Ricardo
 to explain the pattern & gains from trade
 explanation on comparative advantage was based
on the labor theory of value, which was later
rejected.
 Haberler later explained the comparative
advantage in terms of the opportunity cost theory
(as reflected in the PPF).

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 2.2 The Mercantilists views on trade
 Mercantilism - the belief that the way for a nation to become
rich & powerful was to have more exports than imports.
 An export surplus will lead to inflows of bullion, or precious
metals (gold & silver); imports will cause an outflow of money.
 The more the gold & silver, the richer & more powerful is a
country, hence a govt. will encourage exports but restrict
imports.
 The amount of gold & silver – assumed fixed & all nations
cannot have export surplus at the same time - means that one
nation could gain only at the expense of other nations.

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7
 Adam Smith and the Criticism on Mercantilism
 In 1776, Adam Smith published the first modern statement
of economic theory, An Inquiry into the Nature and Causes
of the Wealth of Nations
 The Wealth of Nations attacked mercantilism—the
system of which dominated economic thought in the
1700s
 The mercantilists were criticized for their ‘static view’ of
the world economy (i.e. the world’s wealth was fixed)
 Smith proved wrong the belief that trade was a zero sum
game—that the gain of one nation from trade was the
loss of another

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 On the other hand… Voluntary exchange (trade) is a
positive sum game — both nations can gain - a dynamic
view  both trading partners could simultaneously
enjoy higher level of production & consumption with
trade.

 All nations would gain from free trade through a

Laissez-faire system.

 The theory of absolute advantage was proposed to

explain the idea of free trade.

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Theory of Absolute Advantage
Adam Smith (1723 - 1790)

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2.3 Theory of Absolute Advantage : Adam Smith
 Adam Smith ideas based on…
 The capability of one country to produce more of a
product with the same amount of input than another
country
OR
 The ability of a country to produce a good using fewer
resources than another country (lower opportunity cost)

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2.3 Theory of Absolute Advantage : Adam Smith

 According to Adam Smith’s theory of absolute advantage,

2 nations would benefit if each specialized in the
production of the commodity that it has absolute advantage
in & then traded with the other nation.
 In other words, when one nation is less efficient in
producing a commodity, it has absolute cost disadvantage
with respect to that product and so it should import those
goods and it will export those goods that it has an absolute
cost advantage.
 Outcome of process  utilization of resources in the most
efficient way & output of both commodities will ↑.

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 ILLUSTRATION OF ABSOLUTE ADVANTAGE
Table 2.1 Absolute Advantage
U.S. U.K.
Wheat (bushel/hour) 6 1
Cloth (yards/hour) 4 5
 1 hour of labor in the U.S. produces 6 bushels of wheat
(6W/hour) but the U.K. only produces 1W/hour of labor  U.S.
> efficient than the U.K in producing wheat so the U.S. has an
absolute advantage in the production of wheat.
 U.S. can only produce 4C/hour but the U.K. can produce >
yards of cloth i.e. 5C/hour of labor  U.K. has an absolute
advantage in the production of cloth.

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 Table 2.1 Absolute Advantage
U.S. U.K.
Wheat (bushel/hour) 6 1
Cloth (yards/hour) 4 5
 If the U.S. exchange 6W for 6C, the U.S. gains 2C (because
originally the US has 4C before trade) or saves 30 min of labor
time (1 hour of labor in the US can produce 4C; hence an extra
2C will free-up 30 minutes of labor time).

 The U.K. also gain since the 6W received from the U.S. would
require 6 hrs of labor time to produce in the U.K (because 1
labor hr in the UK can only produce 1W but with trade UK
gets 6W). These same 6 hrs can now be used to produce 30C
in U.K. (6 hrs x 5 yards of cloth per hr).

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 By exchanging 6C for 6W the U.K gains 24C (from the 30C
- 6C = 24C in order to get the 6W). U.K. gain more than
U.S but more importantly, both nations can gain from
specialization and trading with each other.

 Thus, while the mercantilists believed that 1 nation could

gain only at the expense of another nation, Smith believed
that ALL nations would gain from free trade.

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 PROBLEMS:
End of Chapter 2 problem: question 1)

Table 2.5 shows bushels of wheat and yards of cloth that the
United States and United Kingdom can produce with 1 hour of
labor time under four different hypothetical situations. In each
case, identify the commodity in which the United States and
United Kingdom have an absolute advantage or disadvantage.

