International Economics: Learning Goals

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CHAPTER T W O
2 International Economics
Eleventh Edition
The Law of Absolute & Comparative

Advantage
Dominick Salvatore
John Wiley & Sons, Inc.
Salvatore: International Economics, 11th Edition © 2013 John Wiley & Sons, Inc.
Learning Goals:
 Understand the law of absolute &
comparative advantage.
 Understand the relationship between

opportunity costs and relative commodity
prices.
 Explain the basis for trade and show the gains

from trade under constant cost conditions.
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Introduction
 Basic questions:
 What is the basis for trade?
 What are gains from trade?
 What is the pattern of trade?
 Assume two-nation, two-good world
Different Trade Theories
1. What is the basis for trade?

Reasons countries trade goods with each other
include:
 Differences in the technology used in each country (i.e.,
differences in each country’s ability to manufacture
products)
 Differences in the total amount of resources (including labor,

capital, and land) found in each country
 The proximity of countries to each other (i.e., how close they

are to one another)
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Concerns of Trade Theory
The classical theory of international trade is

concerned with the following three questions:
2. What are the gains from trade?

 In other words, if countries benefit from
international trade, where do the gains
come from, and how are they divided
among the trading countries?
© Palmatier
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Concerns of Trade Theory
The classical theory of international trade is

concerned with the following three questions:
3. What is the structure/pattern of trade?
In other words, which goods/services are
exported, and which are imported?
What are the fundamental laws that govern
international allocation of resources and the
flow of trade?
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Different Trade Theories
Understanding the Gains from

International Trade
Nations (or firms in different nations) trade
with each other because they benefit from it!
We can divide the different trade theories in four

categories...
 Early Trade Theory: Mercantilists
 Classical Trade Theory: Ricardian Model
 Modern Trade Theory: Heckscher-Ohlin Model
 Alternative Approaches to Trade Theory
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The Mercantilists’ Views on Trade
 Mercantilism
 Economic philosophy in 17th and 18th
centuries, in England, Spain, France, Portugal
and the Netherlands.
 Belief that nation could become rich and

powerful only by exporting more than it
imported.
 Mercantilism advocates government
intervention to achieve a surplus in the
balance of trade
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 Mercantilism
 Export surpluses brought inflow of gold and
silver.
 Trade policy was to encourage exports and
restrict imports.
 One nation gained only at the expense of
another.
 It views trade as a zero-sum game - one in
which a gain by one country results in a loss
by another
 Mercantilists measured wealth of a nation by

stock of precious metals it possessed.
 Today, we measure wealth of a nation by its

stock of human, man-made and natural
resources available for producing goods and
services.
 The greater the stock of resources, the greater the
flow of goods and services to satisfy human
wants, and the higher the standard of living.
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International Trade Theory: Absolute Advantage
Adam Smith argued that a country has an absolute

advantage in the production of a product when it is more
efficient than any other country in producing it
According to Smith, countries should specialize in the

production of goods for which they have an absolute
advantage and then trade these goods for the goods produced
by other countries
In 1770s, Adam Smith argued that import restrictions would
reduce the gains from specialization and make a nation
poorer. He used absolute advantage to explain the benefits of
trade.
© Palmatier
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Trade Based on Absolute Advantage:

Adam Smith
 A nation has absolute advantage over another

nation if it can produce a commodity more
efficiently.
 When one nation has absolute advantage in

production of a commodity, but an absolute
disadvantage with respect to the other nation in a
second commodity, both nations can gain by
specializing in their absolute advantage good and
exchanging part of the output for the commodity
of its absolute disadvantage.
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Adam Smith
 Examples:
 Canada is efficient in growing wheat, inefficient
in growing bananas.
 Nicaragua is efficient in growing bananas,
inefficient in growing wheat.
 Canada has absolute advantage in wheat,
Nicaragua has absolute advantage in bananas.
 Mutually beneficial trade can take place if both
countries specialize in their absolute advantage.
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Adam Smith
 Specialization and trade benefit both

countries.
 Adam Smith and other classical economists
advocated a policy of laissez-faire, or
minimal government interference with
economic activity.
 Free trade would cause world resources to be
utilized most efficiently, maximizing world
welfare.
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Adam Smith
U.S. U.K.
Wheat (bushels/hour) 6 1
Cloth (yards/hour) 4 5
 U.S. has an absolute advantage over U.K. in wheat.

