1. An Introduction to International Economics
Chapter 2: Comparative Advantage
Dominick Salvatore
John Wiley & Sons, Inc.
Dale R. DeBoer
University of Colorado, Colorado Springs

3. 2.1 Introduction

4. In Topics2-5, we shall study the pure theory of international trade.
In this Topic, we shall try to understand the answers to three basic questions that the pure theory of trade is concerned with.

5. The first question is: What is the basis for trade
The first question is: What is the basis for trade? (Here we deal with the questions:why trade between two nations can happen?)
The second basic question is: What is the pattern of trade? (Here we deal with the questions: What commodities are traded? And Which commodities are exported and imported by each nation?)
The third basic question is: what are the gains from trade? (Here we deal with the questions: How are the gains from trade generated? How large are the gains? How are the gains divided among trading nations? )

6. The basic questions of international trade
What is the basis of trade?
Two answers to this question will be discussed in this chapter: Absolute Advantage and Comparative Advantage

7. The basic questions of international trade
What is the basis of trade?
What are the gains from trade?
The models of Absolute and Comparative Advantage show that the gains from trade are increased consumption gained through specialization in production and trade.

8. The basic questions of international trade
What is the basis of trade?
What are the gains from trade?
What is the pattern of trade?
What determines the pattern of specialization that drives international trade?

9. 2.2 the Mercantilists’ Views on Trade

10. The specific aspects in this Topic
* Mercantilists’ Views on Trade
* Trade Based on Absolute Advantage
* Trade Based on Comparative Advantage
* Comparative Advantage and Opportunity Costs
* The Basis for and the Gains from Trade Under Constant OC

11. The Mercantilists What is wealth?
The Mercantilist answer was the stock of precious metals possessed by a country.

12. The Mercantilists What is wealth? How can precious metals be obtained?
Extraction from naturally occurring stocks
This option is available to few countries

13. The Mercantilists What is wealth? How can precious metals be obtained?
Extraction from naturally occurring stocks
Earn precious metals through exports of goods and services
Since payment for exports is made with precious metals, exporting causes precious metals to flow into a country
Similarly, since payment for imports is also made with precious metals, importing causes precious metals to flow out of country

14. The Mercantilists What is wealth? How can precious metals be obtained?
The natural conclusion – exports must exceed imports for a country to become wealthy!

15. The Mercantilists What is wealth? How can precious metals be obtained?
The natural conclusion – exports must exceed imports for a country to become wealthy!
Can this condition hold for all countries?
No!
Therefore, the wealth of one country must come at the expense of another country.

16. The Mercantilists What is wealth? How can precious metals be obtained?
The natural conclusion – exports must exceed imports for a country to become wealthy!
Can this condition hold for all countries?
Mercantilist policy
Strict government control over economic activity to ensure a positive trade balance

17. The Mercantilists What is wealth? How can precious metals be obtained?
The natural conclusion – exports must exceed imports for a country to become wealthy!
Can this condition hold for all countries?
Mercantilist policy
A further look at the Mercantilists
Federal Reserve Bank of San Francisco’s “Major Schools of Economic Theory”
FRBSF WWW link

18. Is “wealth” precious metals?
To the Mercantilists, yes.

19. Are precious metals “wealth”?
To the Mercantilists, yes.
Modern measures of wealth are based on a country’s ability to produce the goods and services that improve quality of life.
Hence, the Mercantilist conclusion is based a definition of wealth the differs significantly from modern notions of wealth.
This distinction leads to very different conclusions about how to become a wealthy nation.

20. Briefly, the mercantilists maintained that:
the way for a nation to become rich and powerful was to export more than it imported.The resulting export surplus would then be settled by an inflow of bullion, or precious metals, primarily gold and silver.
the government had to do all in its power to stimulate the nation’s exports and discourage and restrict imports.

21. (However since all nations could not simultaneously have an export surplus, and the amount of gold and silver was fixed at any particular point in time, so,) One nation could gain only at the expense of other nations. That is, trade is zero-sum game.
Thus, the mercantilists believed that national interests were basically in conflict. SO,they preached economic nationalism.

