International Economics Eleventh Edition CHAPTER T W O 2 International Economics Eleventh Edition The Law of Comparative Advantage Dominick Salvatore John Wiley & Sons, Inc. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Learning Goals: Understand the law of comparative advantage. Understand the relationship between opportunity costs and relative commodity prices. Explain the basis for trade and show the gains from trade under constant cost conditions. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Assume two-nation, two-good world 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, 11th Edition © 2013 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, 11th Edition © 2013 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, 11th Edition © 2013 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, 11th Edition © 2013 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, 11th Edition © 2013 John Wiley & Sons, Inc.

Trade Based on Absolute Advantage: Adam Smith Examples: 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, 11th Edition © 2013 John Wiley & Sons, Inc.

Trade Based on Absolute Advantage: Adam Smith Specialization and trade benefit both countries. Adam Smith and other classical economists advocated a 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, 11th Edition © 2013 John Wiley & Sons, Inc.

Trade Based on Absolute Advantage: Adam Smith U.S. U.K. Wheat (bushels/hour) 6 1 Cloth (yards/hour) 4 5 U.S. has an absolute advantage over U.K. in wheat. U.K. has an absolute advantage over U.S. in cloth. Both nations can gain from specializing in production and then trading. Salvatore: International Economics, 11th Edition © 2013 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, 11th Edition © 2013 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 opportunity cost of a good is the amount of a second good that must be given up to release just enough resources to produce one additional unit of the first good. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Trade Based on Comparative Advantage: David Ricardo U.S. U.K. Wheat (bushels/hour) 6 1 Cloth (yards/hour) 4 2 U.K. has an 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 a comparative advantage in wheat. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Both countries can gain from trade. The Gains from Trade Both countries can gain from trade. The US gains as long as 6W trade for more than 4 C. The UK gains as long as 2C trades for more than 2 W. Thus the range for mutually beneficial trade is: 4C < 6W <12C Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Comparative Advantage with Money Wages in the two countries will adjust to reflect productivities Suppose that the wage rate in the U.S. is $6/hour, and wages in the U.K. are ₤1/hour In the U.S., 1 worker hour produces 6 bushels of wheat, each bushel of wheat will cost $1. Likewise, in the U.K., 1 worker hour will produce 2 yards of cloth, so a yard of cloth will cost ₤0.50. If the exchange rate is $1 = ₤2, we can show each country’s prices in terms of U.S. dollars. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Comparative Advantage with Money, cont. U.S. U.K. Price of one bushel of wheat $1.00 $2.00 Price of one yard of cloth 1.50 1.00 The table reflects an exchange rate of $1 = ₤2 For mutually beneficial trade, the price of a bushel of wheat must be between $1 and $2. Changes in exchange rates will change gains from trade and possibly patterns of trade. Salvatore: International Economics, 11th Edition © 2013 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, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 2-1 The Production Possibility Frontiers of the United States and the United Kingdom. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Basis for and the Gains from Trade under Constant Costs In the absence of trade, a nation’s 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, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 2-2 The Gains from Trade. Salvatore: International Economics, 11th Edition © 2013 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, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 2-3 Equilibrium-Relative Commodity Prices with Demand and Supply. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

The Basis for and the Gains from Trade under Constant Costs Suppose that world demand for wheat intersects world supply in the portion of the supply curve between zero and B in the left panel of the previous graph. Then trade takes place at the pretrade price in the U.S., which will not completely specialize, and all the gains from trade accrue to the U.K. This is the small country case, demonstrating “the importance of being unimportant.” Salvatore: International Economics, 11th Edition © 2013 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. Case Study 2-4 shows Golub’s result. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

FIGURE 2-4 Relative Labor Productivities and Comparative Advantage–United States and United Kingdom. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Case Study 2-4: Relative Unit Labor Costs and Relative Exports—United States and Japan (Figure 2.5) Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

Appendix A2.1 Comparative Advantage with More Than Two Commodities As with two commodities, nations will export the goods that can be produced comparatively cheaply and import the goods that they produce less efficiently. A2.2 Comparative Advantage with More Then Two Nations Similarly, results can be generalized to more nations, or to the combination of more nations and more commodities. Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.

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