Republic of the Philippines

Bicol University
College of Business, Economics and Management
Daraga, Albay
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

A. OVERVIEW
This topic is centered in the understanding of labor productivity and comparative advantage of one
nation and another. It includes the following subtopics:

• The Concept of Comparative Advantage • Determining the Relative Price After Trade
• One Factor Economy • Gains from Trade
• Prices and Supply • Misconceptions about Comparative Advantage
• Trade in One Factor Economy • Adding Transport Costs and Nontraded Goods

A. OBJECTIVES

• Define terminologies and understand the concept of comparative advantage and the different
empirical evidence the model.
• Understand existing patterns of international trade using the model.

B. LEARNING OBJECTIVES

Introduce the concept of comparative advantage and develop a specific model of how comparative
advantage determines the pattern of international trade.

C. INSTRUCTIONS
1. Kindly read and comprehend this topic on International Trade Theory: Labor Productivity
and Comparative Advantage. Bear with the length of the modules. You need to read in order
to learn. However, if some of the concepts confuse you, I will explain them to you on our next
virtual meeting. Do your best to comprehend. As I’ve said, dreams are unreachable for a
motivation too low. Kaya mo yan, tiwala lang! I’m here to guide you.
2. Watch the video suggestions or read the suggested materials, if there’s any.
3. Prepare the Assignment. The deadline is a week after you receive this module. Send the output
with the filename: ITA_Topic I Output_Course-Year & Block_Surname, First Name,
Middle Initial (ex. ITA_Topic I Output_BS Economics 3B_Garcia, Riza L.)
4. Should you have any questions or concerns, do not to hesitate to send me a message in these
mediums:
a. Private Comment in the Classwork Tab on Google Classroom
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

b. Messenger Group Chat

c. Email at riza.garcia@bicol-u.edu.ph
5. Enjoy your own pace, ‘cause learning is never a race. In these hard and trying times, I
understand that you are walking on a rough patch. Do not forget to pause, breathe, and carry
on! You got this!
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

E. DISCUSSION Hi! I’m Ms. Riza. Today, we’ll learn together.

Don’t let the complexity hinder you from having
another perspective in learning
internationalization. Aja aja!

Two reasons why countries trade:

1. They are different from each other. They benefit from their differences by reaching an arrangement in which each does
the things it does relatively well.
2. To achieve economies of scale in production. That is, if each country produces only a limited range of goods, it can
produce each of these goods at a larger scale and hence more efficiently than if it tried to produce everything.

However, as a first step toward understanding the causes and impacts of trade, simpler models with only one of these reasons
are beneficial. The next four chapters provide methods to assist us understand how differences between countries lead to trade and
why this commerce is mutually beneficial. This chapter begins with a basic introduction to the notion of comparative advantage
before moving on to build a particular model of how comparative advantage influences the pattern of international trade.

THE CONCEPT OF COMPARATIVE

ADVANTAGE

On the valentine’s day of 1996, US Presidential candidate Patrick Bucharan bought roses for his wife, he took such event
to denounce growing imports of roses in the country. He said that the growing number of imports of roses from Columbia put
American growers out of business. The case of winter roses is a great example of a gain from trade. It takes heated greenhouses,
a great expense in energy, capital investment, and other scarce resources to produce winter roses for American sweet hearts, right?
Such inputs of production could have been used to produce other goods; this is what we call trade-off ~ opportunity costs. The
opportunity cost of roses in terms of computers is the number of computers that could have been produced with the resources used
to produce a given number of roses.

Say for example, the cost of producing 10 million is equal to Million Thousand
producing 100, 000 computers. Then, opportunity cost 10MillionRoses = 10, Roses Computers
000 computers. Those 10 million roses could have just been grown in
United States -10 +100
Columbia, and America could have just been producing computers. Don’t
you think? This arrangement in production, with the United States Columbia +10 -30
concentrating on computers and Colombia focused on roses, the size of the Total 0 +70
global economic pie grows. Because the globe is generating more, it is theoretically conceivable to increase everyone's standard of
living. The rationale for this growth in global output is because international commerce allows each country to specialize in
manufacturing the good in which it has a comparative advantage. A country has a comparative advantage in manufacturing an
item if the opportunity cost of producing that good in comparison to other goods is lower in that country than in others.
Furthermore, Colombian workers are less efficient than their U.S. counterparts at making sophisticated goods such as
computers, which means that a given amount of resources used in computer production yields fewer computers in
Colombia than in the United States. So, the trade-off in Colombia might be something like 10 million winter roses for
only 30,000 computers. In this case, Colombia has a comparative advantage in winter roses, whereas the US has
a comparative advantage in computers. The level of life in both countries may be raised if Colombia produces roses
for the US market and the US manufactures computers for the Colombian market.

