The Basics of Comparative

Advantage
Chapter 6
 Content of this lesson
• Short introduction on the reasons why
countries trade
• The principle of comparative advantage
and the notion of opportunity cost
• Analysis of an economy with one factor of
production
• International trade in a one-factor world
• Discussion and limits of the theory
 Why countries trade?
There are two answers to that question
• 1) countries have various capacities, which they
may exploit by specialising in the activities
where thay are the best (this is the thory of
comparative advantage, which we will see in the
three next chapters
• 2) By opening themselves to trade, countries
can specialise in a limited number of products
and raise the scale of production, thus gaining in
productivity. This is not contradictory to the
previous reason but draws on another set of
analysis which will be seen in a fourth lesson
 1) The principle of comparative
advantage and opportunity cost
• All production activities need production factors.
Factors which are used in any activity are
withdrawn from another activity, and their true
cost is the value of the production which has
been abandoned. That is the opportunity cost.
• For instance, there is an opportunity cost in
producing T-shirts, which is the value of
automobiles, which might have been produced
with the resources used. If in Europe, the same
quantity of resources allows the output of 10 mn
T-shirts or 10 th cars, and in China of 10 mn
shirts and 3 th cars, Europe should drop shirts
and produce cars, and China the other way
round. World output would grow.
 Comparative advantage
• A country is said to have a comparative
advantage in the production of a good if the
opportunity cost of this good is lower than that of
other coutries
• Trade between countries is mutually beneficial if
each country exports to the other the goods in
which it has a comparative advantage
• There is no need of a five-year plan to reach this
result: market mechanisms leads automatically
to that. The rest of the lesson will show how
 2) A one-factor economy
• Imagine an economy which produces only
2 goods (wine and cheese), with only one
factor of production (labour), available in
quantity L
• qw hours of labour  1 unit of wine
• qc hours of labour  1 unit of cheese
• Let represent that on a graph, choosing
qw = 20, qc = 10 and L = 1000
The equation of the red line below is 20 Yw + 10 Yc ≤ 1000
which may be rewritten as Yw = (L/qw) – (qc/qw) Yc
So that the opportunity cost is the slope of the red line

P OSSIBILITIES OF P RODUC TION

OF OUR ONE-FAC TOR TWO-P RODUC TS EC ONOMY

100

Yw
80 AT THIS P OINT THE COUNTRY P RODUCTION
P RODUCES ONLY WINE FRONTIER
60

AT THIS P OINT THE COUNTRY

40
P RODUCES ONLY CHEESE

20

0
0 20 40 60 80
Yc
Ouput of Cheese
 Relative prices and the supply of
goods
• Let the prices of wine and cheese be Pw and Pc.
This price will go entirely to labour so that the
wage of the wine producer will be Pw/qw and
Pc/qc for cheese producers
• If one of these wages is more than the other,
everyone will switch to that activity
• Only if these wages are equal will the country
produce both goods: we thus shold have Pc/qc =
Pw/qw
• If we rewrite this equality, we see that in a
closed economy, the relative price of products is
equal to the relative quantity of labour they need
 What would happen on the graph if
prices were different?
• The graph below represents two lines of prices: the steepest one is
when the price of cheese is high, and the smoothest one is when
the price of cheese is low. The slope of the lines is the price of
cheese
P RIC ES, THE P R ODUC TION FRONTIER
A ND THE C HOIC E OF P R ODUC TION

100

Yw
THE PRICE OF CHEESE IN TERMS THE P RICE OF CHEESE IS
80 OF WINE IS LOW, SO THAT HIGH, SO THAT P RODUCERS
P RODUCERS P RODUCE ONLY DECIDE TO PRODUCE ONLY
WINE AT P OINT A CHEESE AT POINT B
60
A

