COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE AND FACTOR MOBILITY 137

CHAPTER 8
COMPARATIVE ADVANTAGE, INTERNATIONAL
TRADE AND FACTOR MOBILITY

In previous chapters we studied how

producers and households interact with each
8.1 Ricardo's Theory of
other in product and factor markets. We can
Comparative Advantage
think of such interaction as trade between

and Benefit from Trade

producers and households, in the sense that
each party has something to offer to the
8.2 Factor Endowment
other. Not only producers and consumers
Theory of International
within a country trade with each other, the

Trade
countries themselves, i.e., consumers and
producers across countries, trade/exchange

8.3 Factor Mobility

with each other in goods and services. This
is called international trade. As an example
of trade in goods, India exports tea to the
rest of the world and imports petrol. Many
foreign banks today offer banking services
in India, which is an example of trade in
services.
In this chapter, our objective is to learn
some fundamentals of international trade.
This is very important, because countries, in
general, are much more interdependent today
than they were 30 or 40 years ago.
In the process, we learn a very important
concept in economics, called comparative
advantage. Through this concept, we will
understand that promoting international
trade is not a bad thing, and, it is not true
that, if one country gains from it, some other
country has to lose. On the contrary, we will
138
learn that trading with each other is,
by and large, a mutually beneficial
activity.
The idea behind comparative
advantage (to be defined in Section 8.1)
and gains from trade can be
understood through this example.
Suppose that you are a very good pop
singer and a very good cook. But you
are much more productive as a singer
than as a cook. This is in the sense
that if you sing you get Rs. 5,000 per
hour, whereas you can hire an
excellent cook at the rate of Rs. 300
per hour, i.e., if you cook, you save
Rs. 300 per hour. One option for you
will be to pursue a singing career and
still cook for yourself be self-
sufficient, so-to-speak. That is, you
are capable of doing both and you
actually choose to do both. Consider
now the alternative option of hiring a
cook and engaging yourself full time
in singing. Which option will you
prefer? Surely, the latter. Now think
about this example in a different light.
The option to do both activities is like
choosing not to do trade between your
service as a cook and your service as
a singer. The latter option is like
importing the service that you do not
have comparative advantage in (that
is, cooking) and, specialising and
exporting the service you have
comparative advantage in (that is,
singing).
What applies for an individual in
the above example also applies to a
country. A country, in comparison
to producing all goods it can produce
and not trading, is better off by
INTRODUCTORY MICROECONOMICS
(a) producing more of the goods which
it can produce relatively cheaply and
exporting part of them and (b)
producing less possibly none of the
goods which it cannot produce
relatively cheaply compared to other
countries and importing them. This is
the idea behind comparative
advantage. Put differently, it implies
that countries can trade and benefit
by exploiting their differences. In
simpler language, it means that you
and I are different, I have something
which you want but cannot obtain that
easily, and you have something that I
want but cannot get that easily;
both are better off by trading with
each other.
This principle was first
demonstrated formally by a famous
English economist, named David
Ricardo. In what follows, we first
discuss Ricardos theory of
comparative advantage. It is the
simplest and yet a very elegant
exposition of how international trade
can be beneficial to a country.
Although Ricardo wrote about it
almost two hundred years ago (in the
early 19th century), its relevance is felt
even today.
As we will see, Ricardos theory of
comparative advantage and trade is
based on differences in technology
across countries. We also consider
another source (basis) of comparative
advantage, namely, differences in
factor supplies across countries. The
next two sections study these
alternative sources of comparative
advantage.
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
International trade refers to
movement of goods and services. In the
real world, not only goods and services,
but also factors of production move
from one place to another. The chapter
ends with a discussion of movement
of factors.
8.1 RICARDOS THEORY OF
COMPARATIVE ADVANTAGE
AND BENEFIT FROM TRADE
We will make a number of simplifying
assumptions so as to clearly bring out
the essence of this theory. Assume that
there are two countries in the world:
India (N) and Australia (A). Each can
produce two goods, say, cricket bats
and footballs. Perfect competition
prevails in the market for each good.
