1. Chapter 2: The law of comparative advantage
Why do countries (or in fact everybody) trade, and what are the gains from trade ?
Development of trade theory
Classical trade theory – Smith and Ricardo
Neoclassical trade theory – Heckscher-Ohlin
Modern trade theory – imperfect competition

2. Thomas Munn (1571-1641) - mercantilism
Although a Kingdom may be enriched by gifts received, or by purchase taken from some other Nations, yet these are things uncertain and of small consideration when they happen. The ordinary means therefore to increase our wealth and treasure is by Foreign Trade wherein we must ever observe this rule; to sell more to strangers yearly than we consume of theirs in value. For …. that part of our stock (exports) which is not returned to us in wares (imports) must necessarily be brought home in treasure.

3. Adam Smith – Wealth of Nations 1776 http://www. adamsmith
It is the maxim of every prudent master of a family, never attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them from the shoemaker
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 from them with some part of the product of our own industry, employed in a way in which we have some advantage
Trade is not a zero sum game – everyone can win

4. Adam Smith – theory of absolute advantage
A country should produce and export a good if it can produce the good in a more efficient manner than other countries
Production process very simple – labour is the only factor input, and prices depend on labour hours only

5. Production per labour hour
Absolute Advantage
Production per labour hour
In the US
In the U.K.
Wheat (W) 6 1
Cloth (C) 4 5

6. Absolute Advantage
In this example, the U.S. has an absolute advantage in wheat and the U.K. in cloth.
The US should export wheat and import cloth. It will be in everyone's interest that countries specialise
Obviously correct, and probably some trade is happening along these lines

7. Absolute Advantage
However, the theory does not go very far – what will happen if a country does not possess an absolute advantage in the production of any good?
Enter David Ricardo and the theory of comparative advantage

10. David Ricardo: Principles of Political Economy and Taxation (1817)
Two men can both make shoes and hats, and one is superior to the other in both employments; but in making hats he can only exceed his competitor by one-fifth, or 20 %, and in making shoes he can excel him by one-third or 33-1/3%. Will it not be in the interest of both that the superior man should employ himself exclusively in making shoes, and the inferior in making hats?

11. Comparative Advantage
Production per labour hour
U.S.
U.K.
Wheat (W) 6 1
Cloth (C) 4 2

12. Comparative Advantage
Labour hours per unit of
U.S.
U.K.
Wheat (W)
1/6 1
Cloth (C)

13. Comparative Advantage
The U.K doesn't seem to have an advantage in anything – is there still a basis for trade ?
Where is the U.S. relatively most efficient, or the U.K. least inefficient ?
W: U.S. is 6 : 1 = 6 times as efficient C: U.S. is 4 : 2 = 2 times as efficient

14. Comparative Advantage
The U.S. has a comparative advantage in wheat, and the U.K. in cloth
The U.S. should export W to the U.K. in exchange for C
Another way to determine the pattern of comparative advantage – relative prices based on the labour theory of value

15. Relative prices Relative price of W (PW/PC) in the U.S.
= 1/6 / 1/4 = 2/3
Relative price of W (PW/PC) in the U.K.
= 1 / ½ = 2
The relative price of W is lowest in the U.S. – which then has a comparative advantage in W

16. Gains from trade – opportunity cost
For mutually beneficial trade to take place, the international relative price of W must lie between the autarky prices, that is between 2/3 and 2
Assume world relative price = 1
How can the US use 1 hour?
Produce 6 bushels of W or 4 yards of cloth
If 6 bushels of W is produced and exported to the U.K., gain is 6 – 4 = 2 yards of cloth

17. What about the U.K. ? How can the U.K. best use 1 hour ?
Produce 1 W or 2 C
Assume 2 yards of C is exported to the US in exchange for 2 bushels of W
Gain as opposed to own production is 1 – 1 = 1 unit of W

18. Terms of trade
What if the relative price of W falls to 2/3, i.e. the pre-trade relative price in the US ?
The U.K. will get 1,5 W in exchange for 1 C, and reap all benefits from trade
Price of export good/Price of import good = terms of trade

19. Production possibility curves

20. Gains from trade

21. Equilibrium commodity prices

22. Labour productivity and comparative advantage

23. Trade and unit labour costs