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2 IE Labor Productivity and Comparative Advantage EDITED
2 IE Labor Productivity and Comparative Advantage EDITED
COMPARATIVE
ADVANTAGE
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
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.
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
Lecture 5: Non-tariff
Lecture 3: H-O model
barriers
INTERNATIONAL TRADE THEORIES
Heckscher-Ohlin Theory
• 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.
GAINS FROM TRADE
Autarky US: 6W=4C UK: 1W=5C
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
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.
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.
3. TRADE BASED ON
COMPARATIVE ADVANTAGE
COMPARATIVE ADVANTAGE AND OPPORTUNITY COST
Millions of Thousands of
Roses Computers
U.S. -10 +100
Ecuador +10 -30
Change 0 +70
Gains from Benefits for US: 6–4=2C Benefits for UK: 2x6 – 6 = 6C
trade ↔ 1⁄2h of producing C ↔ 3h of producing C
GAINS FROM TRADE (CONT.)
The gains from trade by the rate of exchange 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
&C (pre-trade (pre-trade price exchange rates of the two
price 6W:4C)
6W:12C) countries
6W:3C No trade
4 C < 6 W < 12 C
6W:4C 0C 8C 8C No trade
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 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
6W:13C No trade
international trade.
CONTRIBUTIONS
Determined comparative
advantage based on
opportunity cost (OC), not
on labor productivity
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
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
GAINS
FROM
TRADE
GAINS
FROM
TRADE
H-O MODEL
KEY TERMS
• Absolute advantage, p. 34 • Mercantilism, p. 32
• Basis for trade, p. 31 Complete • Opportunity cost
• specialization, p. 47 • theory, p. 42
• Constant opportunity costs, p. • Pattern of trade, p. 31
43
• Production possibility
• Gains from trade, p. 31 frontier, p. 42
• Labor theory of value, p. 41 • Relative commodity prices, p.
• Laissez-faire, p. 35 44
• Law of comparative advantage, • Small-country case, p. 47
p. 36
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
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.
Start…………..