BITS Pilani

Pilani Campus

Chapter 2
THE LAW OF
COMPARATIVE ADVANTAGE
Instructor: Prof. Geetilaxmi Mohapatra1
 Trade Theories
1) Early Trade Theories
2) The Standard trade theory
3) New trade theories / Modern trade
theories

Complementary trade theories

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 Early Trade Theories
1) The Mercantilists’ Views on Trade
2) Trade Based on Absolute Advantage:
– Adam Smith

3) Trade Based on Comparative

Advantage:
– David Ricardo

– Harberler

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 The Mercantilists’ Views
on Trade
• During 17th and 18th century, a group of men wrote
essays and pamphlets on international trade
• They advocated an economic philosophy known
as Mercantilism.
• To become rich and powerful, a country needs to
export more.
• Accumulate precious metals.
• Zero sum game.
• Advocated strict government control.

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 1) The Mercantilists’
Views on Trade (contd.)
Mercantilist views are important for 2 reasons:
1) Other ideas came forward as a reaction to
– view of trade
– on the role of government control .

2) Today, as nations are facing high levels of

unemployment seek to restrict imports
WHY?

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 Absolute Advantage by
Adam Smith
Adam Smith was in favor of
– Policy of Laissez – faire

– Free trade

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 Absolute Advantage by
Adam Smith
Emphasized that for both nations must gain from
trade.
Question:
– How does mutually beneficial trade takes
place?
– Where do these gains from trade come from?

Trade between two nations is based on absolute

advantage.

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 Absolute Advantage by
Adam Smith
When one nation has an absolute advantage over
another in the production of one commodity but has
absolute disadvantage with respect to the other
nation in producing a second commodity,
– both nations gain by each specializing in the
production of the commodity - absolute
advantage
– exchanging with the other nation for the
commodity of its absolute disadvantage.
Resources are utilized efficiently in both the nations.
Output of both the nations increases because of
specialization.
Eg. China (wheat) and Cuba(sugar)
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 Illustration of Absolute
Advantage
• A country has an absolute advantage over another in the
production of a good or service if it can produce that
product using fewer resources or if it can produce more
of that product with the same resources.
US UK
Wheat (bushels/man-hour) 6 1
Cloth (Yards/man-hour) 4 5
• Which country has absolute advantage in Wheat & which
country in Cloth?
• US would export W and import C
• UK would export C and import W
• If exchange rate of 6W = 6C,
• US gains 2C and UK gains 24C.
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 Remark on Adam
Smith’s theory
But, if one country is more productive than another
country in all lines of production?

Is trade possible in the above case???

David Ricardo answer YES

E.g: Lawyer

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 Comparative Advantage
• The less efficient nation should specialize
– in that good where absolute disadvantage is less
– indicating the commodity of comparative
advantage.
– Specialize and export that good.

• While, the commodity where absolute disadvantage

is greater – comparative disadvantage.
– Import that good

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 Illustration of Comparative
Advantage
US UK
-------------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
---------------------------------------------------------------------
US has absolute advantage in both W and C
UK has absolute disadvantage in both W and C.
For US, Comparative advantage is in Wheat
For UK, Comparative advantage is in Cloth.
 What is the range of mutually advantageous trade?
 If the exchange rate is 6W = 6C, who gains how
much? In terms of man labor hours?
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Gains from Trade
 The spread between 4C and 12C is 8C; represents
the total gains from trade.
 What happens in the following case?

 1) Closer the exchange rate to 4C = 6W,

 2) Closer the exchange rate to 12C = 6W,

 A) If the exchange rate is 6W = 10C, who gains how

much?
 B) If the exchange rate is 6W = 8C, who gains how
much?
NOTE: Here all the gains are calculated in terms of C.

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Exception to the Law of
Comparative Advantage
US UK
------------------------------------------------------------------------
Wheat (bushels/man-hour) 6 3
Cloth (Yard /man-hour) 4 2
------------------------------------------------------------------------
Absence of Comparative Advantage.
No mutual beneficial trade

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 Comparative Advantage
with Money
• Given the original situation.
US UK
-------------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
---------------------------------------------------------------------
Note: Considering the productivity level of
workers in US and UK.
Now introducing the wage rate.

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 Comparative Advantage
with Money
• Suppose wage rate in US is $6 per hour and in UK is
£1 per hour. Exchange rate is £1 =$2. US UK
--------------------------------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
--------------------------------------------------------------------------------------------------
Price of one bushel of Wheat (Pw) $1.00 $2.00
Price of one yard of Cloth(Pc) $1.50 $1.00
-----------------------------------------------------------------------------------------------------
 Note: Price of W and C calculated in terms of $.
 What is the pattern of trade between the 2 countries?
 Inefficiencies are more than compensated by the lower wage
rate. How?

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 Comparative Advantage
with Money
• Suppose wage rate in US is $6 per hour and in UK is
£1 per hour.
• Exchange rate is £1 =$1.
US UK
----------------------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
------------------------------------------------------------------------
Price of one bushel of Wheat (Pw) $1.00 $1.00
Price of one yard of Cloth(Pc) $1.50 $0.50
---------------------------------------------------------------------
 What is the pattern of trade between the 2 countries?
 Exchange rate has to increase

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 Comparative Advantage
with Money
Suppose wage rate in US is $6 per hour and in UK is £1
per hour.
Exchange rate is £1 =$3.
US UK
----------------------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
------------------------------------------------------------------------
Price of one bushel of Wheat (Pw) $1.00 $3.00
Price of one yard of Cloth(Pc) $1.50 $1.50
---------------------------------------------------------------------
 What is the pattern of trade between the 2 countries?
 Exchange rate has to fall.