Case A Case B Case C Case D

US UK US UK US UK US UK
Wheat
4 1 4 1 4 1 4 2
(bushels/hour)
Cloth
1 2 3 2 2 2 2 1
(yards/hour)
 Weakness of the Theory of Absolute Advantage
One country has Absolute Advantage in BOTH goods
One Person Per Day of Labor Produces
Country Machines Cloth
U.S. 5 machines 15 yards of cloth
India 1 machine 5 yards of cloth

U.S. has an Absolute Advantage in both goods.

In this scenario, there is obviously no opportunity to trade…
especially not for U.S.
NO… No … No!!! This is not correct. We need to introduce
the concept of:
Comparative Advantage
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The Law of Comparative Advantages in
International Trade

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Trade based on Comparative Advantage:
David Ricardo (1772 - 1823)

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 2.4 Trade based on Comparative Advantage:
David Ricardo
 David Ricardo: Principles of Political Economy (1817)
 Why would trade occur if one country had an absolute
advantage in both goods?
 Should import even if the country is more efficient in
the product’s production than country from which it
is buying.
 Look to see how much more efficient. If only
comparatively efficient, then import.

 We compare the degree of absolute advantage or

disadvantage in the production of goods

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 2.4 Trade based on Comparative Advantage:
David Ricardo
The Law Of Comparative Advantage
 Comparative advantage refers to the ability of a country to
produce a good at lower opportunity cost than another country.
(DEFINITION OF THE LAW)
 According to the law of comp. advantage, even if one nation is
less efficient than the other nation in the production of both
commodities, trading can still benefit both countries.
 A nation should specialize in producing & exporting the
commodity that it has smaller ABSOLUTE DISADVANTAGE
(has comparative advantage) & import the commodity that it
has greater ABSOLUTE DISADVANTAGE (has comparative
disadvantage).
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Assumptions of law of comparative advantage:
 Only 2 nations and 2 commodities
 Free trade
 Perfect mobility of labor within each nation but
immobility between the 2 nations
 Constant costs of production
 No transportation costs
 No technical change
 The labor theory of value

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 ILLUSTRATION OF COMPARATIVE ADVANTAGE
Table 2.2 Comparative Advantage
U.S. U.K.
Wheat (bushel/hour) 6 1
Cloth (yards/hour) 4 2
 U.K. has abs. disadvantage in the production of both wheat &
cloth (because the UK produces less wheat & cloth per labor
hr).
 But since U.K. labor is half as productive in cloth but 6 times
less productive in wheat with respect to U.S.  the U.K. has
a comparative advantage in cloth.
 U.S. has abs. advantage in both wheat & cloth. But since its
abs. advantage is greater in wheat (6:1) than in cloth (4:2) 
the U.S has a comparative advantage in wheat.

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 This means both nations can gain if the U.S. specializes
in the production of wheat and exports some of it in
exchange for cloth from U.K.

 On the other hand, the U.K. will specialize & export

cloth in exchange for wheat from U.S.

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 2.4.1 The Gains From Trade
Table 2.2 Comparative Advantage
U.S. U.K.
Wheat (bushel/hour) 6 1
Cloth (yards/hour) 4 2
 The U.S. can specialize and export wheat while the U.K. can
specialize and export cloth.
 Since U.S. can produce 4C domestically by giving up 6W, it
will not trade if it get less than 4C for 6W.
 To show that both countries can gain, assume the U.S. could
exchange 6W for 6C with the U.K. This means that:
 Gain to U.S. = 2C (6C - 4C = 2C) i.e. save half hour of
labor time (since 4C = 1 hour).

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 Gain to U.K. = 6C (due to the term of trade of 6W for 6C).
This means the UK can save 3 hours of labor (1hr of labor
can produce 2C, so for the 6C it will take 3hrs to produce).
The 6W received from the U.S. would require 6 hours to
produce in the U.K. This 6 hours could be used to produce
12C and give up only 6C to the U.S.

 Total gain from both nations = 2C + 6C = 8C

 Although the U.K. gain more  both nations can gain from
trade even if one of them is less efficient than the other in the
production of both commodities.

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 2.4.2 Rate Of Exchange

 In our previous example, the U.S. would gain if it could

exchange 6W for more than 4C from the U.K. The U.K.
would gain if it can exchange anything less than 12C
(since 1W : 2C so 6W = 12C).
 So, the mutually beneficial range of trade will be:
4C < 6W < 12C

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 Mutually beneficial range of trade:
4C < 6W < 12C
U.K. U.S.
 The closer the rate is to 4C = 6W (the domestic rate in the
U.S), the smaller the gain goes to the U.S & the larger is the
gain to U.K.
 Conversely, the closer the rate to the 6W = 12C, the greater
is the gain to the U.S & less to U.K. (eg. If 6W = 10C, U.S
gain more)
 Conclusion, trade can benefit both countries even if one
nation is less efficient than the other in the production of
both commodities.

