4/5/23

THE LAW OF COMPARATIVE

ADVANTAGE
Dr. Tran Thi Mai Thanh, VNU UEB

LEARNING GOALS
After reading this chapter, you
should be able to:
• Understand the law of
comparative advantage
• What is the basis for trade
• Understand the relationship and what are the gains
between opportunity costs and from trade?
relative commodity prices
• What is the pattern of
• Explain the basis for trade and trade?
show the gains from trade under
constant costs conditions

PREVIEW
1. The Mercantilists’ Views on Trade
2. Trade Based on Absolute Advantage: Adam Smith
3. Trade Based on Comparative Advantage: David Ricardo
4. Comparative Advantage and Opportunity Costs
5. Empirical Tests of the Ricardian Model

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WHAT IS INTERNATIONAL TRADE?

• In a narrow sense, international trade is the exchange of goods
and services across national borders.
• In a broader sense, international trade is the exchange of goods,
services and resources (capital and labor) across national
borders.

INTERNATIONAL TRADE IN
INTERNATIONAL ECONOMICS
International trade International trade
theories instruments

Lecture 2: The law of

comparative advantage Lecture 4: Tariff

Lecture 5: Non-tariff
Lecture 3: H-O model barriers

INTERNATIONAL TRADE THEORIES

Classical International Neo-classical International

Trade Theory Trade Theory

1. Mercantilism Opportunity cost and Comparative

2. Absolute Advantage Advantage
3. Comparative Advantage

Heckscher-Ohlin Theory

Factor Endowments and

Comparative Advantage

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1. THE MERCANTILISTS’
VIEWS ON TRADE

INTRODUCTION

• Economic philosophy in
INTRODUCTION
17th and 18th centuries
• In • England, Spain,
Economic philosophy in 17th
France, Portugal
and 18th centuries and
• In England, Spain, France,
the Netherlands.
Portugal and the
Netherlands.
• Thomas Munn (1571-
• Thomas Munn (1571- 1641),
1641),“England’s treasure
England by
Foreign Trade”
treasure by Foreign
T ade
Thomas Munn
(1571-1641)

MERCHANTILIST’S VIEW
A nation’s wealth is measured by ON TRADE
stock of gold and silver

Accumulate as much gold and Appreciate the role of money

silver as possible
Becoming rich by trade
• Encouraging export
• Restricting/ prohibiting import
Consider gold and silver as the only
form of wealth
Appreciate the role of trade
The State’s role in trade activities

One nation gains

at the expenses of other nations Zero-sum game; Involuntary trade

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CONTRIBUTIONS
• The oldest, pioneer thoughts on International Economics
• Recognize the importance of trade
• Emphasize the government’s role in regulating trade
• Some ideas are still valid until today

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LIMITATIONS
• Nature of the wealth of a nation:
– Gold and silver - the only form of wealth
– How about other resources such as human, man-made and natural
resources?
• Zero-sum game: Trade is beneficial for one nation at the expense
of other nations.
• Assume that wealth increase through circulation, not in
production.
• Cannot explain the pattern of trade.

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2. TRADE BASED ON
THE ABSOLUTE ADVANTAGE

14

ABSOLUTE ADVANTAGE OF ADAM SMITH

ABSOLUTE ADVANTAGE OF ADAM SMITH

“An inquiry into the nature and causes of

Adam Smith (1723-1790) the wealth of Nations” (1776)

Adam Smith A e a e a d ca e f e
15 (1723-1790)
ea f Na (1776)

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ASSUMPTION
• 2 countries, 2 goods
• Labor is the only production factor
• No barriers to trade
• No transportation cost
• Perfect competition in all markets

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THE BASIS FOR TRADE

• Absolute advantage
• A nation has absolute advantage in producing a particular good
if it can produce that good more efficiently than the other
country.
• More efficient: higher productivity of labor (or lower labor cost)

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THE PATTERN OF TRADE

• When one country has absolute advantage in production of a
commodity, but an absolute disadvantage with respect to the
other nation in a second commodity, both nations can gain by
specializing in their absolute advantage good and exchanging
part of the output for the commodity of its absolute
disadvantage.
à Specialize in producing and export goods which a nation has an
absolute advantage and import goods which it has an absolute
disadvantage.

