Strategies for Global Value Added: Gains

Comparative advantage
© Professor Daniel F. Spulber
 Midea: Leading Chinese appliance
manufacturer
Every major manufacturer is producing air
conditioners in China for customers there.

Many of the major manufacturers are

exporting from their facilities in China.

These developments suggest that China has a

comparative advantage in the production
of air conditions and related appliances
relative to its trading partners.

How does this fit into the overall pattern of

exports and imports and the product mix?
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 International product mix

• How do you explain the mix of traded goods?

• How do you explain the location of production in a

particular country for a specific product or service?

• How do you explain the types of goods that are imported

to a particular country?

• What products should the international business provide?

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 A key task of the manager of the international
business is to identify gains from trade

• Coordinate serving and sourcing to maximize net gains

from trade -- these decisions are connected!

• Identify supplier countries and the products that they can

provide

• Identify customer countries and the products they need

• Profit by capturing some of the gains from trade

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 Specialization and division of labor

The division of labor generates

“the greatest improvement in the
productive powers of labor”

“the division of labor is limited by

the extent of the market”

So, greater trade means more

opportunities for greater
productivity
Adam Smith 1723-1790
The Wealth of Nations 1776
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 David Ricardo 1772-1823
Principles of Political Economy and Taxation 1817

“To produce the wine in Portugal, might require

only the labour of 80 men for one year, and to
produce the cloth in the same country, might
require the labour of 90 men for the same time. It
would therefore be advantageous for her to export
wine in exchange for cloth.
“This exchange might even take place, notwithstanding that the commodity
imported by Portugal could be produced there with less labour than in
England. Though she could make the cloth with the labour of 90 men, she
would import it from a country where it required the labour of 100 men to
produce it, because it would be advantageous to her rather to employ her
capital in the production of wine, for which she would obtain more cloth from
England, than she could produce by diverting a portion of her capital from the
cultivation of vines to the manufacture of cloth.”
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Differences in productivity and technology:
The theory of comparative advantage
• Absolute advantage of one
industry over the same industry in
another country is not the issue
• Comparative advantage means
that there are returns to each
country specializing in certain
activities
• Even if a country is better at both
producing clothing and computers
than another country, it is still
better for each to specialize a bit
more in one or the other activity

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 What to produce – computers or clothing?

• Comparative Advantage asks which country is relatively

better at computers than clothing in comparison with the
other country
• A country should focus more on computers than clothing if
transferring resources at the margin from clothing to
computers will yield greater returns than doing so in the
other country
• Correspondingly, the other country should focus more on
clothing (transferring some resources from computers to
clothing)
• There are some costs of transferring resources and
adjusting production

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 Comparative advantage

Sweaters Bicycles England has a

comparative advantage
England 24 18 in sweaters and France
has a comparative
France 6 12 advantage in bicycles

These are the productivities So, England would

of one unit of labor in each export sweaters to
country France and import
bicycles from France

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 Sweaters Bicycles
Comparative advantage
England 24 18

Find the productivity ratios for
each good
England compared to France for
each good:
Sweaters 24/6 = 4
Bicycles: 18/12 = 3/2
France 6 12
• England compared to France is
relatively more productive in
sweaters than bicycles
• England has a comparative
advantage in sweaters

• France has a comparative

The productivity ratio for
sweaters is greater than for advantage in bicycles
bicycles
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 Sweaters Bicycles
Comparative advantage
and gains from trade England 24 18

France 6 12
• Suppose that England exports 54 sweaters and
imports 72 bicycles

• For 72 bicycles, England can shift four units of labor

to sweaters since 72/18 = 4

• Shifting 4 units of labor to sweaters produces

4 x 24 = 96 sweaters, therefore England’s
net gain in sweaters: 96 - 54 = 42
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 Sweaters Bicycles

Comparative advantage and England 24 18

gains from trade
France 6 12
• France imports 54 sweaters. France can shift 9
units of labor to bicycles because 54/6 = 9

• Then France can produce 108 more bicycles since

12 x 9 = 108

• France’s net gain in bicycles:

108 - 72 = 36

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 Each country has a labor force of 20
Suppose that labor is evenly divided by sector.

