note 1-428-934

December 17, 2009

Note on Trade and Comparative Advantage

Introduction

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Whether nations benefit from trade is a question that has been passionately debated throughout
history. The theory of comparative advantage is one of the more useful, yet frequently misunderstood,
topics in economics and public policy. In the almost two centuries since David Ricardo first introduced the
theory it has come to be widely accepted among professional economists. But free trade remains relatively
unpopular among the general public, with only a 32% approval.
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This note introduces the theory of comparative advantage. It is organized into five sections. Section
one provides everyday examples. Section two contains a brief intellectual history of thinking about trade.
Section three introduces the basic model. Section four presents additions to the basic model. Traditional
arguments against free trade are found in section five. A companion note, Beyond Comparative Advantage:
Theories of Strategic Trade (WDI case # 1-428-935) introduces modern approaches, including game theory
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and strategic trade.
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Everyday Examples

A famous and wealthy impresario of stage and screen in the 1940s, Billy Rose was also a world-
class typist and stenographer with many awards to his credit. He would thus have encountered
enormous difficulty in hiring a secretary who could work nearly as well as he himself could. Still, he
hired secretaries because even though he was the worlds best at the job, he could still earn much
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more in an hour spent manipulating his stage and screen empire than he could in typing.
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This is what Ricardos concept of comparative advantage is all about. When compared to his secretaries, Billy
Rose had an absolute advantage in both entertaining the audience and typing. Nevertheless, secretaries were
hired by Billy Rose to allow him to focus on his relative advantagemanaging the entertainment business.

There are numerous examples of individuals utilizing the concept of comparative advantage in their
everyday life:

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2010 William Davidson Institute. Robert E. Kennedy, the Tom Lantos Professor of Business Administration at the
Ross School of Business at the University of Michigan, developed this note with assistance from Research Associate
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Note on Trade and Comparative Advantage 1-428-934

Caring dog owner Susie chooses to focus on her consulting career and pays others to walk her dog
during the business hours
Professional chef Tom purchases fast food meals for personal consumption in order to leave enough
time for frequent television appearances on various cooking topics
Litigation lawyer Katie hires interns for assistance in preparing legal memos so that she could focus
more of her time on court appearances and less time on memo preparation

The logic behind these examples applies to trade between nations as well. The key insight is that people,
organizations, and countries should focus on the things that they do relatively well, and purchase from
others the things that they do relatively poorly. This makes everyone better offallowing specialization,
and increasing both total output and consumption possibilities.

A Brief History

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Starting with Adam Smith, economists have argued that specialization and trade play a key role in
increasing output and improving the wealth of nations. In his most famous work, An Inquiry into the Nature
and Causes of the Wealth of Nations, Smith focused on three main ideas. He argued that specialization
increases efficiency; that trade allows the benefits of specialization to be realized; and that the benefits of

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trade are a benefit to both countries and most individuals.
What is prudence in the conduct of every private family can scarce be folly in that of a great
kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make
it, better buy it of them with some part of the produce of our own industry, employed in a way in
which we have some advantage.
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The key insight is that countries differ in their ability to produce different goods. If Country A can
produce good X at a lower cost than Country B, and if Country B can produce good Z at a lower cost than
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Country A, then surely it would make sense for Country A to focus on producing good X and trading for good
Z. Smiths work focused on the absolute cost of production, concluding that everyone could be made better
off if goods were produced wherever it was most efficient to do so.

Ricardos work expanded significantly on Smiths basic concept. Ricardos Principles of Political
Economy and Taxation, published in 1817, explained that trade can be beneficial even if one country held
an absolute advantage in producing both goods.
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Ricardos analysis made several simplifying notions. His analysis focused on two nations and two
products. Factor markets (i.e. labor, capital, inputs) were ignored. And any differences in efficiency across
countries were assumed to be fixed. While not fully reflective of the complexity of the real world, Ricardos
model provides a starting point for understanding how trade creates value. Section 4 discusses several of
these extensions.

Ricardos Basic Model

Consider a world in which there are only two goods (wine and cheese) and with only two countries,
France and Germany. Each country has a population of 100 people. France is relatively good at producing
wine, but not so good at producing cheese. If all of its workers focus on producing wine, they can produce a
total of 200 bottles per day (two bottles per worker per day). If French workers focus on producing cheese,
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they can produce a total of 100 kilograms of cheese per day (one kilo per worker per day). Of course, some
workers can focus on wine and others on cheese and some combination of the two products can be produced
(see Figure 1A).

Germany on the other hand, is good at producing cheese and less so at producing wine. If all German
workers focus on producing cheese, they can produce 200 kilos of cheese per day (two kilos per worker per
day). If they focus exclusively on producing wine, they can produce 100 bottles of wine (one bottle per
worker per day, see Figure 1B). The tradeoff that each country faces (with no trade) is referred to as the
production possibilities frontier.