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 2.4.3 Exception to Law of Comparative Advantage

 The law of comp advantage will not hold if the absolute

disadvantage that one nation has with respect to another
country is the same in both commodities.

 Table 2.2 - if one hour produced 3W instead of 1W in

the UK

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 2.4.3 Exception to Law of Comparative Advantage

U.S. U.K.
Wheat (bushel/hour) 6 3
Cloth (yards/hour) 4 2
 If one hour produced 3W instead of 1W in the UK, the UK
would be exactly half as productive as the U.S in both
wheat (3W:6W) and cloth (2C:4C).
 Both countries then have comp. advantage in neither
commodity and no mutually beneficial trade could take
place.

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 2.4.4 Comparative Advantage with Money

 Assume wage rate in U.S. = $6/hour. 1 hour produces 6W.

So, price of wheat/bushel is PW = $1 ($6/6W). If 1 hour
produces 4C, so the price of cloth/yard is PC = $1.50 ($6/4C)

 Let wage in U.K. = £1/hour. 1 hour produces 1W So, price

of wheat/bushel is PW = £1 (£1/1W). If 1 hour produces 2C
so the price of cloth/yard is PC = £0.5 (£1/2C)

 If the exchange rate is £1= $2 then the dollar price is shown

in Table 2.3.

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 Table 2.3 Dollar Price of Wheat & Cloth in
the US and UK

The dollar price of wheat & cloth if the exchange rate is £1= $2:

U.S. U.K.
Price of one bushel of wheat $1.00 $2.00
Price of one yard of cloth 1.50 1.00

 Dollar price of wheat is lower in the US ($1.00) & the

dollar price of cloth is lower in the UK ($1.00).
 This means the US can export wheat & import cloth
from the UK.

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 2.4.5 Comparative Advantage & Opportunity Costs
 Labor theory of value – the value or price of a commodity
depends solely on the amt. of labor employed in the
production of a good.
 This means that 1) either labor is the only resource used or
labor is used in the same fixed proportion in the production
of all commodities and 2) labor is homogeneous.
 Neither of these 2 assumptions is true, so we cannot
explain the theory of comp. advantage based on the labor
theory of value. Instead it can be explained on the basis of
the opportunity cost theory (Haberler, 1936).

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 Using the opportunity cost theory, the law of comp.
advantage is sometimes called the law of comparative cost.
 The opportunity cost theory – the cost of a commodity is
the amt. of a second commodity that must be given up to
release sufficient resources to produce 1 additional unit of
the first commodity.
 A nation with the lower opportunity cost in the
production of a commodity has a comparative advantage
in that commodity (and a comparative disadvantage in the
second commodity).

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CALCULATION EXAMPLE [June 2016; Q1(b)]

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 MODEL ANSWER [June 2016; Q1(b)]

Japan Malaysia
Medical instruments (units) 12 48
Rubber tyres (units) 6 12

i) The capability of one country to produce more of a product

with the same amount of input than another country
1 mark
Malaysia has absolute advantage in the production of both
goods. 1 mark
No, it is not possible for both contries to trade.
1 mark

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 MODEL ANSWER [June 2016; Q1(b)]

Japan Malaysia
Medical instruments (units) 12 48
Rubber tyres (units) 6 12

i) The ability of a country to produce a good at lower opportunity

cost than another country.
1 mark
Opportunity cost of producing 1 unit of medical instrument &
1 unit of rubber tyre in both countries:
Japan: Malaysia:
12M : 6R 48M : 12R
1M : 6/12 = 1/2R = 0.5R 1M : 12/48 = 1/4R = 0.25R
1R : 12/6 = 2M 1R : 48/12 = 4M
2 marks 2 marks 37
 MODEL ANSWER [June 2016; Q1(b)]

Japan: Malaysia:
1M : 0.5R 1M : 0.25R
1R : 2M 1R : 4M

Japan has comparative advantage in the production of rubber

tyres because the opportunity cost of 1 rubber tyre is lower
(2M) compared to Malaysia (4M). 1 mark
Malaysia has comparative advantage in the production of
medical instruments because the opportunity cost of 1 medical
instrument is lower (0.25R) compared to Japan (0.5R). 1 mark

iii) Mutually beneficial trade can take place with Japan specializing
& exporting rubber tyres to Malaysia while Malaysia
specializing & exporting medical instruments to Japan.
2 marks
 Assignment

June 2015
Question 1 (b)
To be discussed in the next class

June 2013
Question 2 (a)

To be handed in as part of assignment 1

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2.5 The Production Possibility Frontier (PPF) under
Constant Cost

 PPF (transformation curve) - shows the alternative

combinations of 2 commodities that a nation can
produce by fully utilizing all of its resources given
the available technology.