There is one factor of production, say,
labour (L). Each country is endowed
with a given supply or what is called
endowment of labour, say LN = 100
and LA = 120 respectively for India and
Australia. Furthermore, the labour
required to produce one unit of output,
or what is called the labour coefficient,
is given in each sector. As a numerical
example, suppose that
Producing 1 cricket bat in India
requires 10 units of labour
Producing 1 football in India
requires 20 units of labour
Producing 1 cricket bat in Australia
requires 15 units of labour.
Producing 1 football in Australia
requires 60 units of labour
1
In turn, this means constant marginal physical product of labour.
AND FACTOR MOBILITY 139
This is written more compactly in
Table 8.1.
Table 8.1 Labour Coefficients
India Australia
Cricket Bats 10 15
Footballs 20 60
In terms of concepts introduced in
Chapter 3, the average physical
product of labour is the inverse of the
labour coefficient. Thus, labour
coefficient being given means constant
average physical product of labour or
constant output per worker.1
We are almost ready to define
comparative advantage.
8.1.1 Absolute Advantage and
Comparative Advantage
Between two countries, one is said to
have absolute advantage in a good if
it can produce that good absolutely
more efficiently than the other country.
A country is said to have comparative
advantage in a good if it can produce
it relatively more efficiently or relatively
less inefficiently, compared to the
other country.
We now apply these definitions to
Table 8.1 and say that India has
absolute advantage in producing both
goods, and Australia in none. Because,
in the production of either good, labour
required to produce one unit is less
in India than in Australia. More
importantly for us, let us determine who
140
has comparative advantage in what.
See that, in India, the labour coefficient
ratio of the football sector to the cricket
sector is 20/10 = 2, whereas, in
Australia, the same ratio is 60/15 = 4.
Hence, in India, labour is relatively more
productive or efficient in the football
sector. Therefore, India, has
comparative advantage in producing
footballs. Although Australia is less
efficient in producing both goods, it is
relatively less so in producing cricket
bat. Hence Australia has comparative
advantage in producing cricket bats.
By definition, both countries cannot
have comparative advantage in
producing the same good.
8.1.2 Production Possibility Curves
Given the labour coefficients and the
labour endowment in each country, we
can draw the Production Possibility
Curve (PPC) for each country. This will
serve as a background to analysing
how international trade affects an
economy.
Recall from Chapter 1 the concept
of marginal opportunity cost along a
PPC. It says how much of one good has
to be sacrificed to ensure a unit
increase in the production of the other.
Consider India for instance. Suppose,
starting from a given allocation of
labour between the football sector and
the cricket bat sector, the production
of football increases by one unit. From
Table 8.1, this requires additional
labour equal to 20 (since this is labour
coeffcient in producing football). As 20
units of labour leave the cricket bats
sector to produce one extra football, by
INTRODUCTORY MICROECONOMICS
how much will the production of cricket
bats fall? It is equal to 20 divided by
the labour coefficient in producing
cricket bats (that is, 10). This gives
20/10 = 2 cricket bats as the marginal
opportunity cost of football.
Note that the marginal opportunity
cost of football is constant (equal to 2
cricket bats) at any initial allocation
of resources, because the labour
coefficients are constant. You can
similarly calculate that cost in
Australia, which is also constant,
equal to 60/15 = 4. Thus labour
coefficients being given imply that the
marginal opportunity cost of either
good along the PPC is constant. In turn,
from Chapter 1, we know that constant
marginal opportunity cost implies a
straight line PPC. Hence the PPC is a
straight line in a Ricardian economy.
Fig. 8.1 shows the PPCs of India and
Australia. Recall that Indias
endowment of labour is 100, i.e.,
LN =100. If all its labour resources are
used in producing football, they will
produce 100/20 = 5 footballs. If,
instead, they are all used in producing
cricket bats, they will produce
100/10 = 10. These points are
respectively marked on the football axis
and cricket bat axis in fig. 8.1(a). The
straight line, DE, joining these two
points is the PPC of India. The PPC of
Australia, GH, is derived in a similar
manner, which is shown in fig. 8.1(b).
8.1.3 No Trade
In order to see how international trade
makes a difference, suppose that
initially there is no trade between the
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
(a) India
Fig. 8.1 The Production Possibility Curves
two countries. There are four important
points to note for the world economy,
in which there is no trade.
1. Since there is no opportunity to
