The Law of

Comparative
Advantage
Chapter 2

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

1/29

1 Introduction
Examine the development of trade theories
Discuss the law of absolute advantage
Analyze the comparative advantage
Analyze the opportunity costs
Know theroduction possibility frontiers

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

2/29

1 Introduction
Key

terms

Mercantilism
Laissez-faire
Law of comparative advantage
Opportunity cost theory
Production possibility frontier
Constant opportunity cost
Relative commodity price
Complete specialization

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

3/29

2 Mercantilists Views on Trade

Mercantilism
Representative: Thomas Munn (1571-1641)
Wealth: The way for a nation to become rich
and powerful was to export more than it
imported. The resulting surplus would then be
settled by an inflow of bullion. The more gold
and silver a nation had, the richer and more
powerful it was.
Policy: free trade policy.
The nature of the trade: a zero-sum game.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

4/29

2 Mercantilists Views on Trade

Purposes of Mercantilists Trade Theory
To maintain

larger and better armies with

more gold and silver and consolidate their
power at home and acquire more colonies;
To do more business with more gold in
circulation;
To stimulate national output, develop
national economy and increase employment.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

5/29

3 Absolute Advantage
The basis for trade:
Absolute advantage
If one nation is more
efficient than another
nation in the
production of one
commodity, the nation
has absolute
advantage in that
commodity.

Adam Smith (17231790)

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

6/29

3.1 Where Do Gains Come

From?

The pattern of trade: Both nations can gain by

each specializing in the production of the
commodity of its absolute advantage and
exporting part of its output to the other nation for
the commodity of its absolute disadvantage.
Policy: Free trade policy to make better use of
resources and maximize world welfare.
By specialization, resources are utilized in the
most efficient way and the output of both
commodities will rise. The increased output
measures the gains from specialization in
production available to be divided between the
two nations through trade.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

7/29

3.2 Mercantilists & Adam

Smith

Mercantilists: One nation could only gain at the

expense of another nation and each
government should take strict control of all
economic activities and trade. They should
adopt protectionist measures to stimulate
exports and restrict imports.
Some of the views are still alive and even
thriving today in a sort of neo-mecantilism.
Adam Smith: All nations could gain from free
trade and each nation should adopt a laissezfaire policy.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

8/29

3.3 Illustration of
Absolute Advantage
Wheat(bushels/man-hour)
Cloth(yards/man-hour)

U.S.
6
4

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

U.K.
1
5

9/29

3.4 Comments on the Absolute Ad

It can only explain small part of world trade
today, it can not explain most of the trade
between the developed and the developing
countries.
Can we use the theory to carry out
foreign trade?

It can not even explain the trade

between advanced countries
because their productivities are
almost the same.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS

10/29

4 The Law of
Comparative Advantage

David Ricardo (1772-1823)

Works: Principles of Political Economy and Taxation
ANHUI UNIVERSITY OF FINANCE & ECONOMICS

11/29

4.1 The Law of

Comparative Advantage
It explains how mutually beneficial trade can
take place even when one nation is less efficient
than ( has an absolute disadvantage) the other
nation in the production of all commodities.
The less efficient nation should specialize in
and export the commodity in which its absolute
disadvantage is smaller (this is the commodity
of its comparative advantage), and should
import the other commodity.
The more efficient nation should specialize
in and export the commodity in which its
absolute advantage is greater and import the
other commodity.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS

12/29

4.2 Illustration of
Comparative Advantage
Wheat(bushels/manhour)
Cloth(yards/man-hour)

U.S.
6
4

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

U.K.
1
2

13/29

4.3 How Can They Trade?

How can they trade if one nation is in absolute
disadvantage in the production of both commodities?
They can still trade when the wage is sufficiently
lower in one nation than it is in the other and when both
commodities are expressed in the same currency.
Wheat(bushels/man-hour)
Cloth(yards/man-hour)

Unit Price of Wheat

Unit Price of Cloth

U.S.
6
4
U.S.
$1.00
$1.50

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

U.K.
1
2
U.K.
$2.00
$1.00
14/29

4.4 Exception to the Law of

Comparative Advantage
Wheat(bushels/man-hour)
Cloth(yards/man-hour)

U.S.
6
4

U.K.
3
2

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, unless the absolute disadvantage is in
the same proportion for the two commodities.
This kind of exception is rare.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS

15/29

4.5 Assumptions for

Comparative Advantage
221
Free trade
Perfect mobility of labor within
each nation but immobility
between the two nations
Constant costs of production
No transportation costs
No technical change

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

16/29

5 The Opportunity Cost Theory

It is the amount of a second commodity that

must be given up in order to release enough

resources to produce one additional unit of the
first commodity (comp. cost stresses the
opportunity cost).
The nation with lower opportunity cost in the
production of a commodity has a comparative
advantage in that commodity and a comparative
disadvantage in the second commodity.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

17/29

5 The Opportunity Cost Theory

Opportunity Costs of Wheat in Terms of Cloth
1W
2/3C

1W
2C

Opportunity Costs of Cloth in Terms of Wheat

3/2W
1C

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

1/2W
1C

18/29

5.1 Production Possibility

Schedules in U.S. & U.K.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

19/29

5.2 PPF Under Constant Cost

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

20/29

5.3 Consumption Frontier

It shows the combination of consumption that
the nation actually chooses to consume.
In the absence of trade, the production
possibility frontier is also the consumption
frontier.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

21/29

6 Basis For & Gains From Trade

Under Constant Costs

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

22/29

6.1 Equilibrium Relative

Commodity Prices With D & S

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

23/29

6.2 Large and Small Country

Large country: Its trade can influence the world
price.
Small country: Its trade can not affect the world
supply and demand.
When a small country trades with large nations,
the trade will take place at the pretrade-relative
commodity prices in the large nation. Then, the
small nation receives all of the benefits from
trade.
ANHUI UNIVERSITY OF FINANCE & ECONOMICS

24/29

7 Test of Ricardian Trade

Model
MacDougall (using 1937 data)
Balassa (using 1950 data)
Stern (using 1950 and 1959 data)
Glub (using 1990 data)

Summary:
Comparative advantage seems to be based on
a difference in labor productivity or costs, as
postulated by Ricardo.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

25/29

7.1 Labor Productivity and

Comparative Advantage

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

26/29

7.2 Comments on Comparative Ad

Ricardian trade model has to a large extent
been empirically verified, but it has a serious
shortcoming: it assumes rather than explains
comparative advantage.
Ricardo in general provided no explanation
for the difference in labor productivity and
comparative advantage between nations and no
enough explanation about the effect of
international trade on the earnings of factors of
production.

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

27/29

8 Questions for Discussion

What was the basis for and pattern of trade
according to Adam Smith? How were the
gains from trade generated?
In what way was Ricardoa law of comparative
advantage superior to Smiths theory of
absolute advantage? How do gains from trade
rise with comparative advantage?
What is the relationship between opportunity
costs and the production possibility frontier
of a nation?
ANHUI UNIVERSITY OF FINANCE & ECONOMICS

28/29

ANHUI UNIVERSITY OF FINANCE & ECONOMICS

29/29