CHAPTER 3 - WHY EVERYBODY TRADES: COMPARATIVE ADVANTAGES AND

FACTOR PROPORTIONS
 Model with two products to show the effects of resource reallocations between industries.

Adam Smith's - Theory of Trade (Late 18th)

Mercantilism : viewed trade as a zero-sum activity : one gains the other loses.
Smith opposed mercantilism.

Absolute Advantage

 Adam Smith:
o 2 countries
o 2 goods
o 1 factor economy

Labor productivity: is the production per hour.

A country will export products for which it has an absolute advantage. A country will export the products it can
produce in less time… with a higher labour productivity.

Basis for trade: (Absolute) differences in labour productivity.

Assumed: excess supplied are exported, excess demands are met by imports.

Ricardo's Theory of Trade (Early 19th)

Comparative advantage:
 A country will export products that it can produce at a low opportunity cost (in terms of other goods that
could be produced within the country).

Basis for trade: Relative differences in labour productivity. (Model with only 1 factor: labour)

Opportunity cost: The OC of producing 1 unit of one good is measured by the value of other goods and services that
cannot be produced because the resources are used instead to produce this product.

PRODUCTIVITY US ROW
CLOTH (UNITS/HOUR) 0.25 1.0
WHEAT (UNITS/HOUR) 0.50 2/3=0.67

OPPORTUNITY COSTS OF US ROW

1 UNIT OF CLOTH 2.00 2/3 = 0.67
1 UNIT OF WHEAT 0.50 3/2 = 1.5

 International price of 1 unit of cloth in terms of units of wheat is within the range: [0.67;2.00]
See Handout pages 10-12
Lorsque tu cherches le cout d’opportunité d’un bien, tu mets ce bien en dessous dans
l’équation
1. 4 hours
2. 2 units of wheat
3. 2 units of wheat per unit of cloth (2W/C)

𝑇𝑖𝑚𝑒 𝑡𝑜 𝑚𝑎𝑘𝑒 1 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑐𝑙𝑜𝑡h 4

1+ 2) 𝑡𝑖𝑚𝑒 𝑡𝑜 𝑚a𝑘𝑒 1 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑤h𝑒𝑎𝑡 = 2 = 2
It takes 4 hours to make 1 unit of cloth. During this time, 2 units of wheat could have been produced.

𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑜𝑓 𝑤h𝑒𝑎𝑡 0.5

3. = 02.25 = 2
𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑖𝑡𝑦 𝑜𝑓 𝑐𝑙𝑜𝑡h + tu es proche de 0, plus tu
2𝑊 as un avantage comparatif
In one hour, the USA can produce twice as much wheat as cloth. 𝐶 DONC tu exportes le bien
4.
0.67𝑊 avec le CO le plus faible.
𝐶

0.67𝑊 2𝑊
5. The ROW has a lower opportunity cost in cloth than the USA ( 𝐶 < 𝐶 )
The ROW therefore has a comparative advantage in cloth and will export cloth.

0.67𝑊
6. ROW will ask at least to cover its cost of 𝐶

2𝑊
7. USA will not pay more than xhat it costs them to produce (no more than 𝐶
)

8. Price between 0.67 and 2 W/C

Ricardo's Constant Costs and the PPC

 PPC: Production Possibility Curve

Also, called
 PPF: Production Possibility Frontier

 PPC: shows combinations of output that the economy can produce with full employment of resources and
maximum productivity.

 The slope of the PPC indicates: the relative price of cloth (the good on the x-axis) with no trade.

Production possibility Curve for 100 billion of hours for the USA
PRODUCTIVITY US ROW
CLOTH (UNITS/HOUR) 0.25 1.0
WHEAT (UNITS/HOUR) 0.50 2/3=0.67

The ROW has an absolute advantage in both goods: the PPC of

the ROW is further away of the origin than the PPC of the USA.

The ROW has a comparative advantage in cloth. The ROW is 4

times more productive in cloth than the USA (but only 1.34 more
productive in wheat than the USA)

Limit of this analysis: marginal cost is assumed constant.

Trade Line
Trade line: shows combinations of goods that the economy can consume with trade.

1𝑊
Assume the price of trade is 𝐶

 Each country specializes completely in the production of one good. (point S1)
 Each country consumes on the trade line (point C1)

With trade, constant cost

 Each country gains from trade:
o Consumes outside the PPC (= more than it
can consume in S0 before trade)
o On a higher indifference curve (if you draw
indifference curves: C1 is on a higher
indifference curve that S0)

More modern portrayal of the Ricardo’s

Theory: Increasing marginal costs
See chapter 4

 Comparative Advantage with increasing O.C.