trade, in each country, the
consumption of a good cannot
exceed how much of that good is
produced. In other words, the
consumption possibilities are
limited to the PPC, i.e., the country
cannot consume at any point
outside its PPC. We can say that
the PPC is equal to a countrys
consumption possibility curve. In
our example, it is DE for India and
GH for Australia.
2. It will also be useful to know the
relative price of one good in terms
of the other in each country. What
do we mean? Recall that both
goods are produced in competitive
markets. From Chapter 6, we know
that, under perfect competition,
free entry and exit imply zero profits.
AND FACTOR MOBILITY 141
(b) Australia
Thus, in each sector, price will be
equal to the average cost. In this
economy, the average cost of a good
is equal to the wage rate times the
labour required to produce one unit
of the good. For example, let WN be
the wage rate in India. Then the
average cost of, say, football is Rs.
WN 20. This will be equal to the
price of football, say PF. Similarly, PC
= Rs. WN 10, where PC is the price
of cricket bats. Thus the relative
price of football is equal to PF/PC =
WN 20/(WN 10) = 2. That is, if
you have a football, sell it in the
market and use the money to buy
cricket bats, you will get 2 cricket
bats. The relative price of cricket
bats is the inverse of that of
football, equal to 1/2. In general,
the relative price of a good is
defined in terms of some other good
and is equal to the amount of the
142
other good that one gets in
exchange for one unit of the good
in question. Put differently, it is an
exchange ratio between goods. We
then have the exchange ratio in
India in the no-trade situation
equal to
2 cricket bats for 1 football.
You can similarly calculate the
exchange ratio in Australia:
4 cricket bats for 1 football.
We can call these the domestic
exchange ratios.
3. Notice that the relative price of a
good in each country is equal to
its marginal opportunity cost (as
price is equal to marginal cost
under competitive conditions). In
Australia for example, the
relative price of football is 4
cricket bats and the marginal
opportunity cost of football is
also 4 cricket bats.
4. Also notice from the exchange
ratios that football is relatively
cheaper in India, which has
comparative advantage in
producing football, and cricket
bats are relatively cheaper in
Australia, which has comparative
advantage in producing cricket
bats. This is intuitive.
The stage is ready now to
understand the effect of international
trade.
8.1.4 Effect of International Trade
Let India and Australia now open up
trade. Further, let there be free trade,
i.e., no restrictions like trade taxes or
any limits on how much a country can
INTRODUCTORY MICROECONOMICS
export or import etc. Also, assume
that there is no transport cost of
moving goods between the two
countries. (We make these strong
assumptions, not because they are
critical for our argument, but because
they help us to see the effect of trade
very clearly.)
The above assumptions imply that
the exchange ratios or the relative price
of a good will be the same in the two
countries. It is because, if a good is
cheaper in one country than in the
other, every one in both countries will
buy the product from the former
country and this will push its price up.
In equilibrium, the exchange ratios will
be the same. We can call this the world
exchange ratio or what is called the
world terms of trade.
Range of World Terms of Trade
The next question is: what will be the
equilibrium world terms of trade?
Terms of trade, in general, refer to a
relative price and we know from
Chapter 5 that the equilibrium price
of a good is determined by supply and
demand forces. The supply side of an
economy is represented by the PPC of
a country. But we do not have any
information on the demand side.
Hence, we cannot determine the world
terms of trade exactly.
We can, however, find its range: it
will lie in between the domestic
exchange ratios. In this example, it
means that the world relative price of
football will be in between 2 and 4
cricket bats. It cannot exceed 4 or fall
short 2. Why? Suppose it exceeds 4, say
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
1 football for 5 cricket bats. Then, in
both countries, a football fetches more
than it fetches in the no-trade situation
and thus both would like to export
football. But this is not possible, since
there is no third country they can both
export to: by definition, the two
countries comprise the world economy.
(When there are more than two
countries, you can group them into the
home country and the rest of the
world and the same argument holds.)
You can similarly argue that if the world
terms of trade are 1 football for
something less than 2 cricket bats, both
countries would want to import football
and that is not possible. This proves
that the equilibrium world terms of
trade will lie between the domestic
exchange ratios. Assume that the world
terms of trade lie strictly in between