Production Possibilities without Trade

Figure 1A Figure 1B

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In a world without trade, Frances opportunity cost of producing an extra kilo of cheese is to not
produce two bottles of wineso the price of cheese is two bottles of wine. Germanys opportunity cost
of producing a kilo of cheese is a half of a bottle of wineso the price of cheese is 0.5 bottle of wine.
Measured by output per person-day of labor, France is twice as efficient as Germany when producing wine
(two vs. one bottles per day per worker). Germany is twice as efficient as France at producing cheese (two
vs. one kilos per day per worker).

While France and Germany are both developed, relatively productive countries, France is relatively
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better at producing wine and Germany is relatively better at producing cheese. Using Ricardos terminology,
France is said to have a comparative advantage in producing wine, and Germany to have a comparative
advantage at producing cheese.

If there is no trade between France and Germany, each country is limited to consuming only the
products that it produces. This means that the lines in Figures 1A and 1B reflect both the production
and the consumption possibilities frontier for each country. Each can produce and consume at any point
along its production possibilities frontier. Which point it chooses depends on local preferences. Since wine
is relatively expensive in Germany and cheese is relatively expensive in France, consumption will likely
be tilted a bit toward the cheaper good in each country (see points A and B in Figures 1A and 1B). Two
feasible consumption bundles might be 120 kilos of cheese and 40 bottle of wine in Germany, and 40 kilos
of cheese and 120 bottles of wine in France. (The exact production/consumption choice is not important
to this example.)
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How would the situation change if we allow trade between the two countries? With trade, a country
is no longer restricted to consuming what it produces, meaning that its consumption can diverge from its
production possibilities.

Given that cheese is expensive in France (two bottles per kilo), and is cheap in Germany (a half bottle
per kilo), the two countries have an incentive to specialize their production and trade with each other.
Look at the situation from the perspective of a French winemaker. If the vintner exchanges wine with a
local cheese maker, he receives a half kilo of cheese for each bottle of wine. A German cheese maker will be
willing to give the vintner as much as two kilos of cheese per bottle, which is what he or she can receive
from local winemakers. The French vintner comes out ahead if he gets anything more than 0.5 kilo per
bottle. The German cheese maker comes out ahead if he gets a bottle of wine for anything less than two
kilos of cheese.

Assume for the moment that the countries agree to trade wine for cheese at a price of one bottle per

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kilo. If France produces only wine, it can obtain a kilo of cheese for each bottle of wine. Because France
has to give up less wine per kilo (i.e. the price has fallen), a whole new set of consumption possibilities
open up (see Figure 2A). France can now consume bundles of wine and cheese that were not possible with
no tradefor example, 130 bottles of wine and 70 kilos of cheese (see point A in Figure 2A), an outcome
where consumption of both products rises.

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The same holds for Germany. When the Germans trade with the French, they can exchange cheese for wine
at one kilo per bottle. This allows German consumption possibilities to expand as well (see Figure 2B).

Production Possibilities with Trade

Figure 2A Figure 2B
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Note that neither countrys production possibilities changed. But trade allows each to have a set of
new, expanded, consumption possibilities.

What if One Country is Better at Everything?

In the example above, each country was more efficient at producing one good than its potential trading
partner. But what if one country is better at producing both goods?

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Ricardos theory suggests that what matters is comparative advantage, meaning that it still makes sense
to trade even if one country is more productive at producing all goods.

In the example above, France has an advantage in wine production, and Germany enjoys an advantage
in cheese production. How would the situation change if the French got themselves organized, went to
business school, and started drinking lots of coffee? Would it still make sense to trade with Germany if
Frances production efficiency tripled for both goods? If this happened, Frances new production possibilities
frontier would range from 600 bottles of wine to 300 kilos of cheese, or anything in between. This would
make French absolutely more efficient than the Germans in both wine and cheese production (see Figure
3). Would trade still make sense?

Figure 3
When One Country Has an Absolute Advantage

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The answer is yes, because the production possibilities in each country differ, there are still potential
gains from trade. Note that even though productivity has risen, France must still forego producing two
bottles of wine to produce a kilo of cheese. If instead, France trades with Germany, it can obtain a kilo of
cheese to consume in exchange for only one bottle of wine. As with the first example, Frances consumption
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possibilities increase with trade (ex. shift from A to A). Exchange between the two countries also gives
Germany consumption possibilities unattainable without trade (ex. shift from B to B).

Adding to the Model

In the years since Ricardos original work on trade, several important extensions have been added to
the model. While trade in the real world is undoubtedly more complicated than Ricardos simple model, none
of these extensions change the core insight that nations gain by specializing in those things in which they
have a comparative advantage.

