Trade with a technologically advanced

nation:
Theory of Comparative advantage

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Implicit assumptions of the absolute advantage theory:

1. Only labour productivity matters

2. Labour requirements do not change with scale of operation (CRF or CRS)
3. Competitive factor and product markets (low price comes from low cost)
4. No transportation costs
5. Advantage is based on productivity
6. Size of market, labour force is identical.
7. Demand is always large enough to maintain full employment
8. No labour migration, no capital inflows or outflows
9. Products trade only, no services trade, buyers and produces may remain
separated
10. Each nation has an advantage in production.

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Labour requirement for unit production
Which country has absolute
advantage in Textile?

Textile Television Which country has absolute

advantage in Television?
US 10 5

Sri Lanka 20 25

US has absolute advantage in both commodities

• Let us assume that both countries have identical labour resource of

100, the only difference is labour productivity or technology

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Comparative
advantage
Due to David Ricardo
Corn laws – tariff on corn imports – 1815
Repeal in 1846
Ricardo – member of British parliament – lived
till 1823. His theory of comparative advantage
was instrumental in repeal of Corn Laws… and
also behind modern day free trade treaties.
• 2 countries A, B 2 goods x and y
• Between country A and B, A has a comparative
advantage (CA) in good x if,
L(Ax)/L(Ay) < L(Bx)/L(By)
Where L(Ai)= labour required to produce 1 unit of
good ‘i‘ in country ‘A’.
If one country has a CA in one of the products, the
other country automatically has a CA in the other
product.
Argument: If free trade is allowed between countries
with comparative advantage, (may not be absolute
advantage) world’s productive efficiency will
increase.
Both countries may gain in terms of consumption
possibilities. The smaller/ technologically backward
country gains more.
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Defining
comparative advantage

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Televisions Production possibility frontiers
20 Tex TV
US 10 5
SL 20 25
US’s consumption ,
production in absence Labour resource
of trade in each country
= 100
Sri Lanka’s
consumption ,
4 production in absence
of trade

5 10 textiles

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 Before trade
P(textile) P(TV) P(Tex)/ Textile Television
P(TV)
US 10 5
US 10 5 2
Sri Lanka 20 25 4/5 Sri Lanka 20 25

Assume
• Markets are competitive with large number of small players.
• Production is subject to CRS
• Identical wages in 2 countries
• Labour as the only input

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 Before trade Tex TV
P(Tex) P(TV) P(Tex)/ P(TV) P(TV)/P(Tex) US 10 5
US 10 5 2 1/2
SL 20 25
Sri Lanka 20 25 4/5 5/4

US US has a comparative advantage in TV.

TV producers in US
find that P(TV) in Sri Lanka/L(TV) in US > P(Tex) in Sri Lanka /L(Tex) in US
That is earning in TV sector (5) > earning in Textile sector (2)
So they export TV to Sri Lanka due to possibility of higher earning.
Price of TV begin to settle between 5 and 25 in both countries. (say 15)
Now earning in TV sector (3) > earning in Textile sector (2)

Textile producers in US find the same.

So it is gainful for both TV and Textile producers to produce TV.

US specialises in TV.
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 Before trade Tex TV
P(Tex) P(TV) P(Tex)/ P(TV) P(TV)/P(Tex) US 10 5
US 10 5 2 1/2
SL 20 25
Sri Lanka 20 25 4/5 5/4

Sri Lanka US produces TV and no textile. So Sri Lanka has the opportunity
to produce Textile even if they are not as efficient.
So textile is solely produced in Sri Lanka.

Given that price of TV = 15, price of textiles settles between 12 and 30.
This has to be proved.

• Why is P(tex) < 30?

Say P(tex) settles at 31 (or any price >30)

In US Earning per worker in TV = 3 (see previous slide)
If P(tex) settles at 31, Earning per worker in US = 31/10 = 3.1 > 3
Then TV workers in US would move to Textile production. Supply of textile will
increase, and price will fall to less than 31 that is 30 or below.
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 Before trade Tex TV
P(Tex) P(TV) P(Tex)/ P(TV) P(TV)/P(Tex) US 10 5
US 10 5 2 1/2
SL 20 25
Sri Lanka 20 25 4/5 5/4

Sri Lanka Why is P(tex) > 12?

Say P(tex) settles at 11 (or any price <12)

In Sri Lanka earning per worker in TV (if they produce TV) = 15/25 = 3/5
And earning per worker in Textile = 11/20 < 3/5
So Sri Lanka moves to TV.
The entire world demand of textile remains unmet.
Price of textile rises to 12 or above.

Hence 12 < P(tex) < 30, say 25

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 Before trade Tex TV
P(Tex) P(TV) P(Tex)/ P(TV) P(TV)/P(Tex) US 10 5
US 10 5 2 1/2
SL 20 25
Sri Lanka 20 25 4/5 5/4

Sri Lanka…. continued

US produces TV and no textile. So Sri Lanka has the opportunity to produce Textile even
if they are not as efficient.
So textile is solely produced in Sri Lanka. Price settles between 12 and 30 say, at 25.
TV producers in Srilanka find that
If they withdraw 1L from TV, loss or earning per worker = 25/ 25 = 1(at old price of TV)
or 15/25 = 3/5 (at new price)
If this 1L is engaged in Textile, Textile production rises by 1/20,
gain in earning per worker = 25*(1/20) = 5/4
There is gain from moving into textile production.
Also TV market is captured by US. So they move to textile production.
Textile producers in Sri Lanka find that they have an expanded market in US. So they
continue to produce textiles.
Sri Lanka specialises in Textile.
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P(TV)

5 15 25
Pre trade in Post trade in Pre trade in
US both Sri Lanka

P(Tex)

10 12 20 25 30

Pre trade in Pre trade in Post trade in

US Sri Lanka both

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 Before trade After trade
P(textile) P(TV) P(Tex)/ P(textile) P(TV) P(Tex)/
P(TV) P(TV)
US 10 5 2 25 15 5/3
Sri Lanka 20 25 4/5 25 15 5/3

4/5 5/3 2
P(tex)/P(TV) Pre trade in Post trade in Pre trade in
Sri Lanka both US

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Exercise Tex TV
US 10 5
SL 20 25
P(TV)
5 20 25
Pre trade in Post trade in Pre trade in
US both Sri Lanka

If TV price settled at 20 under free trade,

what would be the maximum price for textile?
And what would be the minimum price for textile?