FOOD FOR THOUGHT: Trade between two countries can benefit both countries if each country
exports the goods in which it has a comparative advantage.
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

ONE FACTOR ECONOMY

To introduce the role of comparative advantage in determining the pattern of international trade, we imagine that only
two goods, wine and cheese, are produced. The technology of the economy is summarized by the labor productivity
in terms of unit of labor requirement~ the number of hours of
aLW- unit labor requirement in wine production
labor required to produce a pound of cheese or a gallon of wine. aLC- unit labor requirement in cheese production
For example, 1 cheese: 1 hour, 1 gallon of wine: 2 hours. Notice, L- total labor supply
by the way, that we’re defining unit labor requirements as the Qw- economy’s production of wine
inverse of productivity—the more cheese or wine a worker can Qc- economy’s production of cheese
produce in an hour, the lower the unit labor requirement. For the a lwQw labor used in producing wine

basis of the discussion, we use the following: a lCQC labor used in producing cheese

Production Possibilities Because any economy has limited resources, there are limits on what it can produce, and
there are always trade-offs; to produce more of one good, the economy must sacrifice some production of another
good. These trade-offs are illustrated graphically by a production possibility frontier, which shows the maximum
amount of wine that can be produced once the decision has been made to produce any given amount of cheese, and
vice versa. The production possibility frontier is determined by the limits on the economy’s resources—in this case,
labor. Because the economy’s total labor supply is L, the limits on production are defined by the inequality
aLCQC + aLWQW ≤ L

⏰ L = 1, 000 Then the total labor used in production is

(1 * pounds of cheese produced) + (2 * gallons of wine produced)
🍷alwQw = 2 hours This total must be no more than the 1,000 hours
of labor available.
🧀alCQC = 1 hour
total labor used in production

Qw If the economy devoted all its

labor to cheese production, it could,
produce L/aLC pounds of cheese (1,000
pounds). If it devoted all its labor to wine
production instead, it could
produce L/aLW gallons—1,000/2 = 500
gallons—of wine. And it can produce
L/aLW any mix of wine and cheese that lies on
(500
Gallons) the straight line connecting those two
extremes. When the production
possibility frontier is a straight line, the
QC opportunity cost of a pound of cheese in
L/aLC terms of wine is constant. As we saw in
(1,000
pounds) the previous section, this opportunity cost
The line PF shows the maximum amount of cheese an economy can is defined as the number of gallons of
produce given any production of wine, and vice versa. wine the economy would have to give up
in order to produce an extra pound of
cheese. In this case, to produce another pound would require aLC person-hours. Each of these person-hours could in
turn have been used to produce 1/aLW gallons of wine. Thus, the opportunity cost of cheese in terms of wine is aLC/aLW.
For example, if it takes one person-hour to make a pound of cheese and two hours to produce a gallon of wine, the

Ihanda mo na ang self for a deeper

understanding of these equations. Mukha
lang mahirap yan, pero kakayanin mo!
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

opportunity cost of each pound of cheese is half a gallon of wine This opportunity cost is equal to the absolute value
of the slope of the production possibility frontier.

PRICES and SUPPLY

However, in order to estimate what the economy will produce, we must examine pricing. We
need to know the relative price of the economy's two goods, that is, the price of one item in relation to
the other. Individuals' desires to maximize their profits drive supply decisions in a competitive market.
Because labor is the only factor of production in our simplified economy, the availability of cheese
and wine will be governed by the mobility of labor in the sectors, whichever pays higher.

⏰ L = 1, 000 Therefore, a worker 👷 will earn $4 an hour

🍷alwQw = 2 hours; 1 🍷 PW = $7 if it produces 🧀, while $3.5 ($7/2 hrs) an

🧀alCQC = 1 hour; 1 🧀 PC = $4 hour if it produces 🍷.

But what if cheese prices drop to $3 a

In this example, since workers earns more in cheese
pound? In that case, workers can earn
production at $4/hr, workers will produce cheese better, and more by producing wine, and the
economy will specialize in wine
the economy will specialize in cheese production as a whole. production instead.

The economy will specialize in the production of cheese if the relative price of cheese exceeds its
opportunity cost in terms of wine; it will specialize in the production of wine if the relative price of cheese is
less than its opportunity cost in terms of wine. In the absence of international trade, an economy would have to
produce both goods for itself. But it will produce both goods only if the relative price of cheese is just equal to its
opportunity cost.