 U.K. has an absolute advantage over U.S. in cloth.
 Both nations can gain from specializing in
production and then trading.
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Trade Based on Comparative Advantage:

David Ricardo
 Law of Comparative Advantage

 Even if one nation is less efficient than (has
absolute disadvantage with respect to) the
other nation in production of both
commodities, there is still a basis for mutually
beneficial trade.
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David Ricardo
U.S. U.K.
U.S. U.K.
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David Ricardo
U.S. U.K.
 U.K. has an absolute disadvantage in both goods.

 Since U.K. labor is half as productive in cloth but
six times less productive in wheat compared to
U.S., the U.K. has a comparative advantage in cloth.
 U.S. has a comparative advantage in wheat.
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The Case of No Comparative Advantage
U.S. U.K.
U.S. U.K.
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The Case of No Comparative

Advantage
 There is one (not very common) case where there is
no comparative advantage. This occurs when the
absolute disadvantage that one nation has with
respect to another nation is the same in both
commodities.
 For example, if one hour produced 3W instead of 1W
in the United Kingdom (see Table 2.2), the United
Kingdom would be exactly half as productive as the
United States in both wheat and cloth.
 The United Kingdom (and the United States) would
then have a comparative advantage in neither
commodity, and no mutually beneficial trade could
take place.
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REVIEW
U.S. U.K.
U.S. U.K.
U.S. U.K.
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Comparative Advantage and

Opportunity Costs
 The original idea of comparative advantage

was based on the labor theory of value:
 The value or price of a commodity depends
exclusively on the amount of labor used to
produce it.
 Can use the opportunity cost theory to
explain comparative advantage:
 The opportunity cost of a good is the amount of a
second good that must be given up to release just
enough resources to produce one additional unit
of the first good.
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Opportunity Costs
 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).
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Opportunity Costs
U.S. U.K.
Opportunity cost U.S. U.K.
(Autarky)
Wheat 1W = 2/3C 1W = 2C
 In which country, the opportunity cost of wheat is

lower?
 Which country has a comparative advantage over
the other country in wheat?
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The Gains from Trade
 Both countries can gain from trade by each

specializing in the production and exporting
of the commodity of its comparative
advantage.
 The US gains as long as 6W trade for more
than 4 C.
 The UK gains as long as 2C trades for more
than 1 W.
 Thus the range for mutually beneficial trade
is: 4C < 6W <12C
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The Production Possibility Frontier

under Constant Costs
 Opportunity costs can be illustrated with the
production possibility frontier, or
transformation curve
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US UK
Wheat ∆ W Cloth ∆C Wheat ∆ W Cloth ∆C
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
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US UK
Wheat ∆ W Cloth ∆C Wheat ∆ W Cloth ∆C
180 0 60 0
150 -30 20 20 50 -10 20 20
120 -30 40 20 40 -10 40 20
90 -30 60 20 30 -10 60 20
60 -30 80 20 20 -10 80 20
30 -30 100 20 10 -10 100 20
0 -30 120 20 0 -10 120 20
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Opportunity U.S. U.K.
cost
(Autarky)
Wheat 30W = 20C 10W = 20C
=> 1W = 2/3C => 1W = 2C
Constant Constant
opportunitity cost opportunitity cost
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 Production Possibilities Frontier
 Slope: downward or upward?
 Line: straight or curve?
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FIGURE 2-1 The Production Possibility Frontiers of the

United States and the United Kingdom.
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Opportunity Costs and Relative

Commodity Prices
 We have seen that the opportunity cost of
wheat is equal to the amount of cloth that the
nation must give up to release just enough
resources to produce one additional unit of
wheat.
 This is given by the (absolute) slope of the
production possibility frontier, or
transformation curve, and is sometimes
referred to as the marginal rate of
transformation
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Commodity Prices
 Figure 2.1 shows that the (absolute) slope of
the U.S. transformation curve is 120/180 =
2/3 = opportunity cost of wheat in the United
States and remains constant.
 The slope of the U.K. transformation curve is
120/60 = 2 = opportunity cost of wheat in the
United Kingdom and remains constant.
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Commodity Prices
 On the assumptions that prices equal costs of
production and that the nation does produce
both some wheat and some cloth, the
opportunity cost of wheat is equal to the price
of wheat relative to the price of cloth (PW /PC).