the two domestic exchange ratios. As
an example, suppose that they are
equal to
1 football for 3 cricket bats.
Specialisation
Now think about how much of each
good will be produced in the two
countries. From the viewpoint of India,
the relative price of football is 3 cricket
bats, which is greater than its the
marginal opportunity cost (equal to 2
cricket bats). This will mean that there
are abnormal profits in the football
sector. Hence resources (labour) will
move out of the cricket bat sector to
the football sector. This process will
continue until there is no production
of cricket bats in India. That is, India
specialises in football, i.e. produces
AND FACTOR MOBILITY 143
football only. Mark that football is the
good, in the production of which India
has comparative advantage. By similar
argument, Australia specialises in
cricket bats, in which it has
comparative advantage. Specialisation
occurs as the world terms of trade are
different from the domestic exchange
ratio. This is shown in fig. 8.2, which
graphs the same PPCs as in fig. 8.1
(shown by the dashed lines). Indias
and Australias production points in
free trade are shown at points D and
H respectively.
We can then summarise that in the
Ricardian world economy, as long as
the world terms of trade differ from the
domestic exchange ratio, a trading
country specialises in the good, in the
production of which it has comparative
advantage. This is how international
trade affects production and resource
allocation in an economy.
Consumption Possibilities
Now we come to the last stage of our
discussion. What are the consumption
possibilities facing the two countries
and how do they benefit from trade? But
before we address this question, we
should know what we mean by exports
and imports. Exports of a commodity
are equal to its production minus its
consumption, whereas imports of a
commodity are equal to its
consumption minus its production. In
other words, if a good is exported
(imported), then its production exceeds
(falls short of) its consumption in the
country.
144
(a) India
Fig. 8.2 Free International Trade in the Ricardian Economy
In fig. 8.2, since India produces at
D, one consumption possibility for her
is the point D itself. But there are other
possibilities. For instance, it can export
one football in exchange for 3 cricket
bats (all imported), or 2 footballs in
exchange for 6 cricket bats (all
imported) and so on. These
possibilities give rise to the heavy line
DE', whose slope is 3, equal to the
relative price of football in the world
market. 2 Put differently, the
consumption possibility curve for India
at the world terms of trade, equal to 1
football for 3 cricket bats, is the heavy
line DE'. This situation is surely a
better proposition for India than no
trade, which only offered the
consumption possibilities along the PPC
2
The concept of slope of a straight line is explained in Appendix 2.
INTRODUCTORY MICROECONOMICS
(b) Australia
that lies to the left of or inside the line
DE'. Alternatively, you can see that for
every possible consumption point in the
no-trade situation, e.g., A, except the
corner points on the PPC, there is at least
one point on DE', which guarantees
more consumption of each good. Hence,
free trade must be preferred to no trade.
By similar argument, Australias
consumption possibility curve is now
the heavy line G'H, whose slope is also
equal to 3, the relative price of football
in the world market. The line G'H lies
outside Australias PPC. Thus
Australia also benefits from free trade.
Note that, irrespective of which
consumption points on DE' and G'H are
chosen, India exports footballs and
Australia exports cricket bats. That is,
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
each country exports the good it
has comparative advantage in. This
is a very general principle of
international trade.
The lesson to be learnt from the
Ricardian theory is that a country
benefits from international trade by
specialising and exporting the
products that it has comparative
advantage in. This is true even when
a country is more efficient in
producing all goods in an absolute
sense.
8.2 FACTOR ENDOWMENT THEORY
OF INTERNATIONAL TRADE
In the Ricardian theory, it is the
difference in technology that forms
the basis of comparative advantage
and mutually beneficial trade.
Otherwise, if the ratio of labour
coefficients is the same between the
two countries, then the domestic
exchange ratios will be the same; no
country will have comparative
advantage in producing any good
and there will be no reason to trade.
Even if international trade is opened
between the two countries, nothing
will change in any country.
However, technology differences are
not only basis for comparative
advantage and trade. Differences in
relative factor endowment (to be defined
in a moment) form another major basis
for comparative advantage. The theory
3
It was formulated originally by two Swedish economists, Eli Heckscher and Bertil Ohlin, and is