FOOD FOR THOUGHT: In the absence of international trade, the relative prices of goods are
equal to their relative unit labor requirements.

TRADE IN ONE FACTOR

ECONOMY

Suppose there are two countries, one is Home 🏠 and the other is Foreign 🌎

⏰ L ⏰ L*

🏠 🍷alw
🧀alC 🌎 🍷a*lw
🧀a*lC
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

In general, the unit labor requirements can follow any pattern. For example, Home could be less productive
than Foreign in wine but more productive in cheese, or vice versa. For the moment, we make only one arbitrary
assumption:
aLC/aLW < a*LC/a*Lw OR aLC/a*Lc < aLW/a*Lw

We are assuming that the ratio of the labor required to produce a pound of cheese to that required to produce
a gallon of wine is lower in Home than it is in Foreign. More briefly still, we are saying that Home’s relative
productivity in cheese is higher than it is in wine. But remember that the ratio of unit labor requirements is equal to
the opportunity cost of cheese in terms of wine; and remember also that we defined comparative advantage precisely
in terms of such opportunity costs. So, the assumption about relative productivities equates that Home has a
comparative advantage in cheese.

When one country can produce a unit of a good with less labor than another country, we say that the first
country has an absolute advantage in producing that good. In our example, Home has an absolute advantage in
producing cheese. What we will see in a moment, however, is that we cannot determine the pattern of trade from
absolute advantage alone. In the absence of trade, the relative prices of cheese and wine in each country would be
determined by the relative unit labor requirements. Thus, in Home the relative price of cheese would be alc/aLW; in
Foreign it would be a*LC/a*LW. Once we allow for the possibility of international trade, however, prices will no longer
be determined purely by domestic considerations. If the relative price of cheese is higher in Foreign than in Home, it
will be profitable to ship cheese from Home to Foreign and to ship wine from Foreign to Home. This cannot go on
indefinitely, however. Eventually, Home will export enough cheese and Foreign enough wine to equalize the relative
price. But what determines the level at which that price settles?

DETERMINING THE RELATIVE

PRICE AFTER TRADE

We need general equilibrium analysis to take into account the linkage between the markets for cheese and
wine. One useful way to keep track of two markets at once is to focus not just on the quantities of cheese and wine
supplied and demanded but also on the relative supply (RS) and demand (RD):

𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒑𝒐𝒖𝒏𝒅𝒔 𝒐𝒇 𝒄𝒉𝒆𝒆𝒔𝒆 𝒔𝒖𝒑𝒑𝒍𝒊𝒆𝒅 𝒐𝒓 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅

𝑮𝒂𝒍𝒍𝒐𝒏𝒔 𝒐𝒇 𝒘𝒊𝒏𝒆 𝒔𝒖𝒑𝒑𝒍𝒊𝒆𝒅 𝒐𝒓 𝒅𝒆𝒎𝒂𝒏𝒅𝒆𝒅

World general equilibrium requires that relative supply equal relative demand, and thus the world relative
price is determined by the intersection of RD and RS. Let’s recall that Home will specialize in the production of wine
whenever PC/PW < aLC/aLW. Similarly, Foreign will specialize in wine production whenever PC/PW < a*LC/a*LW.

Kung nalilito ka na at this point,

go back to the first few segments of
this module. Relax, kaya mo yan!

Next, when the relative price of cheese PC/PW is exactly aLC/aLW, we know that workers in Home can earn
exactly the same amount making either cheese or wine. So, Home will be willing to supply any relative amount of the
two goods, producing a flat section to the supply curve. We have already seen that if PC/PW is above aLC/aLW, Home
will specialize in the production of cheese. As long as PC/PW < a*LC/a*LW, however, Foreign will continue to specialize
in producing wine. When Home specializes in cheese production, it produces L/aLC pounds. Similarly, when Foreign
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

specializes in wine, it produces L*/a*LW gallons. So, for any relative price of cheese between aLC/aLW and a*LC/a*LW,
the relative supply of cheese is
(L/aLC)/(L*/a*LW)

If PC/PW < a*LC/a*LW, we know that Foreign workers are indifferent between producing cheese and wine.
Thus, here we again have a flat section of the supply curve. Finally, for PC/PW > a*LC/a*LW, both Home and Foreign
will specialize in cheese production. There will be no wine production, so that the relative supply of cheese will
become infinite.
Let’s have a numerical example!

