Chapter 2: Absolute and

Comparative Advantage
Main reference: Ch.2-Salvatore’s
Ch.2 textbook

2-1
 The basic questions of international
trade

• What is the basis of trade?

– Two answers to this question will be discussed in
this chapter: Absolute Advantage and
Comparative Advantage

2-2
 The basic questions of international
trade

• What is the basis of trade?

• What are the gains from trade?
– The models of Absolute and Comparative
Advantage show that the gains from trade are
increased consumption gained through
specialization in production and trade.

2-3
 The basic questions of international
trade

• What is the basis of trade?

• What are the gains from trade?
• What is the pattern of trade?
– What determines the pattern of specialization that
drives international trade?

2-4
 The Mercantilists

• What is wealth?
– The Mercantilist answer was the stock of precious
metals possessed by a country.

2-5
 The Mercantilists

• What is wealth?
• How can precious metals be obtained?
– Extraction from naturally occurring stocks
• This option is available to few countries

2-6
 The Mercantilists

• What is wealth?
• How can precious metals be obtained?
– Extraction from naturally occurring stocks
– Earn precious metals through exports of goods
and services
• Since payment for exports is made with precious
metals, exporting causes precious metals to flow into a
country
• Similarly, since payment for imports is also made with
precious metals, importing causes precious metals to
flow out of country

2-7
 The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!

2-8
 The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!
• Can this condition hold for all countries?
– No!
– Therefore, the wealth of one country must come at
the expense of another country.

2-9
 The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!
• Can this condition hold for all countries?
• Mercantilist policy
– Strict government control over economic activity
to ensure a positive trade balance

2 - 10
 The Mercantilists

• What is wealth?
• How can precious metals be obtained?
• The natural conclusion – exports must exceed
imports for a country to become wealthy!
• Can this condition hold for all countries?
• Mercantilist policy
• A further look at the Mercantilists
– Federal Reserve Bank of San Francisco’s “Major
Schools of Economic Theory”

2 - 11
 Is “wealth” precious metals?

• To the Mercantilists, yes.

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 Are precious metals “wealth”?

• To the Mercantilists, yes.

• Modern measures of wealth are based on a
country’s ability to produce the goods and
services that improve quality of life.
– Hence, the Mercantilist definition of wealth differs
significantly from modern notions of wealth.
– This distinction leads to very different
conclusions about how to become a wealthy
nation.

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 Absolute advantage

• Built on the ideas of Adam Smith

– The Library of Economic Liberty Biography of
Adam Smith

2 - 14
 Absolute advantage

• Built on the ideas of Adam Smith

• Absolute advantage exists between nations
when they differ in their ability to produce
goods.
– More specifically, absolute advantage exists when
one country is good at producing one item, while
another country is good at producing another
item.

2 - 15
 An example of absolute advantage

• Countries Units produced per hour

– US
10
– UK 9
• Goods 8
7
– Wheat
6 Wheat
– Cloth
5
4 Cloth

3
2
1
0
US UK

2 - 16
 An example of absolute advantage

• One hour of labor time produces six bushels of

wheat in the US but only one in the UK.
• One hour of labor time produces five yards of cloth
in the UK but only four in the US.
• Thus, US is more efficient than, or has an absolute
advantage over, UK in the production of wheat.
• UK is more efficient than, or has an absolute
advantage over, US in the production of cloth.
• With trade, US would specialize in the production of
wheat and exchange part of it for British cloth.
• The opposite is true for the United Kingdom.
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 An example of absolute advantage

• How does specialization Units produced per hour

and trade advantage US?
10
– By reducing cloth 9
production, resources 8
are freed for producing 7
more wheat 6 Wheat
– Each hour of 5
4 Cloth
production change
3
costs 4 unit of cloth
2
but gains 6 units of
1
wheat 0
US UK

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 An example of absolute advantage

• How does specialization and trade advantage

US?
– If the US exchanges six units of wheat (6W)
for six units of British cloth (6C), the US gains
2C or saves 1/2 2 hour or 30 minutes of labor
time.
– Since the US can only exchange 6W for 4C
domestically.