Find a range for textile price.

And verify.

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Exercise Tex TV
US 10 5
With free trade P(tex) / P(TV) should settle between
the pre-trade price ratios in US and Sri Lanka. SL 20 25

4/5 2
P(tex)/P(TV) Pre trade in Pre trade in
Sri Lanka US

If P(TV) = 20 then 16 < P(Tex) < 40

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 Tex TV
US 10 5
Verifying that P(tex) < 40
SL 20 25
Say, P(tex) is not < 40 , Say P(tex) = 41
P(TV) = 20, given

In US, earning in TV = 20/5 = 4

earning in Textile = 41/10 = 4.1
 US produces textile

In Sri Lanka, earning in TV = 20/25 = 0.8

earning in textile = 41/20 = 2.05
 Sri Lanka produces textile

Both countries produce textile, No one produces TV.

Supply of textile is too large, and supply of TV is nil.
So, either P(tex) falls or P(TV) rises.
If P(TV) is given at 20 then P(tex) falls to 40 or less.

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 Tex TV
US 10 5
Verifying that P(tex) > 16
SL 20 25
Say P(tex) is not > 16 , Say P(tex) = 15
P(TV) = 20, given

In US, earning in TV = 20/5 = 4

earning in Textile = 15/10 = 1.5
 US produces TV

In Sri Lanka, earning in TV = 20/25 = 0.8

earning in textile = 15/20 = 0.75
 Sri Lanka produces TV

Both countries produce TV, No one produces textile.

Supply of TV is too large, and supply of textile is nil.
So, either P(tex) rises or P(TV) falls.
If P(TV) is given at 20 then P(tex) rises 16 or more.

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 Before trade After trade
US Sri Lanka US Sri Lanka
P(textile) 10 20 25 25
P(TV) 5 25 15 15

P(Tex)/ P(TV) 2 4/5 5/3 5/3

Effect on Textile Price rise Price rise

consumers / producers from 10 to 25 from 20 to 25
Effect on TV consumers Price rise Price fall
/ producers from 5 to 15 from 25 to 15

4/5 5/3 2
P(tex)/P(TV) Pre trade in Post trade in Pre trade in
Sri Lanka both US
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Televisions Production possibility frontiers
20
Slope of US’s PPF = 2

Slope of Sri Lanka’s PPF = 4/5

Slope of new price line = 5/3

US’s Consumption in
presence of trade

Sri Lanka’s
4 consumption
in presence of
trade

5 10 textiles

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Possible Consumption Gain to US due to

Selling goods (exports) at a 3 times higher price (than in autarky)

and buying goods (imports) at 2.5 times higher price (than in autarky)
=> Earning increases more than prices

Possible Consumption Gain to SriLanka due to

Selling goods (exports) at the 1.25 times higher price (as in autarky)
and buying goods (imports) at 0.6 times cheaper (than in autarky)
=> Earning increased while price falls
Consumption possibility in both countries increase, as compared o autarky.

But, even in the post trade situation,

the technologically backward country maintains a low consumption as
compared to the advanced nation.
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Trade between EU and Kenya

Kenya is a net exporter to EU in

• Apparel / leather products
• Food products
• Wood products

Kenya is a net importer from EU in

Professional and scientific equipment Transport equipment
Textiles Machinery Rubber/ plastic products
Chemicals furniture metals
Paper / prints footwear beverage

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 Conclusion

Every nation, technologically advanced or backward, is supposed to have

comparative advantage over some product or the other.

Trade, based on comparative advantage, should benefit all nations by

raising their consumption possibilities beyond production possibilities.

Industry adjustments / unemployment is expected as temporary

phenomena.

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Exercise

“Introduced in the fuel hungry 1970s, America’s ban on crude oil exports
was all but forgotten when the economy boomed and imports soared. Now
it is in the news again. …. Cash strapped oilmen would like to sell their
product abroad and are lobbying to lift the ban. The free trade in crude
boost output, investment, jobs, pay, profits, tax revenues – and GDP by $86
billion.” …. “But politicians are fearful.”
– The Economist 28th March 2015.

Why should the politicians be fearful? What problems can be caused by

this export of crude oil?

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Why should the politicians be fearful?
What problems can be caused by this export of crude oil?

1. Price of oil may fall in the world market (outside USA) due to increased
supply.
2. Domestic price of crude oil should rise. Consumers and domestic oil
refineries will be affected.
3. The job protection argument – the crude oil exported to Europe will be
refined there and return to USA, only leaving the refining jobs to Europe.

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Reading

From reading material on module 1-

“Trade and Technology – The Ricardian Model ”

From web sources

• http://www.ibj.com/articles/53495-bohanon-styring-print-column-template
BOHANON & STYRING: Why ‘free trade’ is almost always a good thing

• http://www.cato.org/blog/benefit-free-trade-not-exports-its-lower-prices-things-
we-want
The Benefit of Free Trade Is Not Exports, It’s Lower Prices on Things We Want

• https://whistlinginthewind.org/2013/03/12/challenging-economics-theory-of-
comparative-advantage/
Challenging Economics – Theory of comparative advantage

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