International Trade Theory

Chapter 2: The Law of Comparative Advantage

OUTLINE
2.1 Introduction
2.2 The Mercantilists Views on Trade
2.3 Trade Based on Absolute Advantage: Adam Smith
2.4 Trade Based on Comparative Advantage:
David Ricardo

2.5 Comparative Advantage and Opportunity Costs

2.6 The Basis for the Gains from Trade Under
Constant Costs
2.7 Empirical Tests of the Ricardian Model
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2.1 Introduction
Two Basic questions of international trade
theory.
(1) What is the basis for trade and what are the gains
from trade?
(2) What is the pattern of trade?

This chapter examines the development of trade

theory from the mercantilists to Adam Smith, David
Ricardo and Gottfried Haberler, and seeks to
answer the basic questions.

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Export Pattern of Trkiye -1-

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Export Pattern of Trkiye -2-

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Sectoral Distribution of Trade

(Exports)

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Sectoral Distribution of Trade

(Imports)

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Geographical Destination of Exports

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Geographical Destination of Imports

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Sectoral Composition of TR-EU Trade

(Exports)

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2.2 The Mercantilists Views on Trade

The more gold and silver and a nation had, the richer
and more powerful it was.

Thus the way for a nation to become rich is to export

more than it imported.

The resulting export surplus would then be settled by an

inflow of bullion or precious metals such as gold and
silver.

Thus the mercantilists advocated restrictions on imports

and incentives for exports.
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2.2 The Mercantilists Views on Trade

A nation can gain in international trade only at the
expense of other nations.

i.e., Trade is a zero-sum game.

Criticism:
(1) The measure of the wealth of a nation?
(2) Rulers vs. common people

Case Study 2-2 Mercantilism is Alive and Well in the

Twenty-First Century

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2.3 Trade Based on Absolute Advantage:

Adam Smith
Adam Smith, The Wealth of Nations, 1776.
2.3A. Absolute Advantage
When one nation is more efficient than (or has an
absolute advantage over) another in the production of
one commodity but is less efficient than (or has an
absolute disadvantage with respect to) the other nation
in producing a second commodity,

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2.3 Trade Based on Absolute Advantage:

Adam Smith
then both nations can gain by each specializing in the
production of the commodity of its absolute advantage
and exchanging part of its output with the other nation
for the commodity of its absolute disadvantage.
Examples:
(1) Nations
(2) Individuals:
Thus, Adam Smith believed that all nations would gain
from free trade and strongly advocated a policy of laissezfaire and free trade.
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2.3 Trade Based on Absolute Advantage:

Adam Smith
2.3B. Illustration
Table 2.1. The number of units produced by each hour of labor time

U.S.

U.K.

Wheat(bushels/hour)

Cloth(yards/hour)

The U.S. is more efficient than (or has an absolute advantage

over) the U.K. in the production of Wheat but is less efficient
than (or has an absolute disadvantage with respect to) the
U.K. in producing Cloth.
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2.3 Trade Based on Absolute Advantage:

Adam Smith
With trade, the U.S. would specialize in the production
of wheat and exchange part of it for British cloth.
The opposite is true for the U.K.
If the U.S. exchanges 6W for 6C, the U.S. gains 2C or
saves 1/2 hour of labor time. Similarly the U.K. also
gains. (Explain!)

Note: Absolute advantage can explain only a very small

part of world trade. Examples:

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2.4 Trade Based on Comparative Advantage:

David Ricardo
David Ricardo, Principles of Political Economy and
Taxation, 1817.

2.4A. The Law of Comparative Advantage

If one nation has an absolute disadvantage with respect to
the other nation in the production of both commodities, the
first nation should specialize in the production of and
export the commodity in which its absolute disadvantage is
small (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).
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2.4 Trade Based on Comparative Advantage:

David Ricardo
Illustration:
Table 2.2. The number of units produced by each hour of labor time

U.S.

U.K.

Wheat(bushels/hour)

Cloth(yards/hour)

- The U.S. is more efficient than (or has an absolute

advantage over) the U.K. in the production of both
commodities.
- The U.K. is less efficient than (or has an absolute
disadvantage over) the U.S. in the production of both
commodities.
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2.4 Trade Based on Comparative Advantage:

David Ricardo
- But the U.K. has a comparative advantage in cloth, and the
U.S. has a comparative advantage in wheat. (Explain!)
- With trade, the U.S. would specialize in the production of
wheat and exchange part of it for British cloth.
- The opposite is true for the U.K.
- If the U.S. exchanges 6W for 6C, the U.S. gains 2C or
saves 1/2 hour of labor time. Similarly the U.K. also gains.
(Explain!)

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2.4 Trade Based on Comparative Advantage:

David Ricardo
2.4B. The Gains from Trade
- The relative prices before trade:

U.S.: (Pw/Pc)us = 4/6

U.K.: (Pw/Pc)uk = 2/1
- If the U.S. exchanges 6W for 6C, the U.S. gains 2C or
saves 1/2 hour of labor time. Similarly the U.K. also
gains. (Explain!)
- The U.S. would be indifferent to trade if it received 4C
from the U.K. in exchange for 6W. The U.S. wouldnt
trade if it received less than 4C for 6W.
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2.4 Trade Based on Comparative Advantage:

David Ricardo
- The U.K. would be indifferent to trade if it received 1W
from the U.K. in exchange for 2C. The U.K. wouldnt trade
if it received less than 1W for 2C.
- i.e., Both nations would gain from trade as long as the
international relative price (terms of trade) is

4C < 6W < 12C

(Pw/Pc)US < (Pw/Pc) < (Pw/Pc)UK
4/6 < (Pw/Pc) < 2/1
- If, for example, they trade 6W for 6C [(i.e., (Pw/Pc) = 1)],
then both would gain. (Explain!)
- Examples:
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2.4 Trade Based on Comparative Advantage:

David Ricardo
2.4C. Exception to the Law of Comparative
Advantage
- When the absolute disadvantage that one nation has with
respect to another nation is the same in both commodities.