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 An example of absolute advantage

• Does specialization and Units produced per hour

trade also advantage
10
the UK? 9
– By reducing wheat 8
production, resources 7
are freed for producing 6 Wheat
more cloth. 5
Cloth
– Each hour of production 4
change costs 1 units of 3
wheat but gains 5 units 2
of cloth. 1
0
US UK

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 An example of absolute advantage

• Does specialization and trade also advantage the

UK?
– The 6W that UK receives from US is equivalent
to or would require six hours of labor time to
produce in UK.
– These same six hours can produce 30C in UK
(6 hours times 5 units of cloth per hour).
– By being able to exchange 6C (requiring a little
over one hour to produce in UK) for 6W with
US, UK gains 24C, or saves almost five labor -
hours.
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 Policy recommendations from
absolute advantage

• The fact that the United Kingdom gains much more

than the United States is not important.
• Specialization and trade advantage both countries.
• Therefore, the best policy is to allow producers and
consumers in both countries unfettered access to
goods from both countries to maximize the number
of advantageous trades that can occur.
• In other words, laissez-faire.
faire.
– The policy of minimum government interference
with economic activity.

2 - 22
 A fatal flaw?

• Absolute advantage requires one country to be better at

production of one product and another country to be
better at production of another good for specialization
and trade to be mutually advantageous.
• What if one country is better at everything?
– Absolute advantage, however, can explain only a very
small part of world trade today, such as some of the
trade between developed and developing countries.
– Most of world trade, especially trade among
developed countries, could not be explained by
absolute advantage.
– The theory of comparative advantage provides this
answer.
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 Comparative advantage

• Built on the ideas of David Ricardo

– The New School History of Economic Thought
Biography of David Ricardo
– In 1817, Ricardo published his Principles of
Political Economy and Taxation
– One of the most important and still
unchallenged laws of economics, with many
practical applications

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 Comparative advantage

• Built on the ideas of David Ricardo

• The law of comparative advantage shows how
mutually beneficial specialization and trade
may be driven by relative advantages in
production rather than absolute advantages in
production.
– Given the somewhat counter-intuitive
counter nature of
the law of comparative advantage its implications
are best seen through example.

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 Comparative advantage

• According to the law of comparative advantage, even

if one nation is less efficient than (has an absolute
disadvantage with respect to) the other nation in the
production of both commodities, there is still a basis
for mutually beneficial trade.
• The first nation should specialize in the production
and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its
comparative advantage)
• And import the commodity in which its absolute
disadvantage is greater (this is the commodity of its
comparative disadvantage)
disadvantage
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 An example of comparative
advantage
• The statement of the law can
be clarified by looking at
Table 2.2.
• The only difference between
Tables 2.2 and 2.1 is that the
United Kingdom now
produces only two yards of
cloth per hour instead of five.
• Thus, the United Kingdom
now has an absolute
disadvantage in the
production of both wheat and
cloth with respect to the
United States.
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 An example of comparative
advantage

• Countries Units produced per hour

– US 10
9
– UK 8
• Goods 7
6
– Wheat Wheat
5
Cloth
– Cloth 4
3
• The difference lies in
2
the relative productivity 1
of the countries 0
US UK
– In this case, US is more
productive at generating
both goods.
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 An example of comparative
advantage

• However, since U.K. labor is half as productive

in cloth but six times less productive in wheat
with respect to US, UK has a comparative
advantage in cloth.
• US has an absolute advantage in both wheat
and cloth with respect to UK, but since its
absolute advantage is greater in wheat (6:1)
than in cloth (4:2), US has a comparative
advantage in wheat.

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 An example of comparative
advantage
• To summarize, US’s absolute advantage is greater in
wheat, so its comparative advantage lies in wheat.
• UK’s absolute disadvantage is smaller in cloth, so its
comparative advantage lies in cloth.
• According to the law of comparative advantage, both
nations can gain if US specializes in the production of
wheat and exports some of it in exchange for British
cloth.
• In a two-nation, two-commodity
commodity world, if one nation has a
comparative advantage in one commodity, then the other
nation must necessarily have a comparative advantage
in the other commodity.
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 An example of comparative
advantage

• How does specialization Units produced per hour

and trade advantage 10

9
US? 8
– By reducing cloth 7
production, resources 6
Wheat
are freed for producing 5
Cloth
more wheat 4
3
– Each hour of production
2
change costs 4 units of 1
cloth but gains 6 units of 0
wheat US UK

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 An example of comparative
advantage

• How does specialization and trade advantage US?