22. 2.3 Trade Based on Absolute Advantage by Adam Smith

23. 2.3.1 Definition of AA
When one nation is more efficient than (or has an AA over) another in the production of one commodity but is less efficient than (or has an AdisA with respect to ) the other nation in producing a second commodity, then both nations can gain by each specializing in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage.
By this process, resources are utilized in the most efficient way and the output of both commodities will rise.
This increase in the output of both commodities measures the gains from specialization in production available to be divided between the two nations through trade.

24. Adam Smith strongly advocated a policy of laissez-faire as little government interference with the economic system as possible . He (and the other classical economists who followed him) believed that all nations would gain from free trade. Free trade would cause world resources to be utilized most efficiently and would maximize world welfare. illustration of Absolute Advantage

25. Absolute advantage Built on the ideas of Adam Smith
The Library of Economic Liberty Biography of Adam Smith
WWW Link

26. Absolute advantage Built on the ideas of Adam Smith
Absolute advantage exists between nations when they differ in their ability to produce goods.
More specifically, absolute advantage exists when one country is good at producing one item, while another country is good at producing another item.

27. 2.3.2 A numerical example of AA
Table “2+2”modle about U.S. and U.K.
in autarky (under closed ecomomy)
U.S.
U.K.
Wheat (bushels/man-hour) 6 1
Cloth
(yards/man-hour) 4 5

28. Wheat (bushels/man-hour)
table after specialization
U.S.
U.K.
Wheat (bushels/man-hour)
12W /
Cloth
(yards/man-hour)
10C
Note：suppose that two countries are perfect specialization

29. Wheat (bushels/man-hour)
Table after trade/exchange
U.S.
U.K.
Wheat (bushels/man-hour)
6W+6W 6W
Cloth
(yards/man-hour) 6C
6C+4C
note：international exchange rate is 1:1

30. Note ：two trading countries can gain from trade
table gains from trade
U.S.
U.k.
+2c
+24c
or，+0.5man-hour
or, +5man-hour
Note ：two trading countries can gain from trade

31. An example of absolute advantage
Countries
Scotland
Mexico
Goods
Coffee beans
Wool

32. An example of absolute advantage
How does specialization and trade advantage Scotland?
By reducing coffee bean production, resources are freed for producing more wool
Each hour of production change costs 1 unit of coffee beans but gains 4 units of wool

33. An example of absolute advantage
How does specialization and trade advantage Scotland?
Scotland can send 3 units of wool to Mexico and receive 7 units of coffee beans back
Thus, by specializing in production Scotland gains 1 unit of wool and 6 units of coffee per hour of production moved

34. An example of absolute advantage
Does specialization and trade also advantage Mexico?
By reducing wool production, resources are freed for producing more coffee beans
Each hour of production change costs 2 units of wool but gains 10 units of coffee beans

35. An example of absolute advantage
Does specialization and trade also advantage Mexico?
Mexico can send 7 units of coffee beans to Scotland and receive 3 units of wool back
Thus, by specializing in production Mexico gains 1 unit of wool and 3 units of coffee beans per hour of production moved

36. Policy recommendations from absolute advantage
Specialization and trade advantage both countries
Therefore, the best policy is to allow producers and consumers in both countries unfettered access to goods from both countries to maximize the number of advantageous trades that can occur.
In other words, laissez-faire.
The policy of minimum government interference with economic activity.

37. A fatal flaw?
Absolute advantage requires one country to be better at production of one product and another country to be better at production of another good for specialization and trade to be mutually advantageous.
What if one country is better at everything?
The theory of comparative advantage provides this answer.

38. 2.4 Trade Best on Comparative Advantage (CA) : by David Ricardo （1772-1823）
Dale R. DeBoer
University of Colorado, Colorado Springs

39. 2.4.1 definition of CA According to the law of comparative advantage,
even if one nation is less efficient than (or has an absolute disadvantage with respect to) the other nation in the production of both commodities, there is still a basis for mutually beneficial trade.
The first nation should specialize in the production of and export the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage).
let’s see “the illustration of Comparative Advantage”

40. 2.4.2 A numerical example of CA
Table comparative advantages before specialization and trade
U.S.
U.K.
Wheat (bushels/man-hour) 6 1
Cloth
(yards/man-hour) 4 2

41. Table 2 after specialization
U.S.
U.K.
Wheat (bushels/man-hour)
12W /
Cloth
(yards/man-hour) 4C
Note：suppose that two countries are perfect specialization

