CHAPTER T W O

International
Economics
Tenth Edition

The Law of Comparative Advantage

(Part 1)
Dominick Salvatore
John Wiley & Sons, Inc.

In this chapter:
Introduction

The Mercantilists Views on Trade

Trade Based on Absolute Advantage: Adam

Smith
Trade Based on Comparative Advantage: David
Ricardo
Comparative Advantage and Opportunity Costs
The Basis for and the Gains from Trade under
Constant Costs

Introduction
Basic questions:
What is the basis for trade?

What are gains from trade?

What determines which country exports each good?

What benefits do countries get from international

trade?

What is the pattern of trade?

Which goods are exported/imported by each

country?

Assume two-nation, two-good world

The Mercantilists Views on Trade

Mercantilism

Economic philosophy in 17th and 18th centuries,

in England, Spain, France, Portugal and the
Netherlands.

Belief that a nation could become rich and

powerful only by exporting more than it
imported.
A nations wealth is measured by the amount
of precious metals it owns.

The Mercantilists Views on Trade

Mercantilism

Export surpluses bring inflow of gold and

silver.
Trade policy was to encourage exports and
restrict imports.
Mercantilists advocate excessive government
intervention to impose this trade policy.
Trade is a zero-sum game: One nation gains
only at the expense of another. In other words,
mutual benefits from trade are impossible!

The Mercantilists Views on Trade

Mercantilists measured the wealth of a nation

by the stock of precious metals it possessed.

Today, we measure wealth of a nation by its

stock of human, man-made and natural

resources available for producing goods and
services.

Trade Based on Absolute Advantage:

Adam Smith
A nation has absolute advantage over another

nation if it can produce a commodity more

efficiently, i.e. at a lower labor cost (can produce
more per labor hour).
When one nation has absolute advantage in

production of a commodity, but an absolute

disadvantage with respect to the other nation in a
second commodity, both nations can gain by
specializing in their absolute advantage good and
exchanging part of the output for the commodity
of its absolute disadvantage.

Trade Based on Absolute Advantage:

Adam Smith
Example:
Canada is efficient in growing wheat, inefficient
in growing bananas.
Nicaragua is efficient in growing bananas,
inefficient in growing wheat.
Canada has absolute advantage in wheat,
Nicaragua has absolute advantage in bananas.
Mutually beneficial trade can take place if both
countries specialize in their absolute advantage.

Trade Based on Absolute Advantage:

Adam Smith
Specialization and trade advantage both

countries.
Adam Smith (and other classical economists)
advocated policy of laissez-faire, or minimal
government intervention with economic
activity.
Free trade would cause world resources to be
utilized most efficiently, maximizing world
welfare.

Trade Based on Absolute Advantage:

Adam Smith
Production & Consumption
before Specialization & Trade
Wheat (bushels/labor hour)
Cloth (yards/labor hour)

U.S.

U.K.

U.S. has absolute advantage over U.K. in wheat.

U.K. has absolute advantage over U.S. in cloth.

Both nations can gain from specialization in
production and trade if U.S. specializes in
producing and exporting wheat while U.K.
specializes in producing and exporting cloth.

Trade Based on Absolute Advantage:

Adam Smith
Production After
Specialization
Wheat (bushels/labor hour)
Cloth (yards/labor hour)

U.S.

U.K.

12

10

Assume that U.S. exchanges 5W for 5C with U.K.

Consumption After Trade
Wheat
Cloth

U.S.
U.K.
12 5 = 7 0 + 5 = 5
0 + 5 = 5 10 5 = 5

Trade Based on Absolute Advantage:

Adam Smith
Gains from Trade:
Gains from trade are the increased consumption after
specialization in production and trade.
Gains from Trade

Wheat
Cloth

U.S.

U.K.

7 6 = +1 5 1 = +4
5 4 = +1 5 5 = 0

The U.S. gains 1W and 1C from trade. The value of

these gains in the U.S., in terms of labor hours, are 1/6
hour (for the extra unit of wheat) and 1/4 hour (for the
additional unit of cloth). The U.S. saves 25 minutes of
labor time (for every 2 hours) after trade.

Trade Based on Absolute Advantage:

Adam Smith
Gains from Trade:
Consumption After Trade
Wheat
Cloth

U.S.
+1
+1

U.K.
+4
0

The U.K. gains 4W from trade. The value of this

gains in the U.K. are 4 labor hours, since it takes one
hour to produce each unit domestically. These 4 hours
can produce 20 units of cloth in the U.K.!

Trade Based on Absolute Advantage:

Adam Smith
Assume that U.S. exchanges 6W for 6C with U.K.
Consumption After Trade

U.S.

U.K.

Wheat
Cloth

12 6 = 6 0 + 6 = 6
0 + 6 = 6 10 6 = 4

Gains from Trade

Wheat
Cloth

U.S.
U.K.
6 6 = 0 6 1 = +5
6 4 = +2 4 5 = -1

Trade Based on Absolute Advantage:

Adam Smith
Gains from Trade:

The U.S. gains 2C from trade. The value of these

gains in the U.S. are labor hour (since it takes 1 hour
to produce 4C). The U.S. saves 30 minutes of labor
time (for every 2 hours) after trade.

Trade Based on Absolute Advantage:

Adam Smith
Gains from Trade:

The U.K. gains 5W but loses 1C after trade. The

gained 5W are worth 5 labor hours (since it takes 1
hour to produce 1W in the U.K.). The lost 1C is worth
only 1/5 labor hours (or 12 minutes of labor time).
Therefore, the U.K. gains 4.8 labor hours after trade.

The gained 5W could be exchanged domestically in

the U.K. for 25C. Since the U.K. loses 1C, the net gain
to the U.K. is equivalent to 24C (which requires 4.8
labor hours to produce in the U.K.!)