– US would be indifferent to trade if it received only 4C
from UK in exchange for 6W, since US can produce
exactly 4C domestically by utilizing the resources
released in giving up 6W.
– And the United States would certainly not trade if it
received less than 4C for 6W.
– Similarly, UK would be indifferent to trade if it had to
give up 2C for each 1W it received from US.
– And it certainly would not trade if it had to give up
more than 2C for 1W.

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 An example of comparative
advantage
• How does specialization and trade advantage
US?
- Suppose the United States could exchange 6W
for 6C with UK.
- US would then gain 2C (or save 1/2
1 hour of labor
time) since US could only exchange 6W for 4C
domestically.

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 An example of comparative
advantage
• Does specialization and trade also advantage UK?
– It does.
– To see that UK would also gain, note that the 6W that
UK receives from US would require six hours to
produce in UK.
– UK could instead use these six hours to produce 12C
and give up only 6C for 6W from US.
– Thus, UK would gain 6C or save three hours of
labor time.
– The fact that UK gains more from trade than US is not
important at this point.
– What is important is that both nations can gain
from trade even if one of them is less efficient than the
other in the production of both commodities 2 - 34
 An example of comparative
advantage

• We see that both nations would gain by

exchanging 6W for 6C.
• However, this is not the only rate of
exchange at which mutually beneficial trade
can take place.
• Since US could exchange 6W for 4C
domestically (in the sense that both require
1 hour to produce), US would gain if it could
exchange 6W for more than 4C from UK.

2 - 35
 An example of comparative
advantage
• In UK, 6W = 12C (in the sense that both
require 6 hours to produce). Anything less
than 12C that UK must give up to obtain 6W
from US represents a gain from trade for UK.
• To summarize, US gains to the extent that it
can exchange 6W for more than 4C from UK.
UK gains to the extent that it can give up less
than 12C for 6W from US.
• Thus, the range for mutually advantageous
trade is: 4C < 6W < 12C
C
2 - 36
 An example of comparative
advantage
• The spread between 12C and 4C (i.e., 8C) represents the
total gains from trade available to be shared by the two
nations by trading 6W.
• For example, when 6W are exchanged for 6C, US gains
2C and UK 6C, making a total of 8C.
• The closer the rate of exchange is to 4C = 6W (the
domestic, or internal,, rate in US), the smaller is the share
of the gain going to US and the larger is the share of the
gain going to UK.
• The closer the rate of exchange is to 6W = 12C (the
domestic, or internal, rate in UK), the greater is the gain
of US relative to that of UK.
2 - 37
 An example of comparative
advantage
• For example, if US exchanged 6W for 8C with
UK, both nations would gain 4C, for a total
gain of 8C.
• If US could exchange 6W for 10C, it would
gain 6C and UK only 2C.
• The rate of exchange will also determine how
the total gains from trade are actually shared
by the trading nations.

2 - 38
 Implications of comparative
advantage

• Laissez-faire
faire still holds
• Gains need not be equal
• Trade is based on the existence of relative –
not absolute – production advantages

2 - 39
 The Case of No Comparative
Advantage

• There is one (not very common) case where there is

no comparative advantage.
advantage
• This occurs when the absolute disadvantage that
one nation has with respect to another nation is the
same in both commodities.
• For example, if one hour produced 3W instead of 1W
in UK, UK would be exactly half as productive
as US in both wheat and cloth.
• UK (and US) would then have a comparative
advantage in neither commodity, and no mutually
beneficial trade could take place.
2 - 40
 The Case of No Comparative
Advantage
• The reason for this is that (as earlier) US will trade
only if it can exchange 6W for more than 4C.
• However, now UK is not willing to give up more
than 4C to obtain 6W US because UK can produce
either 6W or 4C with two hours domestically.
• Under these circumstances, no mutually
beneficial trade can take place.
• However, its occurrence is rare and a matter of
coincidence, so the applicability of the law of
comparative advantage is not greatly affected.

