ABSOLUTEADVANTAGE THEORY

• NUMBER OF LABOR HOURS NEEDED

TO PRODUCE ONE UNIT OF

SOYBEANS TEXTILES
U.S. 5 15 20
India 20 5 25
 ABSOLUTEADVANTAGE THEORY

• NUMBER OF LABOR HOURS NEEDED TO PRODUCE ONE UNIT OF

SOYBEANS TEXTILES
U.S. 5 15
India 20 5

relative prices (domestic Terms Of Trade,

TOT, before international Trade):
• In U.S. [5/15] or 1 T= 3 S
• In India [20/5] or 4 T = 1S
 ABSOLUTE ADVANTAGE THEORY

Production Before International Trade

(Autarky)

Soybeans Textiles Total

U.S. 1 1 2
India 1 1 2
Total 2 2 4
 ABSOLUTEADVANTAGE THEORY

Allocation of Labor after specialization

SOYBEANS TEXTILES

• U.S. 20 0
• India 0 25
ABSOLUTEADVANTAGE THEORY

Production After Specialization

Soybeans Textiles
U.S. 4 0 4
India 0 5 5
• Total 9
 ABSOLUTE ADVANTAGE THEORY
Assume t hat term o f trade is est ablished t o be one to one
Consumpt ion Af ter Int ernat ional Trade
Soybeans Text iles Total

• U.S. 3 1 4
• In dia 1 4 5

• Cl assical Theor y is useful because:

• 1- - The theory is applicable to today's wor ld in the sense that it expl ai ns why and how tr ade is benefici al to all

• 2- - The theory explai ns why and how a high cost ( wage) countr y li ke U.S. could expor t to a low cost (wage) countr y l ike Indi a.

• 3- - The theory shows w hy special ization i n necessary.

• Classical t heory of int ernat ional trade covers:

• -- - absol ute advantage theory of Adam Smi th

• -- - Comparative advantage theor y of D avi d Ricar do

• Some argue t hat Robert Thorrens had first discovered t he Com parat ive Advantage theory in 1808.

• Assum ption
• Factor s of pr oducti on are not mobil e among countri es.

• There ar e no barr ier s to trade.

• Im por ts ar e paid by exports. Bal ance of tr ade and no bor rowi ng.

• Labor i s the only factor of pr oducti on in ter ms of pr oducti vi ty analysis and cost of pr oduction.

• Pr oducti on exhibi ts constant r eturn to scale.

• Thi s Assum ption means a technol ogical rel ationshi p which shows a change in i nputs wil l lead to a pr opor ti onal change in output.

• Absolut e Advant age : Adam Sm it h

• W ealth of Nations, 1776

• His theor y of inter national trade was very simple and was based on the pr incipl e of:

• -- self i nter est

• -- specializati on
• -- competi tion

• ABSOLUTE ADVANTAGE THEORY

• NUM BER OF LAB OR H OURS NEEDED TO PRO DUCE ONE U NIT O F

• SOYBEANS TEXTILES

• U.S. 5 15
• India 20 5

• r elative pr ices ( dom estic TO T before internati onal Tr ade)

• U.S. [5/15] or 1 T= 3 S
• India [20/5] or 4 T = I S

• Production B ef ore Int ernational Trade

• Soybeans Textiles Total

• U.S. 1 1 2
• India 1 1 2

• In thi s case it is obvious that the U .S. must speciali ze in the production of soybeans and Indi a in the production of texti les. This i s because each can pr oduce it cheaper .

• Al location of Labor after specializati on

• SOYBEANS TEXTILES

• US20 0
• India 0 25

• Product ion A ft er Sp ecialization

• Soybeans Textiles

• US4 0
• India 0 5

• Assum e that ter m of tr ade is establi shed to be one to one

• Consumpt ion Af ter Int ernat ional Trade

Soybeans Textiles Total

• US3 1 4
• India 1 4 5
• 9

• In other wor ds, both countr ies coul d special ize and produce more and tr ade some and consum e mor e. Assum ing int ernat ional terms of t rade ( TOT) is one t o one, US could exchange one uni t of Soybeans for one unit of Textile and keep the r est of the soybeans for domesti c use.
•
• Comparat ive A dvant age

• What if one countr y has absolute advantage i n the pr oduction of both comm odi ti es ?