called the Heckscher-Ohlin theory.
4
It is not that the technology cannot differ between countries. But the idea here is to suppress such
difference and focus on difference in factor endowments.
AND FACTOR MOBILITY 145
that brings out this point is called the
factor endowment theory.3
View the world as having two
countries once again, say, India (N) and
America (A). They produce two goods:
Chairs (C) and Medicine (M). Instead of
one factor of production, suppose that
there are two, labour and capital. They
are required in producing each of these
two goods. There are constant returns
to scale. Furthermore, the technology
of producing either good is same
between India and America and the
production of chairs is relatively labour-
intensive and that of medicine is
relatively capital-intensive.4 All markets
are perfectly competitive.
Suppose that the supply of each
factor in each country is given. We can
call these factor endowments, just like
labour endowment in the Ricardian
theory.
8.2.1 Factor Endowment Difference
Let LN and KN denote the endowments
of labour and capital in India.
Likewise, let L A and KA denote the
endowments of labour and capital in
America. These are absolute factor
endowments. The ratio of absolute
endowments is called the relative
factor endowment. For example,
LN/KN is the relative endowment of
labour in India.
Having defined relative endowment,
we can always compare it between
countries. In our example, we say that
146
India is the relatively labour-abundant
country and America is the relatively
capital-abundant country, if
LN LA
( A) .5
KN KA
Let us assume this, since it is
reasonable to suppose that India is a
relatively labour-abundant country,
compared to America.
8.2.2 Factor Price Difference
What does this difference in relative
factor endowment imply for factor
prices? We first define two terms:
absolute factor price difference and
relative factor price difference. In
general, we say that there is an
absolute factor price dif ference
between two regions or countries if the
reward (price) of a factor dif fers
between the two regions or countries
in absolute terms. For instance, if
labour earns wage equal to Rs. 50 per
day in India and Rs. 200 per day in
America, we say that there is an
absolute wage difference and the wage
rate is less in India than in America.
Similarly, there can be an absolute
difference in the rental rate of capital
between the two countries.
Given our ranking of the relative
endowment in (A), can we say anything
about absolute factor price differences
between India and America? The
answer is no, because the ranking (A)
does not say anything about absolute
endowment levels. But it can say
5
For example, let LN = 1, 500, KN = 500, LA=2,000 and KA = 1000. Then LN/KN = 3, LA/KA = 2, and thus
L N/K N>L A/K A.
INTRODUCTORY MICROECONOMICS
something about relative factor price
difference, where relative factor price is
defined as the ratio of factor rewards.
Suppose that, in America, labour
earns wage equal to Rs. 200 and capital
earn rental equal to Rs. 1,000. In India,
let the wage rate and the rental to
capital be Rs. 100 and Rs. 900
respectively. Thus, the two absolute
factor rewards are less in India. But,
relatively speaking, the wage/rental
ratio is greater in America. It is 1/5 there
and 1/9 in India. In this case, we say
that relative reward (price) of labour is
greater in America and the relative
reward of capital is greater in India.
Indeed, our relative factor ranking (A)
implies this. How?
Our analysis of factor price
determination in Chapter 7 comes into
play. Let us invoke a result from that
chapter which states that, greater the
supply of a factor, the lower is its reward.
In the present context, it implies that,
since India (respectively America) is
relatively labour (respectively capital)
abundant, the wage/rental ratio in India
will be less than that in America. In
other words, India is the relatively low-
wage country and America is the
relatively high-wage country.
8.2.3 Comparative Advantage
We now proceed to analyse how the
dif ference in the relative factor
endowment and the resulting
difference in the relative factor price
determine the flow of goods between the
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE
two countries. Ask yourself which good
will be produced more efficiently (i.e.
with lower cost) in the low wage/rental
ratio country and in the high wage/
rental ratio country. Remember that the
production technology of chairs (C) is
labour-intensive and that of medicines
(M) is capital-intensive. The answer is
that the labour-intensive good C will be
produced relatively more efficiently in
the relatively low-wage, labour -
abundant country, and, the capital-
intensive good (M) will be produced
relatively more efficiently in the relatively
high-wage, capital-abundant country.
We can state this in terms of
comparative advantage. The relatively
labour-abundant, low wage/rental
ratio, country (India) will have
