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CHAPTER T W O

International Economics
Tenth Edition

The Law of Comparative Advantage


Dominick Salvatore
John Wiley & Sons, Inc.

Salvatore: International Economics, 10th Edition 2010 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 Empirical Tests of the Ricardian Model

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Introduction
Basic questions:

What is the basis for trade? What are gains from trade? What is the pattern of trade?

Assume two-nation, two-good world

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

The Mercantilists Views on Trade


Mercantilism

Economic philosophy in 17th and 18th centuries, in England, Spain, France, Portugal and the Netherlands. Belief that nation could become rich and powerful only by exporting more than it imported.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

The Mercantilists Views on Trade


Mercantilism

Export surpluses brought inflow of gold and silver. Trade policy was to encourage exports and restrict imports. One nation gained only at the expense of another.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

The Mercantilists Views on Trade


Mercantilists measured wealth of a nation by

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.

The greater the stock of resources, the greater the flow of goods and services to satisfy human wants, and the higher the standard of living.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Trade Based on Absolute Advantage: Adam Smith


A nation has absolute advantage over another

nation if it can produce a commodity more efficiently.


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.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

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.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

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 interference with economic activity. Free trade would cause world resources to be utilized most efficiently, maximizing world welfare.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Trade Based on Absolute Advantage: Adam Smith


U.S. 6 4 U.K. 1 5

Wheat (bushels/labor hour) Cloth (yards/labor hour)

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.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Trade Based on Absolute Advantage: Adam Smith


No Trade Specialization Trade Trade Gain

U.S. Wheat Cloth 6 4

U.K. 1 5

U.S. 12 0

U.K. 0 10

U.S. 6 6

U.K. 5 5

U.S. 6-4=2

U.K. 5-1=4 -

Assuming each country has 2 unit labor hours and specialize on

the product that has Absolute Advantage US Specialize on Wheat then gain 2 additional Cloth UK Specialize on Cloth then gain 4 additional Wheat

Salvatore: International Economics, 10th Edition 2009 John Wiley & Sons, Inc.

Trade Based on Comparative Advantage: David Ricardo


Law of Comparative Advantage

Even if one nation is less efficient than (has absolute disadvantage with respect to) the other nation in production of both commodities, there is still a basis for mutually beneficial trade.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Trade Based on Comparative Advantage: David Ricardo


U.S. Wheat (bushels/labor hour) Cloth (yards/labor hour) U.S. Wheat Cloth

U.K. 1 2

6 4

U.K.
UK has higher opportunity cost than US in Wheat production US has higher opportunity cost than UK in Cloth production

U.K. has absolute disadvantage in both goods. Since U.K. labor is half as productive in cloth but six times less productive in wheat compared to U.S., the U.K. has a comparative advantage in cloth. U.S. has comparative advantage in wheat.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Comparative Advantage and Opportunity Costs


The original idea of comparative advantage

was based on the labor theory of value:

The value or price of a commodity depends exclusively on the amount of labor used to produce it.

Can use the opportunity cost theory to

explain comparative advantage:

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.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Comparative Advantage and Opportunity Costs


Production Possibilities Frontier A curve that shows alternative combinations of the two commodities a nation can produce by fully using all resources with best available technology. Constant opportunity costs arise when:
1. Resources are either perfect substitutes for each other or used in fixed proportion in production of both commodities, and 2. All units of the same factor are homogeneous.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 2-1 The Production Possibility Frontiers of the United States and the United Kingdom.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

The Basis for and the Gains from Trade under Constant Costs
In the absence of trade, a nations production

possibilities frontier also represents its consumption frontier.


Increased output resulting from

specialization and trade represents nations gains from trade, allowing nations to consume outside production possibilities frontier.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 2-2 The Gains from Trade.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

The Basis for and the Gains from Trade under Constant Costs
Under constant cost conditions, nations will

completely specialize in their comparative advantage .


With complete specialization in both nations,

the equilibrium-relative commodity price of each commodity lies between the pretrade relative commodity price in each nation.

Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 2-3 Equilibrium-Relative Commodity Prices with Demand and Supply.


Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

Empirical Tests of the Ricardian Model


McDougall (1951 and 1952) Argued that costs of production would be lower in the U.S. in industries where U.S. labor was more than twice as productive as U.K. labor. Found positive relationship between labor productivity and exports; industries with relatively productive labor in U.S. have higher ratios of U.S. to U.K. exports, supporting Ricardian theory of comparative advantage. Results supported by Balassa, Stern and Golub in later studies.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 2-4 Relative Labor Productivities and Comparative AdvantageUnited States and United Kingdom.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

2.8 2.6
Output per JPN Worker/ Output per KOR Worker

2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0 0.0


Textiles Fuel Wood Food Basic Iron Office Machinery Non-metal Paper Chemical Electric Machinery Metal General Machinery Transport Machinery

Precision Machinery.

y = 0.2129x + 1.3368 2 R = 0.4598

1.0

2.0

3.0

4.0

5.0

6.0

JPN Exports/KOR Exports

FIGURE 2-4-K Relative Labor Productivities and Comparative AdvantageKorea and Japan.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.

FIGURE 2-5 Relative Exports and Relative Unit Costs United States and Japan.
Salvatore: International Economics, 10th Edition 2010 John Wiley & Sons, Inc.