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The first extension adds additional products and countries. This makes the math, and the examples,
somewhat more complicated. But it doesnt change the core insight that countries can increase their
standard of living by producing and exporting those products in which they have a comparative advantage,
and importing those in which they do not.

A second set of extensions adds in various types of non-production costssuch as transportation,

taxes, tariffs, etc. As an example, a 20% tariff on a product might significantly reduce the benefits of trade
related to that product. Yet as a general rule, non-production costs may lessen the gains from trade, but
dont change the potential.

A third extension adds production inputs to the analysis. Ricardos model simply assumed that countries
have differing production competencies, but he took these differences as given and unchanging. The
Heckscher-Ohlin model explores how factor marketssuch as land, labor, and capitalaffect trade. The
mathematical model suggests that countries with an abundance of capital (e.g. the United States and

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England) will focus on producing capital-intensive products such as steel and automobiles. Countries with an
abundance of labor (e.g. China and India) will focus on producing labor-intensive products such as textiles.
England will then trade its capital-intensive products for Chinese labor-intensive products and vice versa.

A fourth extension pushes the analysis of factor inputs further. Work by economists such as Paul Krugman

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and Michael Porter explores how countries can develop and sustain advantages in certain areas. This work
shows how comparative advantages can be developed, and has led to much work on industrial policy.

Traditional Objectives to Free Trade

While Ricardos theory demonstrates that free trade increases the overall wealth of a nation, critics
make several types of arguments against free trade. These generally fall into three categories.
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The first argument concerns the allocation of gains and losses. In the wine and cheese example above,
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trade benefits consumers in both countries. But it undoubtedly harms French cheese makers and German
vintners. While the country as a whole benefits, there are often certain groups that lose from trade. As a
general rule, the gains from trade are widely dispersed while the losses are concentrated.

Consider lumber and automobiles. Canada has a comparative advantage in producing lumber products
while Japan has an advantage in automobile production. Trade between the countries means that millions
of consumers are able to purchase lumber products (Japan) and cars (Canada) at prices lower than domestic
producers can offer. These gains, however, come at the expense of the Canadian auto and Japanese lumber
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sectors. Firms and workers in these sectors lose from trade and have an incentive to organize themselves
and appeal to politicians for protection. Each consumer, on the other hand, receives only a small individual
benefit, so the incentive to organize and lobby is small. So, even though the economic gains from trade
generally outweigh the losses, the political logic works against trade. In theory, some portion of the gains
from trade could be used to fully compensate those hurt by trade. But this rarely happens.

A second argument for protectionism focuses on so-called infant industries. This argument is frequently
made in relation to introduction of new technologies that might benefit from temporary protection from
foreign competition while the market develops or the firm reaches efficient scale. The argument suggests
that protection would lead to short term costs, but has the potential to generate long-term gains. Critics
of the infant industry argument claim that government is extremely poor at identifying the industries with

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high potential of future comparative advantage and that so-called infant industries tend to never grow up.
Theres always a political rationale to extend the trade protections. The infant industry critique is discussed
in more depth in Beyond Comparative Advantage: Theories of Strategic Trade (WDI case # 1-428-935).

A third objection to free trade concerns national security. The logic is that, even if a country can obtain
military goods cheaply from a foreign producer, cost savings are not worth the risk to national security.
While this logic undoubtedly applies to some products (tanks, missiles, fighter jets, etc.), critics often try
to extend the argument to products easily available from many sources such as military uniforms, food, and
even television broadcasting.

Summary

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The core concept of comparative advantage is powerful and widely applicable. It is important to
remember that, even for countries that are highly productive in many things (the United States or Japan)
or in few things (Haiti, Burundi), every country is comparatively better at some things than at others. Every
country can raise living standards by identifying those areas in which it has a comparative advantage and
focusing on producing those products and using export earnings to import goods that it is relatively poor
at producing.

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As the examples and models in this note demonstrate, both developing and developed nations can
gain by focusing on their relative strengths. Please refer to note Beyond Comparative Advantage: Theories
of Strategic Trade (WDI case # 1-428-935) to learn more about how policy makers can utilize strategic
approaches toward international trade in order to increase the wealth of their nations.
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Endnotes

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According to a 1998 survey by Chicago Council on Foreign Relations, in response to a question pointing out that elimination of
tariffs and quotas would result in lower prices for all while some jobs might be eliminated, only 32% of the public were in favor
of eliminating tariffs and quotas in this scenario.
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Quoted from W.B. Brown and J.S. Hogendorn, International Economics: Theory and Content. Reading, MA: Addison Wesley, 1994.
p.28.
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Smith, Adam. The Wealth Of Nations, Book IV Chapter II, pp. 456-7.

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Notes

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Notes

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Notes

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