comparative advantage in producing
the relatively labour-intensive good.
The relatively capital-abundant, high
wage/rental ratio country (America)
will have comparative advantage in
producing the relatively capital-
intensive good.
8.2.4 International Trade
Thus far we have linked relative factor
endowment difference and relative
factor price difference to comparative
advantage. We next link comparative
advantage to international trade:
i.e.,compared to no trade, in free trade,
a country will produce more and
export the product, in which it has
comparative advantage.
Joining the two links now, we can
say that the relatively labour-abundant,
low wage/rental ratio, country (India)
will export the relatively labour-
AND FACTOR MOBILITY 147
intensive good (chair) and the
relatively capital-abundant, high
wage/rental ratio, country (America)
will export the relatively capital-
intensive good (medicine). This is how
the relative factor endowment difference
and the relative factor price difference
are linked to international trade.
You can reflect back to see that the
aforementioned result is quite
reasonable. This is the gist of the factor
endowment theory. It emphasises
relative factor endowment difference
as the basis of comparative
advantage and predicts that a country
will export those products which uses
its relatively abundant factor more
intensively.
Three remarks are in order.
1. Unlike the material in previous
chapters and our discussion of the
Ricardian theory, the factor
endowment theory has been
merely sketched. A specialised
course in international economics
will deal with this theory in more
detail.
2. In Chapter 7, we learnt that the
demand for a factor is called a
derived demand. This is because
changes in product markets affect
the demand for a factor. In
contrast, the factor endowment
theory illustrates how factor market
differences influence the product
market the pattern of flow of goods
between countries. Thus, a general
and an important point to be learnt
is that, in an economy, factor and
product markets are very much
interrelated.
148
3. Recall the central prediction of the
factor endowment theory. In our
example, India, the relatively
labour-abundant country, exports
relatively labour-intensive goods
and America, the relatively capital-
abundant country exports
relatively capital-intensive goods.
We can look at this conclusion in a
different light. India exporting
relatively labour-intensive goods
can be thought of as India
exporting the services of labour.
Likewise, America exporting
relatively capital-intensive goods
means that America is exporting
capital services. Put differently,
international trade in goods can be
seen as international trade in factor
services. This again shows how
interrelated goods and factor
markets are; it is as if factors are
moving internationally, although
they are not (in our analysis).
8.3 FACTOR MOBILITY
The very last point made brings us to
the very last topic to be analysed in
this book. That is, factors do move
between regions and countries. In our
country daily labour moves typically
from villages to towns. There are
thousands of workers from India who
are working in middle-east countries
like Kuwait and Yemen.
These are not the only instances
of mobility. Unskilled labour moves
from Mexico to America. Skilled
workers move typically from countries
like India and China to Europe and
America.
INTRODUCTORY MICROECONOMICS
We now ask why factors move the
way they do? Here, unlike in the factor
endowment theory, the absolute factor
price difference (already defined) plays
a role. As an example, we have already
noticed that in India daily labour
moves from rural to urban areas. Why
is this so? Because, there is an
absolute factor price difference. Given
such a difference, a factor moves from
the low-reward region to a high-reward
region. Daily labour earns more in an
urban area on an average than in a
rural area on an average. This induces
it to move from rural to urban areas.
However, the absolute factor price
difference or in this case the rural-
urban wage differential, is just an
immediate cause of factor/labour
migration, not the underlying cause.
This chapter and the book ends
with an investigation of why a rural-
urban wage differential exists.
We can think of this issue in terms
of demand and supply of a factor,
studied in Chapter 7. Indeed there are
differences in both demand and supply
sides, which explain the rural-urban
difference in daily wage.
First, there are more nucleus
families, as opposed to joint families,
in urban areas than in rural areas. In
many urban households, both
husband and wife work outside the
home. Hence there is a greater demand
for household services like cleaning,
cooking etc. Also, construction works
are more prevalent in urban than in
rural areas. Both these factors imply
higher demand for daily labour in
urban areas, compared to rural areas.
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE AND FACTOR MOBILITY 149

