International Trade Theory

Comparative Advantage
August 4, 2015

Mercantilists view on Trade

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Mercantilism
The body of writings prevailing during
the 17th and 18th cents. that postulated
that the way for a nation to become
richer was to restrict imports and
stimulate exports. Thus, one nation
could gain only at the expense of other
nations.

Trade based on absolute

advantage:
Adam Smith
Absolute advantage
The greater efficiency that one nation
may have over another in the
production of a commodity. This was
the basis of trade for Adam Smith.

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Trade based on comparative

advantage:
David Ricardo
Comparative advantage
It postulates that a nation should
specialize in and export the commodity
in which its absolute disadvantage is
smaller (this is the commodity of its
comparative advantage), and should
import the other commodity.

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5

Absolute Advantage
Cana
da

Comparative Advantage
PH

Canad PH
a

Wheat
(bushel/hour)

Wheat
(bushel/hour)

Cloth(yards/hour)

Cloth(yards/hour)

Comparative Advantage and

Opportunity Costs
Labor theory of value
The theory that the cost or price of a
commodity is determined by or cab be
inferred exclusively from its labor
content.

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Comparative Advantage and

Opportunity Costs

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Opportunity cost theory

The theory that 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 more
unit of the first commodity.

Production Possibility Frontier

with Constant Cost

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Opportunity costs can be

illustrated with the
production possibility frontier,
or transformation curve.
A curve showing the various alternative
combinations of two commodities that that
a nation can produce by fully utilizing all its
resources with the best technology
available to it.

Production Possibility For wheat and

Cloth
in the US and the UK
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United States

United Kingdom

Wheat

Cloth

Wheat

Cloth

180

60

150

20

50

20

120

40

40

40

90

60

30

60

60

80

20

80

30

100

10

100

120

120

Constant Opportunity Cost

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Arise when
1. resources or factors of production are
either perfect substitutes for each other
or used in fixed proportion in the
production of both commodities
2. all units of the same factor are
homogeneous or exactly the same
quality.