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THE ILLUSTRATION OF ABSOLUTE

ADVANTAGE
US UK
Wheat - W (unit/hour) 6 1
Cloth – C (unit/hour) 4 5

• Determine absolute advantage of each country

• Analyze the pattern of trade according to Adam Smith’s theory

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THE ILLUSTRATION OF ABSOLUTE

ADVANTAGE
US UK
Wheat - W (unit/hour) 6 1
Cloth – C (unit/hour) 4 5

• The US has an absolute advantage over the UK in wheat production (US labor
productivity in producing Wheat is higher than that of UK)
• The UK has an absolute advantage over the US in cloth production (UK labor
productivity in producing Cloth is higher than that of US)
-> The US would specialize in producing wheat; the UK specialize in producing
cloth and then trade with each other.

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GAINS FROM TRADE

Auturky US: 6W=4C UK: 1W=5C

Specialization US produces wheat US produces cloth

Demand Exchanging W to C Exchanging C to W

Exchange rate 6W=6C

Gains from Benefits for US: 6–4=2C Benefits for UK: 5x6 – 6 = 24C
trade ↔ 1⁄2 h of producing C ↔ 4.8 h of producing C

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CONTRIBUTIONS
• Specialization and trade benefit both countries
• Adam Smith and other classical economists advocated a policy of
laissez-faire, or minimal government interference with economic
activity.
• Free trade would cause world resources to be utilized most
efficiently, maximizing the world welfare.

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LIMITATIONS
US UK
Wheat - W (unit/hour) 6 1
Cloth – C (unit/hour) 4 2

• It cannot explain the trade in the case that one country has absolute
advantage in both goods and the other does not have absolute
advantage in any goods.
• The US has absolute advantage in producing both wheat and cloth.
• The UK does have absolute advantage in producing any goods.

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3. TRADE BASED ON
COMPARATIVE ADVANTAGE

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COMPARATIVE ADVANTAGE AND OPPORTUNITY COST

• Ricardian model: differences in productivity of L between

countries cause productive differences, leading to gains from
trade.
• Ricardian model uses the concepts of opportunity cost and
comparative advantage.
• The opportunity cost of producing good X is the cost of not
being able to produce good Y because resources have already
been used to produce good X.

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COMPARATIVE ADVANTAGE AND OPPORTUNITY COST

(cont.)
• A country faces opportunity costs when it uses resources to
produce goods and services.
• E.g., a limited number of workers could be employed to produce
roses or PCs.
• Opportunity cost of producing PCs is the amount of roses not produced
• Opportunity cost of producing roses is the amount of PCs not produced
à How many PCs or roses should a country produce with the limited
resources it has?

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COMPARATIVE ADVANTAGE AND OPPORTUNITY COST

(cont.)

• Suppose U.S. can produce 10 million roses with the same

resources that could produce 100,000 PCs.
• Ecuador can produce 10 million roses with the same
resources that could produce 30,000 PCs.
• Workers in Ecuador are less productive than those in U.S. in
manufacturing PCs.
à Question: what is the opportunity cost of roses in Ecuador?

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COMPARATIVE ADVANTAGE AND OPPORTUNITY COST

(cont.)

• Ecuador has a lower opportunity cost of producing roses.

• U.S. has a lower opportunity cost of producing PCs.
• Ecuador: 10 million roses or 30,000 PCs
• US: 10 million roses or 100,000 PCs

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COMPARATIVE ADVANTAGE AND OPPORTUNITY COST

(cont.)
• A country has a comparative advantage in producing a good if the
opportunity cost of producing that good is lower in the country
than it is in other countries.
• A country with a comparative advantage in producing a good uses
its resources most efficiently when it produces that good
compared to producing other goods.