🏠 🍷alw
🧀alC
= 2 hrs

= 1 hr

🌎
🍷a*lw = 3 hrs

🧀a*lC =6 hrs

Home takes one hour of labor to produce a pound of cheese and two hours to produce a gallon of wine. Meanwhile,
let’s assume that in Foreign it takes six hours to produce a pound of cheese—Foreign workers are much less
productive than Home workers when it comes to cheesemaking—but only three hours to produce a gallon of wine.

1 ℎ𝑟 𝑎𝐿𝑐 That is, the labor used to produce a pound of cheese

🏠Opportunity cost of cheese in terms of wine = 2 ℎ𝑟𝑠 𝑎𝐿𝑤 = ½ could have produced half a gallon of wine.

6 ℎ𝑟𝑠 𝑎∗𝐿𝑐
🌎Opportunity cost of cheese in terms of wine = 3 ℎ𝑟𝑠 𝑎∗𝐿𝑤 = 2 The six hours of labor required to produce a pound of
cheese could have produced two gallons of wine.

The downward slope of RD reflects substitution effects. As the relative price of cheese rises, consumers will
tend to purchase less cheese and more wine, so the relative demand for cheese falls. The equilibrium relative price of
cheese is determined by the intersection of the relative supply and relative demand curves. The figure above shows a
relative demand curve RD that intersects the RS curve at point 1, where the relative price of cheese is between the
two countries’ pretrade prices—say, at a relative price of 1, in between the pretrade prices of 1/2 and 2. In this case,
each country specializes in the production of the good in which it has a comparative advantage: Home produces
only cheese, while Foreign produces only wine. If the relevant RD curve were RD, for example, relative supply and
relative demand would intersect on one of the horizontal sections of RS. At point 2, the world relative price of cheese
after trade is aLC/aLW, the same as the opportunity cost of cheese in terms of wine in Home.

What is the significance of this outcome? If the relative price of cheese is equal to its opportunity cost in
Home, the Home economy need not specialize in producing either cheese or wine. In fact, at point 2 Home must be
producing both some wine and some cheese; we can infer this from the fact that the relative supply of cheese is less
than it would be if Home were in fact completely specialized. Since PC/PW is below the opportunity cost of cheese in
terms of wine in Foreign, however, Foreign does specialize completely in producing wine. It therefore remains true
that if a country does specialize, it will do so in the good in which it has a comparative advantage. For the moment,
let’s leave aside the possibility that one of the two countries do not completely specialize. Except in this case, the
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

Breathe in. Breathe out. Kaya pa?

Pause ka muna if di na kaya. Balik
ka nalang later.

normal result of trade is that the price of a traded good (e.g., cheese) relative to that of another good (wine)
ends up somewhere in between its pretrade levels in the two countries.

FOOD FOR THOUGHT: Trade expands consumption possibilities. International trade allows Home
and Foreign to consume outside their original production frontiers.

GAINS FROM TRADE

• Home could produce wine directly, but trade with Foreign allows it to “produce” wine by producing
cheese and then trading the cheese for wine. This indirect method of “producing” a gallon of wine
is a more efficient method than direct production.
• In the absence of trade, consumption possibilities are the same as production possibilities. trade has
enlarged the range of choice, and therefore it must make residents of each country better off.

MISCONCEPTIONS ABOUT COMPARATIVE

ADVANTAGE
Productivity and Competitiveness
Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign
competition.
This argument fails to recognize that trade is based on comparative advantage.

The Pauper Labor Argument

Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages.

This is a political argument which claims that foreign competition based on low wages harms
the domestic economy. This is usually used by employee organizations such as labor unions to promote
protectionist trade policies restricting imports from abroad.
 Republic of the Philippines
Bicol University
College of Business, Economics and Management
Daraga, Albay

Exploitation
Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages than
workers in other nations.
In the absence of trade, these workers would be worse off. Denying the opportunity is to
condemn poor people to continue to be poor.

ADDING TRANSPORT COSTS AND NON-TRADED

GOODS
There are three main reasons why specialization in the real international economy is not extreme:
• The existence of more than one factor of production.
• Countries sometimes protect industries from foreign competition.
• It is costly to transport goods and services.
The result of introducing transport costs makes some goods nontraded. In some cases, transportation
is virtually impossible. Example such as services like haircuts and auto repair cannot be traded
internationally.

D. SUGGESTED READINGS/VIDEO MATERIALS

• https://youtu.be/jNESLIbM8Ns
• https://youtu.be/ol4NexZ0iII

E. REFERENCE

Krugman , P., Obstfeld , M., & Melitz, M. (2018). International Economics, Theory and
Policy . Pearson.