ChapterTwo:

TheLawofComparative
Advantage

2.2TheMercantilistsViewonTrade
In the 17th century a group of men (merchants,
bankers, government officials, and philosophers)
wrote essays on international trade that advocated an
economic philosophy known as Mercantilism.
In their view, a country becomes rich if it exports
more than it imports.
The surplus in trade balance will result in an inflow of
precious metals; gold and silver.
The more precious metals means a richer and more
powerful nation.
Countries have to do their best to increase exports and
restrict imports.

 Since all countries cannot have surplus at the same

time and because the stock of metals is fixed in the
short run, a country gains from trade only at the
expense of others.
Wealth of nations was measured by the stock of
metals they possess.
In contrast, today we measure wealth of a nation by
its stock of human, man-made, and natural resources
available for producing goods and services.
Mercantilits advocated strict government control of
economic activity because gain from trade comes at
the expense of other nations (i.e. zero-sum-game).

2.3 Trade Based on Absolute Advantage: Adam

Smith (Wealth of Nations: 1776)
A. Absolute Advantage
According to Adam Smith, trade between two nations is
based on absolute advantage.
When one nation is more efficient than (has an absolute
advantage over) another in the production of one
commodity but is less efficient than (has an absolute
disadvantage with respect to) the other nation in
producing a second commodity, 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 nations for the
commodity of its absolute disadvantage.

 By this process, resources are efficiently utilized and

the output of both commodities will rise.
The growth in output measures the gains from
specialization in production available to be divided
between the two nations through trade.
In contrast to the mercantilists, Smith believed that all
nations would gain from free trade and strongly
advocated a policy of laissez-faire:
As little government interference with the economic
system as possible.
Free trade would lead to efficient use of resources and
would maximize world welfare.
Only few exceptions were allowed to this policy.

B. Illustration of Absolute Advantage

Example:
U.S.

U.K.

Wheat(bushels/manhour)

Cloth(yards/manhour)

The table shows that one hour of labor time produces

6 bushels of wheat in the US versus only 1 in the UK,
while one hour of labor time produces 5 yards of cloth
in the UK versus 4 in the US.
Thus, the US has an absolute advantage in producing
wheat, while the UK has an absolute advantage in
producing cloth.
With trade, the US specializes in producing wheat,
while the UK specializes in producing cloth.

 If the US exchanges 6 bushels of wheat (6W) for six

yards of UK cloth (6C), it gains 2C or saves hour of
labor time (since it can only exchange 6W for 4C
domestically).
Similarly, the 6W the UK receives from the US is
equivalent to or would require 6 hours of labor time to
produce in the UK.
These same 6 hours can produce 30C in the UK.
The exchange of 6C for 6W with the US, the UK gains
24C, or saves 5 man-hours.

2.4 Trade Based on Comparative Advantage:

David Ricardo (1815, Principles of Polit. Econ. & Taxation)
A. The Law of Comparative Advantage (LCA)
According to LCA, even if one nation has an absolute
disadvantage with respect to the other nation in the
production of both commodities, there is still a basis
for mutually beneficial trade.
This nation should specialize in the production and
export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its
comparative advantage) and import the commodity in
which its absolute disadvantage in greater (this is the
commodity of its comparative disadvantage).

 Example:
U.S.

U.K.

Wheat(bushels/manhour)

Cloth(yards/manhour)

The UK has an absolute disadvantage in the production

of both commodities with respect to the US
However, since the UK is half as productive in cloth but
6 times less productive in wheat, it has a comparative
advantage in cloth.
The US has an absolute advantage in the production of
both commodities with respect to UK.
Since the US absolute advantage is greater in wheat (6:1)
than in cloth (4:2), it has a comparative advantage in
wheat.

2.5 Comparative Advantage and Opportunity

Costs
A. Comparative Advantage and the Labor Theory of
Value (LTV)
According the LTV, the value or price of a commodity
depends exclusively on the amount of labor going into
its production.
This implies that; 1) either labor the only factor of
production or it is used in the same fixed proportion
in the production of all commodities.
2) labor is homogeneous (i.e. of only one type).
Since neither of the assumptions is true, we cant base
the explanation of comp-adv. on the LTV.

B. The Opportunity Cost Theory (OCT)

According to the OCT, the 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.
Thus, the nation with the lower opportunity cost in
the production of a commodity has a comp-adv. in
that commodity.
If the US has to give up 2/3 of a unit of cloth to
release enough resources to produce an additional
unit of wheat, then the opp. cost of wheat is 2/3 of a
unit of cloth (i.e. 1W=2/3 C)

 If 1W=2C in the UK, then the opp. cost of wheat is

lower in the US, and the US has a comparative (cost)
advantage over the UK in wheat.
In a two-nation, two-commodity world, the UK
would have a comp-adv. In cloth.
According to the LCA, the US should specialize in
producing wheat and export some of it in exchange
for British cloth.