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COMPARATIVE ADVANTAGE AND OPPORTUNITY COST

(cont.)
• U.S. has a comparative advantage in the production of PCs.
• Ecuador has a comparative advantage in the production of roses.
• Suppose initially that Ecuador produces PCs and U.S. produces
roses, and that both countries want to consume PCs and roses.
• Can both countries be made better off?

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Comparative Advantage and Trade

Millions of Thousands of
Roses Computers
U.S. -10 +100
Ecuador +10 -30
Change 0 +70
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Comparative Advantage and Trade (cont.)

• Example shows that when countries specialize in the good in

which they have a comparative advantage, more goods can be
produced and consumed.
• Initially both countries could only consume 10 million roses and
30,000 PCs.
• With specialization, they could still consume 10 million roses, but
could consume 70,000 more PCs.

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32

A ONE FACTOR RICARDIAN MODEL

David Ricardo “The principles of political economy, and

(1772-1823) taxation” (1817)

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ASSUMPTION
• An example with roses and PCs explains the intuition behind
the Ricardian model.
• The Ricardian model assumes:
1. L is the only resource for production.
2. The supply of L in each country is fixed.
3. Only 2 goods are produced and consumed: WHEAT and CLOTH.
4. L is not specific to either industry.
5. Only 2 countries: HOME and FOREIGN.

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34

BASIS FOR TRADE

• Even if a nation is less efficient than the other nation in the

production of both commodities, there is still a basis for
mutually beneficial trade.
• Basis for trade: Comparative advantage
• A country has a comparative advantage in producing one good
when its absolute advantage in producing this good is greater; or
its absolute disadvantage is smaller.
– Higher relative productivity or lower relative cost

35

THE PATTERN OF TRADE

• A nation should specialize in the production and export of

the commodity that it has comparative advantage and
import the commodity that it has comparative
disadvantage.

36

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Illustration of comparative advantage

Good US UK
Wheat – W (unit/hour) 6 1
Cloth – C (unit/hour) 4 2

1. Determine the absolute advantage of the US and the UK.

2. What is the pattern of trade based on the concept of absolute
advantage?
3. Determine the comparative advantage of US and UK.
4. What is the pattern of trade based on the concept of comparative
advantage?

37

Illustration of Good US UK
comparative Wheat – W (unit/hour) 6 1
advantage Cloth – C (unit/hour) 4 2

1. UK has an absolute disadvantage in both goods -> cannot determine the

pattern of trade based on the concept of absolute advantage
2. US has a comparative advantage in Wheat production
(US labor is 06 times as productive in wheat but only 02 times productive in
cloth compared to UK)
3. UK has a comparative advantage in Cloth production
(UK labor is half as productive in cloth but 06 times les productive in wheat
compared to US)
4. US would specialize in production of wheat, UK would specialize in
production of cloth and then exchange with each other.

38

GAINS FROM TRADE

Auturky US: 6W=4C UK: 1W=2C

Specialization US produces wheat UK produces cloth

Demand Exchanging W to C Exchanging C to W

Exchange rate 6W=6C

Gains from Benefits for US: 6–4=2C Benefits for UK: 2x6 – 6 = 6C
trade ↔ 1⁄2h of producing C ↔ 3h of producing C

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GAINS FROM TRADE (CONT.)

The gains from trade by the rate of exchange v The range of exchange rate
The rate of Gains from trade Note for mutually beneficial trade
exchange US UK World
is between the pre-trade
between W exchange rates of the two
(pre-trade (pre-trade price
&C price 6W:4C) countries
6W:12C )

6W:3C No trade 4 C < 6 W < 12 C

6W:4C 0C 8C 8C No trade
v No guarantee for equal gain
6W:5C 1C 7C 8C With trade
from trade: The further the
6W:6C 2C 6C 8C With trade
rate of exchange is from pre-
6W:7C 3C 5C 8C With trade trade, the more benefits that
6W:8C 4C 4C 8C Equal gain a country gains from trade
6W:9C 5C 3C 8C With trade v The more different the
6W:10C 6C 2C 8C With trade countries participating in
6W:11C 7C 1C 8C With trade international trade, the
6W:12C 8C 0C 8C No trade greater the benefits from
international trade.
6W:13C No trade