42. Wheat (bushels/man-hour)
Table with trade or exchange
U.S.
U.K.
Wheat (bushels/man-hour)
8W+4W 4W
Cloth
(yards/man-hour) 4C
Note：suppose that, the exchange rate is 1:1

43. Table gains from trade
U.S.
U.K.
+2w
+2w(or 4c)
or，+0.33man-hour
or, +2man-hour
note：two countries can gain from trade

44. Wheat (bushels/man-hour)
2.4c exception to the CA
U.S.
U.K.
Wheat (bushels/man-hour) 6 3
Cloth
(yards/man-hour) 4 2
This occurs when the AdisA that one nation has with respect to another nation is the same in both commodities.

45. Comparative advantage
Built on the ideas of David Ricardo
The New School History of Economic Thought Biography of David Ricardo
WWW Link

46. Comparative advantage
Built on the ideas of David Ricardo
The law of comparative advantage shows how mutually beneficial specialization and trade may be driven by relative advantages in production rather than absolute advantages in production.
Given the somewhat counter-intuitive nature of the law of comparative advantage its implications are best seen through example.

47. An example of comparative advantage
Countries
Scotland
Mexico
Goods
Coffee beans
Wool
The difference lies in the relative productivity of the countries
In this case, Mexico is more productive at generating both goods.

48. An example of comparative advantage
How does specialization and trade advantage Mexico?
By reducing wool production, resources are freed for producing more coffee beans
Each hour of production change costs 5 units of wool but gains 10 units of coffee beans

49. An example of comparative advantage
How does specialization and trade advantage Mexico?
Mexico can send 9 units of coffee beans to Scotland and receive 7 units of wool back
Thus, by specializing in production Mexico gains 1 unit of coffee beans and 2 units of wool per hour of production moved

50. An example of comparative advantage
Does specialization and trade also advantage Scotland?
It does. To see this consider consider Scotland trading two hours of output.
Two hours of production change from coffee beans to wool costs 2 units of coffee beans but gains 8 units of wool

51. An example of comparative advantage
Does specialization and trade also advantage Scotland?
Scotland can send 7 units of wool to Mexico, receiving 9 units of coffee beans in return
Thus, by specializing in production Scotland gains 1 unit of wool and 7 units of coffee beans

52. Implications of comparative advantage
Laissez-faire still holds
Gains need not be equal
Hours of work traded need not be equal but the advantage still exists
Trade is based on the existence of relative – not absolute – production advantages

53. 2.5 Comparative Advantage and Opportunity Costs

54. 2.5.1 CA and the labor theory of value
Under the labor theory of value, the value or price of a commodity depends on the amount of labor going into the production of the commodity.
This implies:
(1)the labor is the only factor of production; or labor is used in the same fixed proportion in the production of all commodities; and
(2)the labor is homogeneous

55. But, in the real world,
(1) labor is not the only factor of production, nor is it used in the same fixed proportion in the production of all commodities.(e.g., much more capital equipment per worker is required to produce some products than to produce other products). In addition, there is usually some possibility of substitution between labor, capital, and other factors in the production of most commodities.
(2) Furthermore, labor is obviously not homogeneous but varies greatly in training, productivity, and wages.

56. So, the Ricardian theory of CA has been tested empirically.
In any event, the theory of CA need not be based on the labor theory of value but can be explained on the basis of the opportunity cost theory which is acceptable.

57. Does money alter the story?No
Suppose the costs of production are as given below
Mexico: 100 pesos/hour
Scotland: 4 pounds/hour
Suppose the exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
4£ ÷ 1 unit = 4£ per unit
4£ x 10P/£ = 40P per unit

58. Does money alter the story?No
Suppose the costs of production are as given below
Mexico: 100 pesos/hour
Scotland: 4 pounds/hour
Suppose the exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
4£ ÷ 4 units = 1£ per unit
1£ x 10P/£ = 10P per unit

59. Does money alter the story?No
Suppose the costs of production are as given below
Mexico: 100 pesos/hour
Scotland: 4 pounds/hour
Suppose the exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
100P ÷ 10 units = 10P per unit

60. Does money alter the story?No
Suppose the costs of production are as given below
Mexico: 100 pesos/hour
Scotland: 4 pounds/hour
Suppose the exchange rate between pesos and pounds is 1£ = 10P
This gives the unit costs indicated in the chart
100P ÷ 5 units = 20P per unit

61. Does money alter the story?
At these prices goods will naturally flow from the cheaper market (Scotland for wool, Mexico for coffee beans) to the more expensive market.
Again, this demonstrates the law of comparative advantage but through prices not relative outputs.