40

20

B
0
0 20 40 60 80
Yc
Ouput of C heese
 3) International trade in a one-
factor world
• Let suppose now that there are two countries
and still two products
• Suppose that qc/qw < qc*/qw* The oppotunity
cst of cheese is higher abroad and our country
thus has a comparative advantage in cheese
• If qc > qc*, the foreign country has an absolute
advantage in the production of cheese. It may
also be that qw > qw*, and they have also an
absolute advantage in wine!!
• However, despite these two absolute
disadvantages our country has in both
productions, we still may have a comparative
advantage in cheese, if qc/qc* < qw/qw*
The figure below represent the two countries. For the
foreign country we took qw = 10, qc = 8 and L = 800. It is
clear that foreigners are better than «us» in both
productions.
P RODUC TION FRONTIERS
OF TWO EC ONOMIES

100

Yw
80
FOREIGN
COUNTRY
60

40

20
OUR COUNTRY

0 20 40 60 80
Yc
Ouput of Cheese
 Price determination in free trade
conditions
• Our cheese producers might be interested to
export cheese abroad, as the relative price of
cheese is higher there. They would exchange it
on wine and get more wine by unit of cheese
than at home. The same goes for foreign wine
producers. But how will the price be fixed?
• It is clear that we would accept any price for our
cheese as long as we get more than 0.5 units of
wine per unit of cheese. On their side, foreign
wine producers would go on anything better than
1.25 units of cheese for 1 unit of wine
• There is clearly room for bargaining
 The demand factor
• The final relative price of wine and cheese will
be fixed between the limits set up before, but it
will depend on the strength of demand for both
products
• Suppose that there is a huge demand on cheese
in both countries (especially abroad), relative to
wine. In such conditions, even if our country
produces only cheese, we cannot meet the total
demand of cheese of both countries
• Foreigners have still to produce cheese and they
do it at a relatively high opportunity cost. In
these conditions, the international price will set
up at the foreign level of 0.8 wines for 1 cheese
(very profitable for us!)
• The same thing happens if there is a huge
demand for wine, and the foreign country is not
able to supply the whole market. In that case,
the international price for wine (that is the price
which is valid in both countries) will be the price
of our country
• Our country will produce both wine and cheese,
with the price we had before
• However, the total (« world ») output of both
wine and cheese will be higher than before free
trade is open. This allows both countries to
consume more of both products
 The general case
• The two previous cases (huge demand of one of
the products) are limit cases.
• Between these limits, the price will set up
according to relative demand but both countries
will specialise entirely in the product where they
have a comparative advantage
• In total, our country will produce 100 units of
cheese and the foreign country will do 80 units
of wine, which is the maximum total production
available at the « world » level
• A possible price in free trade is 1,5 units of
cheese for 1 unit of wine. Such a price allows
our country to consume more of both products,
as well as for the foreign partner
 Relative wages
• Suppose that the final price is 1,5 units of
cheese for 1 unit of wine. In dollars this would
give us (for instance) a price of 30$ per unit of
wine and 20$ per unit of cheese
• In the foreign country which has specialised in
wine, the hourly wage will be 3$ per hour. In our
country which has specialised in cheese, the
hourly wage will be only 2$
• Thus, wages may remain different in both
countries
 4) Discussion and limits of the
analysis
• Despite the fact that it has been discovered at
the beginning of the 19-th century (by Ricardo),
the principle of comparative advantage is still not
well understood by the public opinion and even
by major politicians in the present world
• A first error which is committed is the confusion
between competitivity and productivity: a country
which would be very unproductive would have
absolute disadvantages in all productions.
Nevertheless, it still has a comparative
advantage somewhere and may thus be
competitive in that area
• A second error is the argument of « social
dumping »: low wage countries threaten the
employment of rich countries. This is false,
because wages only reflect the productivity. Rich
coutries should abandon the productions where
they have no comprative advantage and use the
freed resources to raise the production where
they do have a comparative advantage
• Third error: rich countries « exploit » poor ones.
False again: poor countries would be still poorer
if they did not trade with rich countries
 Limits of the model
• The Ricardian model is somewhat of a
caricature, and specialisation is not so total as it
is presented
• First because there are various factors of
production and that hinders complete
specialisation
• Second because transpor costs remain an
obstacle to specialisation
• Third because many countries still try to protect
themselves from foreign competition by raising
tariff barriers. This of course shows that the
argument of comparative advantage has not
been understood by many people
 End of the lesson
• Any question?