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 Table 2.4 Production Possibility Schedules for Wheat &
Cloth in the US & the UK

United States United Kingdom

Wheat Cloth Wheat Cloth
180 0* 60 0*
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0* 120 0* 120
* Complete
Specialization
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 Table 2.4 Production Possibility Schedules for Wheat &
Cloth in the US

United States U.S.  for each 30W

Wheat Cloth given up, just enough
180 0* resources are released to
30
20 produce an additional
150 20
30 20 20C (i.e 30W = 20C), so
120 40
30 20 the opp. cost of 1W=
90 60 2/3C.
30 20
60 80
30 20
30 100
30 20
0* 120

* Complete
Specialization
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 Table 2.4 Production Possibility Schedules for Wheat &
Cloth in the UK

United Kingdom U.K.  can ↑ output by 20C

Wheat Cloth for each 10W.
60 0* The opportunity cost of an
10
50 20
20 additional 20C is 10W,
10 20 which it has to let go
40 40
10 20 (reduced).
30 60
10 20 The opp. cost of 1W = 2C.
20 80
10 20
10 100 The data can be used to
10
0* 120
20 construct a PPF as shown in
Fig. 2.1
* Complete
Specialization
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 FIGURE 2-1
The Production Possibility Frontiers of the U.S. & the U.K.
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  Points on the curve –
combinations of W and
C that each nation can
produce.
 Any points inside
(below) PPF – possible
but inefficient due to:
 existence of idle
resources exist;
 the nation is not using
the best available
technology

FIGURE 2-1
The Production Possibility Frontiers of the U.S.
45
 Any points above PPF – cannot
be achieved with the given
technology and resources.

 -ve slope of the PPF  to

produce more wheat, nations
must reduce cloth production.

 The PPF for both nations are

straight lines  constant opp.
costs.

FIGURE 2-1
The Production Possibility Frontier of the U.K.
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 Assignment

June 2014
Question 1 (b)
To be discussed in the next class

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Constant opportunity costs:
 Definition - the same amount of 1 commodity must be
given up to produce each additional unit of the second
commodity.
 Occurs when:
 resources are either perfect substitutes for each other or
used in fixed proportion in the production of the
commodities;
 all units of the same factor are homogeneous or exactly
the same quality.
 Not realistic – differ among nations & provide basis for
trade.

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2.6 Opportunity Costs & Relative Commodity Prices
 Opp. Cost is given by
the slope of PPF = the
marginal rate of
transformation.

 Slope of the US
transformation curve (or
the opp. cost of wheat
in the US):
 Pw/Pc = 120/180 = 2/3;
 Pc/Pw = 180/120 = 3/2
or 1.5.

FIGURE 2-1
The Production Possibility Frontiers of the U.S.
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 2.6 Opportunity Costs & Relative Commodity Prices

 Slope of the UK PPF curve:

 Pw/Pc = 120/60 = 2 (or the opp.
cost of wheat in the UK).
 Pc / Pw = ½.
 The lower Pw/Pc in the US
shows that the US has comp.
advantage in wheat (lower
Pc/Pw in UK shows its comp.
advantage in cloth).

FIGURE 2-1
The Production Possibility Frontier of the U.K.
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 2.6 Opportunity Costs & Relative Commodity Prices

 Under constant cost, Pw/Pc  determined solely by

production / supply consideration & demand do not
determine the relative commodity prices.
 Relative commodity prices = price of one commodity
divided by the price of another commodity (i.e. the
slope of the PPF)
 Conclusion – the difference in relative commodity
prices between 2 nations (i.e. the slope of their PPF)
is a reflection of their comp. advantage & provides
the basis of their mutually beneficial trade.

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FIGURE 2-2 The Gains from Trade 52
 FIGURE 2-2 The Gains from Trade

1) without trade, assume 2) with trade, specialization:

production & consumption:
US ---- 90W & 60C (pt A)
UK ---- 40W & 40C (pt A’)
US ----180W & 0C (pt B)
UK ---- 0W & 120C (pt B’)
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 FIGURE 2-2 The Gains from Trade

3) If the US exchange 70W for 4) Gains from specialization &

70C, production &
consumption:
US ---- 110W & 70C (pt E)
UK ---- 70W & 50C (pt E’)
trade:
to US ---- 20W & 10C
(compare E & A)
to UK ---- 30W & 10C
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(compare A’ & E’)