Second, the urban cost of living is

higher than the rural cost of living, so
that families of many daily workers
prefer to live in rural areas. This
implies that, ceteris paribus, the
supply of daily labour in towns is less
than in villages.
Both these factors together imply
that the urban wage must be higher.
We can see this in terms of fig. 8.3.
There are two demand curves. The one
to the right, DDB, can be interpreted
as the demand curve for daily labour
in the urban area and the one to the
left, DDR, can be thought of as that in
the rural area. There are also two
supply curves. The one to the left, SSB,
marks the supply curve in the urban
area and the one to the right, SSR,
marks that in the rural area. The
urban labour market equilibrium is
shown at the point EB where DDB and
SSB intersect. Likewise, the labour
market equilibrium in the rural area
occurs at the point ER where the curves
DDR and SSR intersect. As we can see
clearly, the urban wage, WB is greater
than the rural wage, WR.
Once we establish that there is an
absolute difference in wages, it is easy
to predict that labour wants to move
from a low-wage region to a high-wage
region.
Fig. 8.3 Urban and Rural Wage for Daily
Labour
We note that this is true not just for
unskilled labour but also for skilled
labour. Skilled workers want to move
out of countries like India and China
to the U.S. and Europe in order to earn
higher wage for their skill. Similarly,
capital, which earns less rental in
capital-abundant developed countries,
has an incentive to move (through
multinational firms) to capital-poor,
high-rental, developing countries.
We should carefully note however
that absolute factor price difference is
only an immediate cause or an
indicator of factor movement.
Regional differences or differences
between countries in demand and
supply conditions of factors are the
underlying cause of factor
movement.

SUMMARY
l The principle of comparative advantage implies that countries can benefit
from trade by exploiting their differences.
l In the Ricardian theory, differences in technology form the basis of
comparative advantage.
l Average physical product a factor is the inverse of its coefficient.
150 INTRODUCTORY MICROECONOMICS

l In the Ricardian economy, constant labour coefficients imply that the

marginal opportunity cost of a good, in terms of the other along the PPC,
is constant. This in turn implies that the PPC is a straight line.
l In the absence of trade, a countrys PPC is same as its consumption
possibility curve.
l The world terms of trade lie in between the domestic exchange ratios.
l In the Ricardian economy, a country specialises, in free trade, in the good
in which it has comparative advantage, as long as the world terms of
trade are different from the domestic exchange ratio.
l In the Ricardian economy, as long as the world terms of trade are different
from the domestic exchange ratio, the consumption possibility curve in
free trade lies outside its PPC.
l The Ricardian theory illustrates that a country benefits from international
trade by specialising and exporting the products that it has comparative
advantage in. This is true even when a country is more efficient in
producing all goods in an absolute sense.
l The differences in relative factor endowment also form a basis of
comparative advantage. This is captured by the factor endowment theory.
l A difference in the relative factor endowment causes a difference in the
relative factor price.
l A relatively labour (capital) abundant country will have comparative
advantage in relatively labour (capital) intensive goods.
l Factor endowment theory of trade predicts that a country will export the
products which use its relatively abundant factor more intensively.
l This prediction can also be interpreted as that a country exports the
services of its relatively abundant factor and imports the services of its
relatively scarce factor.
l Absolute factor price difference is the immediate cause, not the underlying
cause, of factor mobility. In turn, absolute factor price difference arises
because of variations in demand and supply factors in respective regions.
l Compared to rural areas, in urban areas, the daily wage rate is higher.
This is because of greater demand for daily labour and less supply of
daily labour in the urban areas.
l The greater demand for daily labour in urban areas stems from higher
demand for household work and construction projects. Higher cost of
living in urban areas implies less supply of daily labour in these areas, as
families of many daily workers prefer to live in rural areas.
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE AND FACTOR MOBILITY 151