• NUMB ER OF LABOR HO URS N EEDED TO PROD UCE ON E UNIT O F

• SOYBEANS TEXTILES

• USal s = 5 alt = 15
• India a' ls =10 a' lt = 20

• relat ive prices Bef ore int ernational Trade

• U.S. 1T /3S
• India 1 T /2 S

• Production B ef ore Int ernational Trade

• Soybeans Textiles Total

• U.S. 1 1 2
• India 1 1 2
• 4

• Comparat ive A dvant age

• U.S. advantage over India ar e:

• Soybeans 5/10 = 1/2 = 3/6

• Textil es 15/20 = 3/4

• U.S. has a higher advantage in both S and T. But US's advantage is hi gher in S . Thi s is because there i s a r elati vel y small er labor r equi rement for the pr oducti on of S than for the production of T. S o, even though the uni ted States has an absolute advantage in the production of S and T, ther e is a hi gher advantage i n the pr oducti on of S. Ther efore U S m ust speci al ize in the production of S and Indi a must speciali ze in the production of T i n which she has a smal ler di sadvantage.

• Graphical Analysis of Comparative Advant age

• Assum ing that the US has 1500 hours of labor endowment and India has 1000 hour s of l abor endowment avail abl e. Then the inter nal , pre-trade PPC, and consum ption possi bi li ty fronti er of each countr y could be r epr esented as follow s:

• Algebra of Com parat ive Advantage

• U.S.

• Let L = the country's l abor supply

• al s = labor needed for one uni t of soybeans.
• al t = " " " " " " textil es

• India
• L' = the countr y's l abor suppl y
• a' ls = l abor needed for one unit of soybeans.
• a' lt = " " " " " " textil es
•

• If als < a' l s ( absol ute advantage) means that hom e labor is m or e efficient in the production of soybeans than for eign labor.

• If alt < a' lt ( absol ute advantage) means that hom e labor is more effi ci ent in the production of texti les than foreign labor .

• So, the questi on becomes whi ch com modity does the United States have a higher advantage or effi ci ency ( least cost) ? W e have a higher effi ciency i n soybeans if

• (als / alt) < ( a'l s/ a' lt)

• Or :

• (als / alt) < ( a'ls / a' l t)

• Thi s m eans that the Uni ted States has a com par ative advantage in the soybean production and India has asm aller comparative disadvant age relative to the Uni ted States i n the pr oducti on of textil es.

• Tr ade Tr iangle

• Assum e that the United States and India speciali zed in S and T respectively. Then the pattern of pr oduction and, consumpti on, expor ts, and im por ts woul d be:

• pr oductionconsumpti on expor ts i mports

• USOD OC CD BC
• BC

• UKO'D' O' C' C'D' B' C'

• B'C'

• It can be shown that the two tri angl es BCD and B' C'D ' ar e sim ilar and identical . They ar e sim ilar because

• -- they ar e both r ight angl e

• -- BD and B'D' ar e par all el ; both represent the inter national T OT and therefor e D and B' are equal angles. As a r esult, B and D' m ust be equal angl es. Also we know that expor ts of US is imports of India and they m ust be equal . Since all thr ee angl es and at least one si de of the two tri angl es ar e equal , the two tr iangles are identical.

• Both tr i angles ar e identical because of the assumption that countr ies m ust pay for thei r im por ts by expor ts. So, im ports of the U.S. ( India) must be

• Comparat ive A dvant age

• NUMB ER OF LABOR HO URS N EEDED TO PROD UCE ON E UNIT O F

• SOYBEANS TEXT ILES

• US5 10
• In dia 15 15

• relat ive prices Bef ore int ernational Trade

• U.S. 1 T = 2 S or 1S=1/2T
• In dia 1 T =1 S
• Comparat ive A dvant age

• Production B ef ore Int ernational Trade

• SoybeansText iles Total

• U.S. 1 1 2
• In dia 1 1 2
• -- -- - -- - --
• 4

• Comparat ive A dvant age

• U.S. advantage over India are:

• Soybeans 5/15
• Textiles 10/15
• Comparat ive A dvant age

• Allocation of Labor aft er specialization

• SOYBEANS TEXT ILES

• US15 0
• In dia 0 30

Com parat ive Advantage

• Product io n Af ter Specializat ion

• Soybeans Text iles Total

• U.S. 3 0 3
• In dia 0 2 2
• Tot al-- - -- - -- -- -- - -- - -- - -- -- -
• 3 2 5

• U.S. has a higher advantage in both S and T. But US's advantage is hi gher in S . Thi s is because there i s a r elati vel y small er labor r equi rement for the pr oducti on of S than for the production of T. So, even though the united States has an absol ute advantage i n the pr oducti on of S and T, ther e is a higher advantage in the pr oduction of S. Ther efor e US must specialize i n the pr oducti on of S and India m ust speci al ize i n the pr oducti on of T in w hi ch she has a sm aller disadvantage.
 Comparative Advantage THEORY

What if one country has absolute advantage in

the production of both commodities ?
NUMBER OF LABOR HOURS NEEDED TO
PRODUCE ONE UNIT OF

SOYBEANS TEXTILES
• US 5 15
• India 10 20
 Comparative Advantage THEORY

relative prices Before international Trade

• U.S. 1T /3S
• India 1T /2S
 Comparative Advantage THEORY

Production Before International Trade

SoybeansTextiles Total
• U.S. 1 1 2
• India 1 1 2
4
 Comparative Advantage THEORY

U.S. advantage over India are:

• Soybeans 5/10 = 1/2 = 3/6

• Textiles 15/20 = 3/4
U.S. has a higher advantage in both S and T relative
to India.
The question is which one should the US specialize
in?
 Comparative Advantage THEORY

U.S. advantage over India are:

• Soybeans 5/10 = 1/2 = 3/6

• Textiles 15/20 = 3/4

But US's advantage is higher in S. Why?

 Comparative Advantage THEORY

U.S. advantage over India are:

• Soybeans 5/10 = 1/2 = 3/6

• Textiles 15/20 = 3/4
But US's advantage is higher in S. Why?

This is because there is a relatively smaller labor

requirement for the production of S than for the
production of T.
 Comparative Advantage THEORY

U.S. advantage over India are:

• Soybeans 5/10 = 1/2 = 3/6

• Textiles 15/20 = 3/4
But US's advantage is higher in S. Why?
This is because there is a relatively smaller labor requirement for the production of S than for the
So, even though the united States has an
production of T.

absolute advantage in the production of S and T,

there is a higher advantage in the production of S.
Therefore US must specialize in the production of S
and India must specialize in the production of T in
which she has a smaller disadvantage.
 Trade Triangle
Assume that the United States and India
specialized in S and T respectively. Then the
pattern of production and, consumption,
exports, and imports would be:
 Trade Triangle
• BCD and B’C’D’ are equal. That is exports pay
for imports.
T T

D’

B B’
C’

S S
O C D O’
 Trade Triangle
• production consumption exports imports
US OD (S)OC CD BC
(T) BC

UK O'D' (S) O'C' C'D' B'C'

• (T) B'C'
 Evaluation of the Classical Model

1-- International trade

• expands PPC
• enhances standard of living for
countries involved
 Evaluation of the Classical Model

2-- Problems:
• it suggests that international trade is
based on the productive capacities of
different countries but it does not
explain why they exist.
 Evaluation of the Classical Model

2-- Problems:
• it suggests that international trade is based on the productive capacities
of different countries but it does not explain why they exist.

• It makes extreme predications about

direction of trade and specialization
which are not borne out in the real
world.
 Evaluation of the Classical Model

2-- Problems:
• it suggests that international trade is based on the productive capacities of
different countries but it does not explain why they exist.
• It makes extreme predications about direction of trade and specialization
which are not borne out in the real world.

• The theory predicts that the greatest gain

from trade come about when the countries
involved are very dissimilar in their
technologies. However, we know that
most of the international trade is among
advanced countries with similar
technologies.