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Commodity Prices
 PW /PC = 2/3 in the United States, and inversely
PC /PW = 3/2 = 1.5. In the United Kingdom, PW
/PC = 2, and PC /PW = 1/2.
 The lower PW /PC in the United States (2/3 as
opposed to 2) is a reflection of its comparative
advantage in wheat.
 Similarly, the lower PC /PW in the United
Kingdom (1/2 as opposed to 2/3 ) reflects its
comparative advantage in cloth.
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Opportunity Costs
 Production Possibilities Frontier

 A curve that shows alternative combinations of
the two commodities a nation can produce by
fully using all resources with best available
technology.
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Constant opportunity costs
 Constant opportunity costs arise when:

 Resources are either perfect substitutes for
each other or used in fixed proportion in
production of both commodities, and
 All units of the same factor are homogeneous.
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Constant opportunity costs
 the same amount of one commodity must be

given up to produce each additional unit of the
second commodity.
 Although opportunity costs are constant in each
nation, they differ among nations, providing the
basis for trade.
 Constant costs are not realistic, however.
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The Basis for and the Gains from Trade under

Constant Costs
 In the absence of trade, a nation’s production

possibilities frontier also represents its
consumption frontier.
 Increased output resulting from
specialization and trade represents nations’
gains from trade, allowing nations to
consume outside production possibilities
frontier.
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FIGURE 2-2 The Gains from Trade.
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Constant Costs
 Under constant cost conditions, nations will

completely specialize in their comparative
advantage .
 With complete specialization in both nations,
the equilibrium-relative commodity price of
each commodity lies between the pretrade
relative commodity price in each nation.
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FIGURE 2-3 Equilibrium-Relative Commodity Prices with

Demand and Supply.
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Constant Costs
 Suppose that world demand for wheat

intersects world supply in the portion of the
supply curve between zero and B in the left
panel of the previous graph.
 Then trade takes place at the pretrade price in
the U.S., which will not completely specialize,
and all the gains from trade accrue to the U.K.
 This is the small country case, demonstrating
“the importance of being unimportant.”
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 Copyright 2013 John Wiley & Sons, Inc.
 All rights reserved. Reproduction or translation of this work beyond

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Permissions Department, John Wiley & Sons, Inc. The purchaser may
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29/11/2020

The Law of Absolute & Comparative

 Understand the relationship between

 Explain the basis for trade and show the gains

 What are gains from trade?

 What is the pattern of trade?

 Assume two-nation, two-good world

Different Trade Theories

1. What is the basis for trade?

 Differences in the total amount of resources (including labor,

 The proximity of countries to each other (i.e., how close they

Concerns of Trade Theory

The classical theory of international trade is

2. What are the gains from trade?

Concerns of Trade Theory

The classical theory of international trade is

Different Trade Theories

Understanding the Gains from

We can divide the different trade theories in four

The Mercantilists’ Views on Trade

 Belief that nation could become rich and

The Mercantilists’ Views on Trade

The Mercantilists’ Views on Trade

 Mercantilists measured wealth of a nation by

 Today, we measure wealth of a nation by its

International Trade Theory: Absolute Advantage

Adam Smith argued that a country has an absolute

According to Smith, countries should specialize in the

Trade Based on Absolute Advantage:

 A nation has absolute advantage over another

 When one nation has absolute advantage in

Trade Based on Absolute Advantage:

Trade Based on Absolute Advantage:

 Specialization and trade benefit both

Trade Based on Absolute Advantage:

 U.S. has an absolute advantage over U.K. in wheat.

Trade Based on Comparative Advantage:

 Law of Comparative Advantage

Trade Based on Comparative Advantage:

Trade Based on Comparative Advantage:

 U.K. has an absolute disadvantage in both goods.

The Case of No Comparative Advantage

The Case of No Comparative

Comparative Advantage and

 The original idea of comparative advantage

Comparative Advantage and

 Consequently, the nation with the lower

Comparative Advantage and

 In which country, the opportunity cost of wheat is

The Gains from Trade

 Both countries can gain from trade by each

The Production Possibility Frontier

The Production Possibility Frontier

The Production Possibility Frontier

The Production Possibility Frontier

The Production Possibility Frontier

The Production Possibility Frontier

FIGURE 2-1 The Production Possibility Frontiers of the

Opportunity Costs and Relative

Opportunity Costs and Relative

Opportunity Costs and Relative

Opportunity Costs and Relative

Comparative Advantage and