40

Good US UK

EXCEPTION Wheat – W (unit/hour) 6 3

Cloth – C (unit/hour) 4 2

No comparative advantage occurs when the absolute disadvantage

that one nation has with respect to another nation is the same in
both commodities.
(The UK is half as productive as the US in both wheat and cloth)

41

CONTRIBUTIONS

• One of the most important theories with many practical

applications.
• Explain the pattern and gains of trade even when one nation is less
efficient than the other nation in the production of both
commodities.

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LIMITATIONS
• Determining comparative advantage based on the labour theory
of value
– Labour is the only factor in production
– Labour is used in the same fixed proportion in the production
of all commodities
– Labour is homogeneous
• Have not explained the sources of comparative advantages

43

4. COMPARATIVE ADVANTAGE AND

OPPORTUNITY COSTS

44

Comparative Advantage and Opportunities Costs

• Determined comparative advantage based on opportunity

cost (OC), not on labor productivity
COMPARATIVE
ADVANTAGE AND
OPPORTUNITY COSTS

Determined comparative
advantage based on
opportunity cost (OC), not
on labor productivity

Gottfried von Haberler The Theory of International Trade

(1900-1995) (1936)

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OPPORTUNITY COSTS
• The opportunity cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources
to produce one additional unit of the first commodity.
• Limited resources -> The trade-off

46

BASIS FOR TRADE

• Basis for trade: Comparative advantage
• A nation has a comparative advantage in a commodity if it can
produce this commodity at a lower opportunity cost than the other
nation.
US UK US UK
W (unit/hour) 6 1 OC of Wheat 2/3C 2C
C (unit/hour) 4 2 OC of Cloth 3/2W 1/2W

-> US has comparative advantage in production of wheat

-> UK has comparative advantage in production of cloth

47

PATTERN OF TRADE
• The US should specialize in producing wheat and export wheat to
the UK.
• The UK should specialize in producing cloth and export cloth to
the US.

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THE PRODUCTION
Production POSSIBILITY
Possibility Frontier (PPF)
FRONTIER (PPF)
• PPF is a curve that shows the alternative combinations of the
• PPF istwo
a curve that showsthat
commodities the aalternative
nation cancombinations
produce by of the utilizing
fully two commodities that
a nation can
all of itsproduce by with
resources fully utilizing
the best all of its resources
technology with
available tothe
it. best technology
available to it.
Y Y PPF under
PPF under increasing cost
constant cost

*C
*B
*A
X X

• What do points outside the PPF curve (C) represent?

• What do points outside the PPF curve (C) represent?
• What do points inside the PPF curve (A) represent? ?
• What do points inside the PPF curve (A) represent?

49

THE PRODUCTION POSSIBILITY

FRONTIER (PPF)
US UK
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
Please draw the
PPF curve of the 120 40 40 40
US and the UK 90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120

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PPF under constant cost

PPF UNDER THE CONSTANT COST
C US C UK
C OC of W = 120/180 = 2/3C OC of W = 120/60 = 2C
120 OC of C = 180/120 = 3/2W 120 C* OC of C = 60/120 = 1/2W

100 100

80 80

60 A 60

40 40 A*

20 20
B
B*

0 20 40 60 80 100 120 140 160 180 W 0 20 40 60 W

• US has comparative advantage in Wheat

• US has comparative advantage in Wheat
• UK has comparative advantage in Cloth
• UK has comparative advantage in Cloth