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 Assumptions of theory of
Comparative Advantage by Ricardo
Ricardo based his theory on a number of simplifying
assumptions:
1) Only 2 nations and 2 commodities
2) Free trade
3) Perfect mobility of labor within each nation but
immobility between the nations
4) Constant costs of production
5) No transportation costs
6) No technical change
7) The labor theory of value.
1 – 6 assumptions can be relaxed but 7 is not valid and
should not be used.
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 Comparative Advantage and
the Labor theory of Value
• Under this theory, the value or price of a
commodity depends exclusively on the
amount of labor going into production of the
commodity.

• What are the basic assumptions behind this

theory?

• Rather it can be explained on the basis of

opportunity cost theory (which is accepted)
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 Comparative Advantage and The
Opportunity Cost Theory
 Developed by Haberler in 1936.
 In
this form, the law of comparative advantage is also
sometimes referred to as the law of comparative cost.

 The opportunity cost theory:

 The cost of a commodity is the amount of a 2nd
commodity that must be given up to release just enough
resources to produce one more extra unit of the 1st
commodity.

 No such assumption like that of labor theory.

A nation with a lower opportunity cost in the production of
a commodity means it has a comparative advantage in
that commodity and vice versa.
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 Comparative Advantage and
Opportunity Cost Theory
US UK
-----------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
-----------------------------------------------------------
 Without trade, what is the opportunity cost of 1W for
US and UK?

 US has less opportunity cost of producing wheat –

comparative advantage and produce and export.

 This is same as given in the law of comparative

advantage based on the labor theory of value.
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 The production possibility Schedules
for W and C in the US and UK
• Opportunity costs can be illustrated with the PPF
or the transformation curve for constant costs
• What is a PPF / PPC?
In US,
1W = 2/3C (constant)
30W = 20C
In UK,
1W = 2C (constant)
10W = 20C

If 6 labors are there,

then what?
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The Production Possibility
Frontier under Constant Costs

The Production Possibility Frontiers

•PPF s are downward sloping.
•What does straight line PPF s reflect?
•Why does Constant opportunity costs arise?
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 Opportunity Cost and Relative
Commodity Prices
• What is the opportunity cost of Wheat?

• It is given by the absolute slope of the PPF.

• Based on the two important assumption

– 1) that prices equals the cost of production
– 2) The opportunity cost of wheat is equal
to the price of wheat relative to the price
of cloth (Pw / Pc)

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 Opportunity Cost and Relative
Commodity Prices
US UK
---------------------------------------------------------
Pw / Pc 2/3 2
Pc / Pw 3 / 2 = 1.5 1 / 2 = 0.5
---------------------------------------------------
 Pw / Pc is lower in US. So what does it indicate?
 Pc / Pw is lower in UK. So what does it indicate?

 What does difference in relative commodity prices

between 2 nations ( given by the difference in slope)
reflect? What is the basis of trade?
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 The Basis for and the Gains from
Trade under Constant Costs
• In autarky, the nation’s PPF become its
consumption frontier.

• What determines which combination of

commodities the nation actually
chooses to produce and consume?

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The Basis for and the Gains from
Trade under Constant Costs

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 Relative Commodity Prices
with trade
• Here both supply and demand curves
are used.
• It shows how the equilibrium relative
commodity price with specialization and
trade is determined.

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 Equilibrium-Relative
Commodity Prices

Equilibrium-Relative Commodity Prices with

Demand and Supply.
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 Generalization
of the theory of
Comparative Advantage:
1) Comparative Advantage with more
than two Commodities
2) Comparative Advantage with more
than two Nations

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Comparative Advantage with
more than two Commodities
Commodity prices in the US and UK
Commodity Price in the U.S. Price in the U.K.

A $2 £6
B 4 4
C 6 3
D 8 2
E 10 1

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Comparative Advantage with more than
two Commodities (contd.)

Suppose £ 1 = $ 2.
Commodity Price in Price in Price in the Export Import
the U.S. the U.K. U.K.in $
A $2 £6 $ 12 US UK
B 4 4 8 US UK
C 6 3 6 Not traded
D 8 2 4 UK US
E 10 1 2 UK US

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Comparative Advantage with more than
two Commodities (contd.)

Suppose £ 1 = $ 3.
Commodity Price in Price in Price in the U.K. Export Import
the U.S. the U.K. in $
A $2 £6 $ 18 US UK
B 4 4 12 US UK
C 6 3 9 US UK
D 8 2 6 UK US
E 10 1 3 UK US

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Comparative Advantage with more
than two Commodities (contd.)

Finally, Suppose £ 1 = $ 1.
Commodity Price in Price in Price in the U.K. Export Import
the U.S. the U.K. in $
A $2 £6 $6 US UK
B 4 4 4 Not traded
C 6 3 3 UK US
D 8 2 2 UK US
E 10 1 1 UK US

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Comparative Advantage with
more than two Nations
Suppose that instead of 2 countries and 5
commodities,
We have 2 commodities (W and C) and 5 countries (A,
B, C, D and E)

With trade, the equilibrium PW /PC will settle

somewhere between 1 and 5.
What happens if PW /PC =3?
If PW /PC =4?
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