62. 2.5.2 the Opportunity Cost Theory: by Haberler in 1936
Haberer explained or based the theory of comparative advantage on the opportunity cost theory.
In this form, the law of comparative advantage （比较利益说）is sometimes referred to as the law of comparative cost.（比较成本说）

63. Definition to the opportunity cost theory:
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.
Consequently, the nation with the lower opportunity cost in the production of a commodity has a comparative advantage in that commodity (and a comparative disadvantage in the second commodity).
E.g.(text book P41): 1W=2/3C

64. Does the source of the productive difference matter?No
The original idea of comparative advantage was based on the labor theory of value.
The labor theory of value holds that costs and prices are solely determined by the labor content of an item.

65. Does the source of the productive difference matter?No
The original idea of comparative advantage was based on the labor theory of value.
The examples given above rely on opportunity cost.
Opportunity cost holds that the cost of an item is the amount of another item the must be given up to release sufficient resources to produce one more unit of the first item.

66. 2.5.3 the Production Possibility Frontier(PPF) under Constant Cost
Opportunity costs can be illustrated with the production possibility frontier, or transformation curve.

67. The production possibility frontier (or transformation curve) is a curve that shows the alternative combinations of the two commodities that a nation can produce by fully utilizing all of its resources with the best technology available to it.
(Let’s see the Table 2.4 and Figure 2.1, in the text book, on page of 43)

69. Notes:
1. points on a frontier
2. points inside, or below a frontier
3. points above the production frontier
4. the downward, or negative, slope of the production possibility frontier
5. the PPF is a straight line
(text book, on page of 42-43)

70. About four concepts:
Opportunity costs（机会成本）
Relative commodity prices （相对商品价格）
The slope of the PPF or transformation curve （PPF的斜率）
The marginal rate of transformation （边际转换率）

71. About four concepts:
Opportunity costs（机会成本）
Relative commodity prices （相对商品价格）
The slope of the PPF or transformation curve （PPF的斜率）
The marginal rate of transformation （边际转换率）

72. The production possibility frontier
The production possibility frontier (PPF) identifies the maximum combinations of two products that a nation can produce by fully utilizing all factors of production with the best technology available.
Consider the production possibilities schedule for an example:
United States
Wheat
Cloth
180
150 20
120 40 90 60 80 30
100

73. Constructing the PPF United States Wheat Cloth 180 150 20 120 40 90 60
150 20
120 40 90 60 80 30
100

74. Constructing the PPF United States Wheat Cloth 180 150 20 120 40 90 60
150 20
120 40 90 60 80 30
100

75. Constructing the PPF United States Wheat Cloth 180 150 20 120 40 90 60
150 20
120 40 90 60 80 30
100

76. Regions of the PPF Productive maximum Underutilized resources
Unattainable with existing resources and technology

77. Trade with the PPF model
Suppose the US and the UK have the PPFs given to the right

78. Trade with the PPF model
Suppose the US and the UK have the PPFs given to the right
Further suppose that each country produces and consumes at the marked spot in the absence of international trade
(90W, 60C)
(40W, 40C)

79. Trade with the PPF model
Can specialization and trade lead to more aggregate production and consumption?
If the US specialized in wheat production and the UK in cloth production, aggregate production would increase from 130W to 180W and from 100C to 120C.
(90W, 60C)
(40W, 40C)

80. 2.6 the basis for and the gains from trade under the constant opportunity costs
Illustration of the gains from trade
(Figure 2.2, text book, on page of 45)
the Equilibrium-Relative Commodity Price with trade
(Figure 2.3, text book, on page of 46)

86. That's all for this Topic.
Thank You!

87. Trade with the PPF model
This increased production would allow each country to consume at a point outside of its PPF as indicated by the blue lines in the graphs.
The increased consumption is the gains from trade.
(110W, 70C)
Production
Production
(70W, 50C)