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Gains from trade

C C
B*
C*
120 120

GAINS US UK
100 100

FROM
80 80
E
70 A
60 60
E*

TRADE
50
40 40 A*

20 B 20

110 W
0 20 40 60 80 90 100 120 140 160 180 W 0 20 40 60 70

BEFORE TRADE
Before trade AFTER TRADE
After trade: 70W=70C
Production Consumption
Production Production
Consumption Consumption
Production Consumption
The US The U.S
The UK The UK

The World The world

52

Gains from trade

C C
B*
C*
120 120

GAINS US UK
100 100

FROM 80
70
60
A
E
80

60

TRADE 50 E*
40 40 A*

20 B 20

110 W
0 20 40 60 80 90 100 120 140 160 180 W 0 20 40 60 70

BEFORE TRADE
Before trade AFTER TRADE
After trade: 70W=70C
Production Consumption
Production Production
Consumption Consumption
Production Consumption
The US A U.S
The (80W, 60C) A (80W, 60C) B (180W, 0C) E (110W, 70C)
The UK A*UK
The (40W, 40C) A* (40W, 40C) B* (0W, 120C) E* (70W, 50C)
The World The world 100C
120W, 120W, 100C 180W, 120C 180W, 120C

53

CONTRIBUTIONS AND LIMITATIONS

CONTRIBUTIONS
• Determining comparative advantage based on opportunity cost
(labor is not necessarily the only factor of production)
• PPF curve and demonstrating the benefits from trade
LIMITATIONS
• Constant opportunity cost
• Have not explained the sources of comparative advantages

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SUMMARY
• This chapter examined the development of trade theory from the
mercantilists to Smith, Ricardo, and Haberler and sought to
answer two basic questions:
• (a) What is the basis for and what are the gains from trade? and
• (b) What is the pattern of trade?
• The mercantilists: a nation could gain in international trade only
at the expense of other nations à restrictions on imports,
incentives for exports, and strict government regulation of all
economic activities.

55

SUMMARY
• Adam Smith: trade is based on absolute advantage and benefits
both nations à trade is positive sum game. Due to some
limitations, absolute advantage explains only a small portion of
international trade today.
• David Ricardo introduced the law of comparative advantage: even
if one nation is less efficient than the other nation in the
production of both commodities, there is still a basis for mutually
beneficial trade. Ricardo, however, explained the law of
comparative advantage in terms of the labor theory of value, which
is unacceptable.

56

SUMMARY
• Gottfried Haberler: explaining the law of comparative advantage in
terms of the opportunity cost theory.
• A straight-line production possibility frontier reflects constant
opportunity costs.
• With trade, each nation can specialize in producing the commodity
of its comparative advantage and exchange part of its output with
the other nation for the commodity of its comparative
disadvantage à both nations end up consuming more of both
commodities than without trade.

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A LOOK AHEAD
In the following lecture, we extend our trade model to more than
one factor of production that helps properly examine the basics of
trade and gains from trade.

H-O MODEL

58

KEY TERMS
• Absolute advantage, p. 34
• Basis for trade, p. 31 Complete
• specialization, p. 47
• Constant opportunity costs, p.
43
• Gains from trade, p. 31
• Labor theory of value, p. 41
• Laissez-faire, p. 35
• Law of comparative advantage,
p. 36
• Mercantilism, p. 32
• Opportunity cost
• theory, p. 42
• Pattern of trade, p. 31
• Production possibility frontier,
p. 42
• Relative commodity prices, p. 44
• Small-country case, p. 47

59

Game 1: Rellay race

Descriptions:
• The game has 20 questions about ten principles of economics. Each group
member will take turns answering one question.
• Time for changing people and answering questions is 45s

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Game 1: Rellay race (cont.)

Instructions:
• The class will be divided into 3 groups. Each group has a secretary and a
team leader.
• Tasks of the team leader: arrange the position of the team members
when participating in the relay game
• Tasks of the secretary: prepare an answer sheet and summarize the
points of the group.
• The group that ranks 1st will get 3 contribution points, the group that
ranks 2nd will get 2 contribution points, and the group that ranks 3rd will
get 1 contribution point.

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Start…………..

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