EXERCISES

Section I
8.1 What is meant by international trade?
8.2 Give one example of international trade in services.
8.3 What is meant by labour coefficient?
8.4 Give the meaning of absolute advantage.
8.5 Give the meaning of comparative advantage.
8.6 What does the Ricardian theory emphasise as a basis of
comparative advantage?
8.7 In the Ricardian theory, which good does a country specialise
in free trade?
8.8 In the no-trade situation, what is the relationship between a
countrys PPC and its consumption possibility curve?
8.9 In the Ricardian theory, in the free-trade situation, what is the
relationship between a countrys PPC and its consumption
possibility curve?
8.10 What does the factor endowment theory emphasise as a basis
of comparative advantage?
8.11 What is meant by relative factor endowment difference?
8.12 What is meant by relative factor price difference?
8.13 What is meant by absolute factor price difference?

Section II
8.14 Give two examples of international trade in services.
8.15 Explain the concept of comparative advantage by using a
suitable example.
8.16 Explain that, in a two-country Ricardian world economy, both
countries cannot have comparative advantage in producing the
same good.
8.17 Explain how, in the Ricardian world economy, constant labour
coefficients imply that the PPC is a straight line.
8.18 In an economy, there is one factor of production, labour. Two
goods are produced: sitar and guitar. 5 units of labour is
required to produce one sitar and 12 units of labour is required
to produce one guitar. Determine the domestic exchange ratio
between sitars and guitars in this country.
8.19 The following table gives labour coefficients in the two sectors
in two countries. Determine which country has absolute
advantage and comparative advantage in which good.
152 INTRODUCTORY MICROECONOMICS

Popland Rockland
Sitar 50 60
Guitar 60 50

8.20 Refer to the previous question. Suppose technological progress

occurs in Popland. As a result, the labour coefficients are now
40 and 30 respectively for the sitar sector and the guitar sector.
Determine which country now has absolute and comparative
advantage in which good.
8.21 A Ricardian economy can produce two goods: tooth brush and
shoe brush. The labour coefficients in these two sectors are
respectively 30 and 90. Its labour endowment is equal to 1,800.
If the world terms of trade facing this country are 1 tooth brush
for 4 shoe brushes, determine how many tooth brushes and
shoe brushes this country will produce in free trade.
8.22 Differentiate (with example) between a capital-intensive good
and a labour-intensive good.
8.23 Explain absolute factor price difference. Why may it arise?
8.24 Explain relative factor price difference. Why may it arise?
8.25 Name two commodities which are relatively labour-intensive in
production.
8.26 Name two commodities which are relatively capital-intensive in
production.
8.27 Name two relatively labour-abundant countries.
8.28 Name two relatively capital-abundant countries.
8.29 The world consists of two countries: Blueland and Yellowland.
There are two factors, labour and land. They produce two
goods, apples and grapes. The production of apples is relatively
more land intensive compared to grapes. Suppose the
endowments in the two countries are as given in the following
table. If both countries engage in free trade with each other,
determine which country will export what.

Blueland Yellowland
Labour 50 60
Land 70 140

8.30 Give two instances where factors are mobile.

8.31 Name two labour-intensive commodities in India.
COMPARATIVE ADVANTAGE, INTERNATIONAL TRADE AND FACTOR MOBILITY 153

8.32 Suppose the supply of workers for household services declines

in the economy. How will it affect the urban and rural wage for
these services?

Section III
8.33 Explain why a relatively labour-abundant country will export
relatively labour-intensive goods.
8.34 Analyse why daily wage is higher in urban areas than in rural
areas.
8.35 Suppose that many of our computer professionals migrate to
foreign countries. Ceteris paribus, how will it affect the salary
of computer professionals in India and abroad?