2 - 41
 Does money alter the story?
Comparative Advantage with Money

• No
• UK has an absolute disadvantage in the production
of both commodities with US but there is still a basis
for mutually beneficial trade.
• How can UK export to US if it is less efficient than
US in the production of both commodities?
• The answer is that wages in UK will be sufficiently
lower than wages in US so as to make the price of
cloth (the commodity in which UK has a comparative
advantage) lower in UK, and the price of wheat lower
in US when both commodities are expressed in
terms of the currency of either nation.
nation
2 - 42
 Comparative Advantage with Money

• Suppose that the wage rate in US is $6 per hour.

Since one hour produces 6W in US, the price of a
unit of wheat is PW = $1. Since one hour
produces 4C, PC = $1.50 50 (from $ 6/4C).
6
• Suppose that the wage rate in UK is £1 per hour.
Since one hour produces 1W in UK, PW = £1
in UK. Since one hour produces 2C, PC = £0.5.
• If the exchange rate between the pound and the
dollar is £1 = $2, then PW = £1 = $2 and PC = £0.5
= $1 in UK.

2 - 43
 Comparative Advantage with Money

• We can see that the dollar price of wheat (the

commodity in which US has a comparative
advantage) is lower in US than in UK.
• The dollar price of cloth (the commodity in which
UK has a comparative advantage) is lower in UK.
• The result would be the same if the price of both
commodities had been expressed in pounds.

2 - 44
 Comparative Advantage with Money

• Business people would buy wheat there and sell it

in UK, where they would buy cloth to sell in the
US.
• Even though U.K. labor is half as productive as
U.S. labor in cloth production, U.K. labor receives
only one-third
third of the U.S. wage rate (£1 = $2 as
opposed to $6 in US), so that the dollar price of
cloth is lower in UK.
• To put it differently, the inefficiency of U.K. labor
relative to U.S. labor in cloth production is more
than compensated for by the lower wages in U.K.
As a result, the dollar price of cloth is less in UK.

2 - 45
 Comparative Advantage with Money

• This is always the case as long as the U.K. wage rate is

between 1/6 and 1/2 2 of the U.S. wage rate.
• If the exchange rate between the dollar and the pound were
instead £1 = $1 (so that the U.K. wage rate was exactly 1/6
1
the U.S. wage rate), then the dollar price of wheat in UK
would be PW = £1 = $1.
• Since this is the same price as in US, US could not export
wheat to UK at this exchange rate.
• At the same time, PC = £0.5 5 = $0.50
$0 in UK, and UK would
export even more cloth than before to US. Trade would be
unbalanced in favor of UK, and the exchange rate between
the dollar and the pound (i.e., the dollar price of the pound)
would have to rise.
2 - 46
 Comparative Advantage with Money

• On the other hand, if the exchange rate were £1 =

$3 (so that the U.K. wage rate was exactly 1/2
1 the
U.S. wage rate), the price of cloth in UK would be
PC = £0.5 = $1.50
50 (the same as in US).
• As a result, UK could not export cloth to US.
• Trade would be unbalanced in favor of US, and
the exchange rate would have to fall.
• The rate of exchange between the dollar and the
pound will eventually settle at the level that will
result in balanced trade.

2 - 47
 Comparative Advantage and its
Assumptions
Ricardo based his law of comparative
advantage on a number of simplifying
assumptions:
• (1) only two nations and two commodities
• (2) free trade
• (3) perfect mobility of labor within each
nation but immobility between the two
nations
• (4) constant costs of production
2 - 48
 Comparative Advantage and its
Assumptions
• (5) no transportation costs,
• (6) no technical change, and
• (7) the labor theory of value.
Although assumptions one through six
can easily be relaxed, assumption seven is
not valid and should not be used for
explaining comparative advantage.

2 - 49
 Comparative Advantage and the
Labor Theory of Value
Under the labor theory of value, the value or
price of a commodity depends exclusively on
the amount of labor used. This implies
(1)that
that labor is the only factor of production
(2)that
that labor is homogeneous.
Since neither of these assumptions is true, we
cannot base the explanation of comparative
advantage on the labor theory of value.