- Explain!

2.4D. Comparative Advantage with Money (Skip)

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2.5 Comparative Advantage and Opportunity

Costs
Assumptions of the Ricardian Model
1) Only two nations and two goods
2) Free trade
3) Perfect mobility of labor within each nation but
immobility between the two nations
4) Constant costs of production
5) No transportation costs
6) No technical change
7) The labor theory of value

While assumptions (1) through (6) can easily be

relaxed, assumption (7) is not valid.
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2.5 Comparative Advantage and Opportunity

Costs
2.5A. Comparative Advantage and the Labor
Theory of Value
- Labor theory of value: the value or price of a good
depends exclusively on the amount of labor going into the
production of the good.

Implications
1) Either labor is the only factor of production or labor is used
in the same fixed proportion in the production of all goods.
2) Labor is homogeneous (i.e., of only one type).

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2.5 Comparative Advantage and Opportunity

Costs
Neither of these implications is true, and hence we cannot
base the explanation of comparative advantage on the
labor theory of value.

Use the opportunity cost theory to explain the

comparative advantage.

2.5B. The Opportunity Cost Theory

- G. Herberler, The Theory of International Trade, 1936.
- The opportunity cost theory: the cost of a good is the amount
of a second good that must be given up to release just enough
resources to produce one additional unit of the first good.

- Examples:
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2.5 Comparative Advantage and Opportunity

Costs
2.5C. The Production Possibility Frontier under
Constant Costs
- The production possibility frontier (or transformation
curve) is a curve that shows the alternative combinations
of the two goods that a nation can produce by fully
utilizing all of its resources with the best technology
available to it.

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2.5 Comparative Advantage and Opportunity

Costs
Table 2.4. Production Possibility Schedules for
Wheat and Cloth in the U.S. and the U.K.
U.S.

U.K.

Wheat

Cloth

Wheat

Cloth

180
150
120
90
60
30
0

0
20
40
60
80
100
120

60
50
40
30
20
10
0

0
20
40
60
80
100
120

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2.5 Comparative Advantage and Opportunity

Costs
Figure 2.1. the Production Possibility Frontiers of
the U.S. and the U.K.

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2.5 Comparative Advantage and Opportunity

Costs
Downward slope: If a nation wants to produce more
of a good, it must give up some of the other good.

Straight line: Opportunity costs are constant. That is,

for each additional 1W to be produced, the U.S. must
give up (2/3)C and the U.K must give up 2C, no
matter from which point on its production possibility
frontier the nation starts.

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2.5 Comparative Advantage and Opportunity

Costs
2.5D. Opportunity Costs and Relative Commodity
Prices
- The opportunity cost is given by the (absolute) slope of the
production possibility frontier.
- This is also called as the marginal rate of transformation.
- Explain:
(Pw/Pc)US = 4/6 = 2/3
(Pw/Pc)UK = 2/1 = 2
- Note that under constant costs, Pw/Pc is determined
exclusively by production considerations in each nation.
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2.6 The Basis for and the Gains from Trade

Under Constant Costs
2.6A. Illustration of the Gains from Trade
Figure 2.2. The Gains from Trade

- Complete specialization
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2.6 The Basis for and the Gains from Trade

Under Constant Costs
2.6B. Relative Commodity Prices with Trade
(Pw/Pc)US < (Pw/Pc) < (Pw/Pc)UK

4/6 < (Pw/Pc) < 2/1

Figure 2.2. The Gains from Trade

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2.7 Empirical Tests of the Ricardian Model

G. D. A. MacDougall (1951, 1952)
- Labor productivity and export data for 25 industries in the
U.S. and the U.K for the year 1937.

Hypothesis
Since wages were twice as high in the U.S. as in the U.K.,
costs of production would be lower in those industries
where American labor was more than twice as productive
as British labor.
These would be the industries in which the U.S. had a
comparative advantage with respect to the U.K. and in
which it would undersell the U.K in third markets.
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2.7 Empirical Tests of the Ricardian Model

Figure 2.4. Relative Labor Productivities and Comparative
Advantage U.S. and U.K.

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2.7 Empirical Tests of the Ricardian Model

Figure 2.4. Relative Labor Productivities and Comparative
Advantage Japan and Korea
2.8

Output per JPN Worker/

Output per KOR Worker

2.6
Precision Machinery.

2.4
2.2

Transport Machinery
Metal

2.0

General Machinery

Paper

1.8

Chemical
Electric Machinery

1.6

y = 0.2129x + 1.3368
2
R = 0.4598

Wood

1.4

Food

1.2
Textiles
Fuel

1.0
0.0

Basic Iron
Office Machinery

1.0

Non-metal

2.0

3.0

4.0

5.0

6.0

JPN Exports/KOR Exports

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2.7 Empirical Tests of the Ricardian Model

Case Study 2-4 Relative Unit Labor Costs and Relative
Exports - U.S. and Japan

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