C. The Production Possibility Frontier (PPF) under

Constant Costs
The PPF: a curve showing the alternative
combinations of the two commodities that a nation
can produce by fully utilizing its resources with the
best technology available to it.
US

UK

Wheat

Cloth

Wheat

Cloth

180

60

150

20

50

20

120

40

40

40

90

60

30

60

60

80

20

80

30

100

10

100

120

120

FIGURE21ThePPFsoftheUnitedStatesandtheUnitedKingdom.

 The US has to give up 30W to produce an additional

20C (30W=20C), the opp. cost of W is 1W=2/3C.
The UK has to give up 10W to produce an additional
20C (10W=20C), the opp. cost of W is 1W=2C.
Constant opportunity costs arise when:
1. Resources are perfect substitutes or used in fixed
proportions in the production of both commodities.
2. All units of the same factor are homogeneous.
While opp. costs are constant in each nation, they
differ among nations, providing the basis for trade.
The opp. cost is measured by the slope of the PPF,
also known as the marginal rate of transformation.

D. Opportunity Costs and Relative Commodity

Prices
Figure 2-1 shows that the (absolute) slope of the US
transformation curve is 120/180=2/3= opp. cost of
wheat in the US and remains constant.
The (absolute) slope of the UK transformation curve
is 120/60=2= opp. cost of wheat in the UK and
remains constant.
Assuming prices equal costs and the nation produces
both commodities, the opp. cost of wheat is equal to
wheat price relative to cloth price (Pw /Pc).
In the US, Pw /Pc=2/3, and inversely Pc /Pw= 3/2=1.5.
In the UK, Pw /Pc=2, and inversely Pc /Pw= =1/2.

 The lower Pw /Pc in the US reflects its comp-adv. in

wheat.
The lower Pc /Pw in the UK reflects its comp-adv. in
cloth.
Conclusion: the difference in relative commodity
prices between the two nations is a reflection of their
com-adv. and provides the basis for mutually
beneficial trade.

2.6 The Basis for and the gains from Trade

under Constant Costs
A. Illustration of the Gains from Trade
With no trade, the US may produce a combination of (90W60C) on its PPF (point A in figure 2-2).
The UK may produce a combination of (40W-40C) on its
PPF (point A/ in figure 2-2).
With trade, the US would specialize in producing wheat and
produce at point B (180W-0C).
The UK would specialize in producing cloth and produce at
point B / (0W-120C).
If they trade 70W for 70C, US consumes 110W-70C (point
E), the UK consumes 70W-50C (point E /).

FIGURE22TheGainsfromTrade.

 The US gains 20W and 10C from trade (E compared

to A), UK gains 30W and 10C (E / compared to A /).
The increase in consumption resulted from the
specialization of the two nations.
Without trade, total production of wheat is 130
(90+40), but with trade it is 180 (all in the US).
Without trade, total production of cloth is 100
(60+40), but with trade it is 120 (all in the UK).
Gains from trade come from the increase in
production (50W and 20C) shared by both nations.
Without trade no nation would specialize in
production because both need to consume some of the
other commodity.

B. Relative Commodity Prices with Trade

In the left panel of figure 2-3, SW(US+UK) is the
combined supply curve of wheat if the two countries
used all of their resources to produce wheat only.
Distance 0B=180W represents maximum quantity
the US can produce with complete specialization.
Distance BB*=60W the maximum quantity the UK
can produce.
Thus, 240W is the maximum quantity both nations
can produce using all o their resources, as a result
SW(US+UK) is vertical at 240W.
Suppose that with trade, the combined demand
curve for wheat is DW(US+UK)

FIGURE23EquilibriumRelativeCommodityPriceswith
DemandandSupply.

 D and S intersect at point E to determine equilibrium

quantity of 180W and equilibrium relative price of
Pw/Pc=1 with trade.
The same for cloth in the right panel.
SC(US+UK) is the combined supply curve of cloth if the
two nations used all resources to produce cloth only.
The UK can produce 120C=0B/ , while the US can
produce another 120=B/ B//.
Suppose that with trade, the combined demand curve
for cloth is DC(US+UK)
D and S intersect at point E / determining the
equilibrium quantity of 120C and equilibrium relative
price of Pc/Pw=Pw/Pc=1 with trade.