2 - 50
 The Opportunity Cost Theory

• Haberler in 1936 to explain the theory of

comparative advantage on the opportunity
cost theory.
• Opportunity cost holds that the cost of an item
is the amount of another item that must be
given up to release sufficient resources to
produce one more unit of the first item.
• No assumption is made here that labor is the
only factor of production or that labor is
homogeneous.
2 - 51
 The Opportunity Cost Theory

• Nor is it assumed that the cost or price of a

commodity depends on its labor content.
• Consequently, the 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).

2 - 52
 The Opportunity Cost Theory -
Example
• In the absence of trade US must give up two-two
thirds of a unit of cloth to release just enough
resources to produce one additional unit of
wheat domestically
• Then the opportunity cost of 1W = 2/3C in US
• And 1W = 2C in UK, then the opportunity cost
of wheat is lower in US than in UK, and US
would have a comparative (cost) advantage
over UK in wheat

2 - 53
 The Opportunity Cost Theory -
Example
• In a two-nation, two-commodity
commodity world, UK
would then have a comparative advantage in
cloth.
• US should specialize in producing wheat and
export some of it in exchange for British cloth.
• This is exactly what we concluded earlier with
the law of comparative advantage based on
the labor theory of value, but now our
explanation is based on the opportunity cost
theory.
2 - 54
 The production possibility frontier

• The production United States

possibility frontier (PPF)
identifies the maximum Wheat Cloth
combinations of two 180 0
products that a nation
can produce by fully 150 20
utilizing all factors of 120 40
production with the best
technology available. 90 60
• Consider the production 60 80
possibilities schedule 30 100
for an example:
0 120
2 - 55
 Constructing the PPF

140 United States

120 Wheat Cloth
100 180 0
80 150 20
Cloth

60
120 40
40
90 60
20
60 80
0
0 50 100 150 200 30 100
Wheat 0 120
2 - 56
 Constructing the PPF

140 United States

120 Wheat Cloth
100 180 0
80 150 20
Cloth

60
120 40
40
90 60
20
60 80
0
0 50 100 150 200 30 100
Wheat 0 120
2 - 57
 Constructing the PPF

140 United States

120 Wheat Cloth
100 180 0
80 150 20
Cloth

60
120 40
40
90 60
20
60 80
0
0 50 100 150 200 30 100
Wheat 0 120
2 - 58
 Regions of the PPF

140

120 Productive maximum

100
Underutilized resources
80
Cloth

60 Unattainable with existing

resources and technology
40

20

0
0 50 100 150 200
Wheat

2 - 59
 Trade with the PPF model

• Suppose the US and the US

140
UK have the PPFs given 120
100

Cloth
80
to the right 60
40
20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat

UK
140
120
100
Cloth
80
60
40
20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat

2 - 60
 Trade with the PPF model

• Suppose the US and the US

140
UK have the PPFs given 120
100
(90W, 60C)

Cloth
80
to the right 60
40
20
• Further suppose that 0
0 20 40 60 80 100 120 140 160 180 200
each country produces Wheat

and consumes at the

marked spot in the UK
140
absence of international 120
100
trade Cloth
80 (40W, 40C)
60
40
20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat

2 - 61
 Trade with the PPF model

• Can specialization and US

140
trade lead to more 120
100
aggregate production (90W, 60C)

Cloth
80
60
and consumption? 40
20
0
• If the US specialized in 0 20 40 60 80 100 120 140 160 180 200

wheat production and Wheat

the UK in cloth
UK
production, aggregate 140
production would 120
100
increase from 130W to Cloth
80 (40W, 40C)
60
40
180W and from 100C to 20
0
120C. 0 20 40 60 80 100 120 140 160 180 200
Wheat

2 - 62
 Trade with the PPF model

• This increased US
140
production would allow 120
100 (110W, 70C)

Cloth
80
each country to 60 Production
40
consume at a point 20
0

outside of its PPF as 0 20 40 60 80 100 120 140 160 180 200

Wheat
indicated by the blue
lines in the graphs. Production UK
140
• The increased 120
100
consumption is the Cloth (70W, 50C)
80
60
40
gains from trade. 20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat

2 - 63