Reading: Chapter 3,

International
Lecture 2- Comparative
Economics-KOM
Advantage
 Theories of Trade
• A number of models/theories are developed to help explain
reasons for trade.
• Mercantilism: emerged in England in mid-16th Century
• Absolute Advantage: Adam Smith (1770s)
• Comparative Advantage(Ricardian model of trade): David Ricardo (1810s)
• Heckscher- Ohlin Theory (mid 1930s)
• New Trade Theory (late 70s)

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Mercantilism
• A country should earn gold and silver and increase its
national wealth.
• Exports would increase its stock of gold.
• Imports would decrease the stock of gold.
• The idea was that a country should have a trade
surplus.
• Maximize export through subsidies.
• Minimize imports through tariffs and quotas.

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 Mercantilism
• David Hume in 1752 identified the weakness of this
theory.
• Exporting more than importing → Balance of Trade (BOT)
surplus →increasing inflows of gold and silver→ increase
the domestic supply of money→ increase in inflation
(why?)
• Prices of domestic goods and hence exports would
increase, imports would be relatively cheaper.
• So BOT surplus would be eliminated.
• Trade is not a zero sum game. It is a positive sum
game.

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 • A country has an absolute
advantage in the production of a
Country Cheese Wine good when it is more efficient
than any other country in
producing it.
Number of Man Number of Man • A country should produce only
Hours required Hours required goods where it is most efficient
per unit per unit (lower cost), and trade for those
goods where it is not efficient.
England 15 30 • Trade is mutually beneficial for the
trading partners.
Portugal 10 15

Absolute Advantage
Comparative Advantage
Ricardian model
• What if a country has an absolute advantage in
the production of all goods, will it still trade?
• Yes, according to the theory of comparative
advantage- Ricardian Model.
• A country should specialize and produce those
goods that it produces relatively more
efficiently/productively, and buy the goods that
it produces relatively less
efficiently/productively.
Comparative Advantage
Ricardian model
• A country has a comparative advantage in producing a good if the
opportunity cost of producing that good is lower in the country than
in other countries.
• Differences in opportunity costs between countries arise due to differences in
productivity.
• What is Opportunity cost?
The Cost of Something Is
What You Give Up to Get It
• Making decisions requires comparing the costs and
benefits of alternative choices.
• The opportunity cost of any item is
whatever must be given up to obtain it.
• It is the relevant cost for decision making.
The Cost of Something Is
What You Give Up to Get It
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition, books, and
fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.
Comparative Advantage
Ricardian model
1. Labor is the only factor of production.
2. Labor productivity varies across countries due to
differences in technology, but labor productivity in
each country is constant.
3. The supply of labor in each country is constant.
4. Two goods: Cheese and Wine
5. Two countries: England and Portugal
Comparative Advantage
Ricardian model- an example
Country Cheese Wine

Number of Man Hours Number of Man Hours required

required per unit per unit

England 15 30

Portugal 10 15
Comparative Advantage
Ricardian model
• A unit labor requirement indicates the constant number of hours of labor required
to produce one unit of output.
• aLC is the unit labor requirement for cheese
• In England: aLC =15
• In Portugal a*LC=10
• aLW is the unit labor requirement for wine.
• In England: aLW = 30
• In Portugal a*LW= 15

• A high unit labor requirement means low labor productivity.