Table showing total output and consumption

before trade takes place
Sweaters Bicycles

England 240 180

France 60 120

Totals 300 300

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 Each country has a labor force of 20. -- Total output rises
England shifts workers 4 from bicycles to sweaters
France shifts 9 workers from sweaters to bicycles

Table showing total outputs -- total outputs increase

Sweaters Bicycles

England 14 x 24 = 336 6 x 18 = 108

France 1x6= 6 19 x 12 = 228

Totals 342 336

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 Sweaters Bicycles

England 24 18
Table showing total
consumption after trade France 6 12

Sweaters Bicycles

England 336 - 54 = 282 108 + 72 = 180

France 6 + 54 = 60 228 - 72 = 156

Totals 342 336

England gets to consume more sweaters and France gets to
consume more bicycles
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 Trade and the product mix
Good 1 Good 2 Good 3

Country A gA1 gA2 gA3

Country B gB1 gB2 gB3

Prod. gA1/ gB1 gA2/ gB2 gA3/ gB3

ratios
Productivity of a unit of labor in each country
for each good.
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 Trade and the product mix
Production function: Zero profit condition:

QA1 = gA1 LA1 PA1 QA1 = WA LA1

PA1 = WA /gA1
Price of each good equals the unit cost of labor
This shows the tradeoff between the cost and
productivity of labor

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 Trade and the product mix

General rule: The low-price country exports and the

high-price country imports.

Country A supplies the good if PA1 < PB1.

Recall that prices equal unit labor costs:

PA1 = WA /gA1 PB1 = WB/gB1
So, Country A supplies the good if lower unit costs:
WA /gA1 < WB/gB1

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 Trade and the product mix
Country A supplies the good if

WA /gA1 < WB/gB1

which is the same as

WA / WB < gA1/gB1

Conclusion: Country with productivity ratio above

wage ratio is the exporting country.
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 Trade and the product mix

Example: Which country exports which good?

Good 1 Good 2 Good 3

Country A 10 45 28

Country B 5 9 7

Prod. 2 5 4
ratios
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 Trade and the product mix

Example: Which country exports which good?

Wages: WA = 18 WB = 6
Wage ratio: WA / WB = 3.

Productivity ratio greater than wage ratio:

Country A exports Good 2 and Good 3 to Country B.

Country A imports Good 1 from Country B.

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 Trade and the product mix
TECHNOLOGY CURVE: List the
gA/gB goods in decreasing order:

Country A supplies goods below X*

Good 2
Country B supplies goods above X*

Good 3
WA/WB

Good 1 gA/gB

X* X
Country A Country B
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 Effect of wage changes
on the product mix
gA/gB Relative wages increase
Relatively higher wages in Country A
Shift in product mix

W1A/W1B

WA/WB

gA/gB

X1 X* X
Country A Country B
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 Trade and the product mix

Table showing prices based on unit costs of labor

Good 1 Good 2 Good 3

Country A 18/ 10 18/ 45 18/ 28

Country B 6/ 5 6/ 9 6/ 7

Helps explain inter-country price differences

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 Managers should understand constant change in
opportunities for sourcing and serving

PHILIPPINES MALAYSIA
Comparative advantage keeps
12,000.0
changing: GDP per capita
in some Asian countries
KOREA THAILAND
10,000.0

8,000.0 INDONESIA CHINA

$ per Capita

6,000.0

4,000.0

2,000.0

0.0
1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1998 2001 2002

Year
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Managers should try to recognize effects of changes
in comparative advantage
Population movements in China reflect shift from
agriculture to industrial production

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 Effect of technological change
on product mix

gA/gB Lower labor requirements in

Country A cause shift in product mix
– even assortment of products
changes within in each country

WA/WB

gA/gB

X* X1 X
Country A Country B
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 Effect of costs of trade
on product mix

gA/gB Country A produces goods from 0 to X**

Country B’s produces goods above X*

Country B sees trade costs as

if wages rise in Country A
WA*/WB
Country A sees trade costs as
if wages rise in Country B
WA/WB*
gA/gB
Country A X* X** Country B X
exports Nontraded exports
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 Effect of lowering costs of trade

• Increases specialization of countries – for given

technology

• Reduces the range of nontraded goods

• Increases the range of traded goods

• Improves national incomes and increases total production

These effects define globalization!

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 Summary and take-away points
• Managers should understand how gains from trade
create value in international business

• The product mix is as much about demand patterns

as it is about production patterns

• Managers should consider costs of trade in

determining the product mix

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