Production Possibilities
• The production possibility frontier (PPF) of an economy shows the maximum
amount of a goods that can be produced for a fixed amount of resources.
• The production possibility frontier of an economy is:
Total amount of labor
aLCQC + aLWQW ≤ L resources (man
hours)
Labor required for
Total Labor required for Total gallons
each pound of
pounds of each gallon of of wine
cheese produced
cheese wine produced produced
produced
Production Possibilities (cont.)
• Suppose England has 270 man hours (L) available for
production while Portugal has 180 man hours(L).
• Maximum Cheese production is
QC = L/aLC when QW = 0.
• Maximum wine production is
QW = L/aLW when QC = 0
PPF
• England Portugal
 • 1 unit of cheese in England costs the same amount to
produce as 0.5 units of wine.
• Production of an extra unit of cheese means
foregoing production of 0.5 units of wine (i.e. the
opportunity cost of a unit of cheese is 0.5 units of
wine).
Opportunity • 1 unit of cheese in Portugal costs the same amount to
produce as 0.67 units of wine.
Costs • Production of an extra unit of cheese means
foregoing production of 0.67 units of wine (i.e. the
opportunity cost of a unit of cheese is 0.67 units of
wine).
• In terms of opportunity cost, therefore, it is
comparatively cheaper to produce cheese in England.
 • Likewise, in Portugal, a unit of wine costs 1.5
units of cheese to produce.
• In England, a unit of wine costs 2 units of
cheese to produce.
Opportunity • In terms of opportunity costs, therefore, it is
comparatively cheaper to produce wine in
Costs Portugal.
 Opportunity Costs and Slope of PPF
• The slope of the PPF :
Slope = Rise/Run
= (L/aLW / L/aLC )
= aLC / aLW
For example, in England
= 15 hours per unit of C/30 hours per unit of W
= 0.5 W/C
• This is the opportunity cost of Cheese- i.e. to produce 1 more unit of cheese requires England
to give up producing 0.5 units of wine.
• The PPF slopes downward – it indicates a tradeoff
• Can you calculate the slope of the PPF in Portugal? What is its interpretation?
 • Before trade, England spends 120 man hours on
cheese and the rest on wine production.
• Before trade, Portugal spends 90 hours on
cheese and the rest on wine production.
Autarky • How many units of cheese and wine are
produced in each country?
• What is the total production of cheese and
wine in the world?
• Now let’s introduce trade….
 • Because relative or comparative costs differ, it will still be
mutually advantageous for both countries to trade even
though Portugal has an absolute advantage in both
commodities.
• England is relatively better (lower opportunity costs) at
Comparative producing cheese than wine: so England is said to have
a COMPARATIVE/ RELATIVE ADVANTAGE in the
production of cheese.
Advantage • Should specialize in production of cheese –
produce only cheese and import wine from
Ricardian Portugal.
• Portugal is relatively better (lower opportunity costs) at
model producing wine than cheese: so Portugal is said to have
a COMPARATIVE/ RELATIVE ADVANTAGE in the
production of wine.
• Should specialize in production of wine-produce
only wine and import cheese from England.
 • If both countries now specialize completely
then,
• Which country will produce what
Is Trade commodity?
• How many units will be produced in each
Mutually country?
Beneficial? • Will specialization lead to benefits?
• Suppose they trade 10 units of cheese for 6
units of Wine, then will they be better off
after trade?
Is Trade Mutually Beneficial?
Country Production and Specialization Consumption after
Consumption before trade
Trade (10 Cheese:6Wine)
Cheese Wine Cheese Wine Cheese Wine

England 8 5 18 0 8 6
Portugal 9 6 0 12 10 6
Total 17 11 18 12 18 12

Note: Trade is advantageous for the two countries when

each must have at least as much to consume of one good
and more to consume of the other.
Comparative • This theory therefore suggests that trade is a
Advantage positive-sum game in which all countries that
participate realize economic gains.
 • Relative Price- Price of one good in terms of another good.
• Relative price of cheese: Pc /PW
• The relative prices at which goods are traded internationally -
external relative prices
• The relative prices at which they are traded within a country ,
opportunity costs- internal relative prices
Relative • When the relative price of cheese during trade settles strictly in
Prices- between the opportunity costs of cheese
i.e. aLC /aLW < Pc /PW < a*LC /a*LW
External and • workers in England produce only cheese- complete
Internal specialization
• workers in Portugal produce only wine - complete specialization
• There are mutual gains from trade.
Gains from Trade
• Gains from trade come from specializing in the type of production
which uses resources most efficiently, and using the income
generated from that production to buy the goods and services that
countries desire.
• where “using resources most efficiently” means producing a good in which a
country has a comparative advantage.
Gains from Trade
• English workers earn a higher income from cheese production
because the relative price of cheese increases with trade.
• Portuguese workers earn a higher income from wine production
because the relative price of cheese decreases with trade (making
cheese cheaper) and the relative price of wine increases with trade.
Gains from Trade
• Think of trade as an indirect method of production that
converts cheese into wine or vice versa.
• Without trade, a country has to allocate resources to
produce all of the goods that it wants to consume.
• With trade, a country can specialize its production and
exchange for the mix of goods that it wants to consume.
Gains from Trade
• Consumption possibilities expand beyond the production possibility
frontier when trade is allowed.
• With trade, consumption in each country is expanded because world
production is expanded when each country specializes in producing
the good in which it has a comparative advantage.
Question
• Can you think of some criticisms of this theory ?
 Empirical Evidence
• Do countries export those goods in which their productivity is
relatively high?
• The ratio of U.S. to British exports in 1951 compared to the ratio
of U.S. to British labor productivity in 26 manufacturing
industries suggests yes.
 Empirical Evidence
• A very poor country like Bangladesh can have comparative advantage
in clothing despite being less productive in clothing than other
countries such as China because it is even less productive compared
to China in other sectors.
Empirical Evidence
• The main implications of the Ricardian model are well supported by
empirical evidence:

• productivity differences play an important role in international trade

• comparative advantage (not absolute advantage) matters for trade

 Restrictions of the Ricardo Model
• 2 countries / 2 goods

• Same workers across sectors

• No migration

• No transportation costs

• No barriers to trade

• Unit labor requirements constant

• One factor /Labor = the only input in the production