COMPARATIVE ADVANTAGE
• For international trade, one product can be
exported and the other imported
• A country tends to be a net exporter of some
products and a net importer of others
• Why do countries trade?
o Adam Smith’s original explanation: Absolute
Advantage
o David Ricardo’s principle of comparative
advantage allows us to explain better
o production-possibility curve (PPC)
summarizes national production capabilities
Adam Smith’s Theory of Absolute Advantage
• promoted free trade by comparing nations to
households
• US vs rest of world: wheat and cloth
o Produced using labor
o Suppose that the US is better at
o producing wheat, rest of the world cloth
o US focuses on producing wheat
▪ each country’s ability to produce
• labor productivity - number of units of output
that a worker can produce in one hour
• number of hours that it takes a worker to
produce one unit of output
• US - absolute advantage in producing wheat
because labor productivity in wheat is higher
• rest of the world – cloth
• no trade - each country will have to produce both
• with trade - shift its labor resources
• shifting one hour of labor results
o US: a decrease of 0.25 unit of cloth and an
increase of 0.5 unit of wheat
o World: a decrease of 0.4 unit of wheat and an
increase of 1 unit of cloth
• US apparent shortage of cloth is met by imports
of cloth
• trade allows each country to exploit its absolute
advantage in producing some product
• both countries will gain from trade by splitting
the benefits of the enhanced global production
Ricardo’s Theory of Comparative Advantage
• there is a basis for beneficial trade whether or
not countries have any absolute advantage
• opportunity cost - production of the other
product that is given up
• principle of comparative advantage - export the
goods and services that it can produce at a low
opportunity cost
• each can benefit by exporting products in which
it has the greatest relative advantage
o importing products in which it has the least
relative advantage
• The United States has absolute disadvantages in
both goods
Ricardo’s Constant Costs and the Production-Possibility
Curve
• relative price - ratio of one product price to
another
• no trade: US four hours of labor - 2 wheat units
or 1 cloth unit
• relative price of cloth - wheat units per unit of
cloth (W/C)
• relative price of wheat - C/W
• arbitrage profit
o cloth in the rest of the world for 0.67 W
o sells it in US for 2.0 W
o arbitrage profit of 1.33 W
o acquiring wheat in the United States at 0.5 C
per wheat unit
o profitable international trade - new
worldwide equilibrium
• remove cloth from the rest of the world by
exporting, cloth becomes more expensive
relative to wheat but cheaper in the US
• equilibrium international price ratio must fall
within the range of the two price ratios that
prevailed in each country before trade
• 0.4 W/C intl price for cloth
o rest of the world would want to import cloth,
export wheat
o below the cost of producing cloth at home
(0.67 W/C)
o US import cloth, export wheat
o cloth price pushed up as a result of the
excess demand
o agree: cloth price somewhere in the range
0.67 to 2.0 W/C
• 1 W/C intl price for cloth
o both countries gain
o US gains: produces a unit of wheat by giving
up only 0.5 unit of cloth, can export this wheat
unit and receive 1 unit of cloth.
o ROTW: produces a unit of cloth by giving up
only 0.67 unit of wheat, can export this cloth
unit and receive 1 unit of wheat.
• each country having an absolute advantage in
one product is also a case of comparative
advantage
• comparative advantage is more general and
powerful
o different price ratios if no trade
o comparative advantage even if it has no
absolute advantage
• OC of a unit of wheat within the United States (0.5
C/W) lower than OC in ROTW (1.5 C/W)
• US will export wheat, even though it has an
absolute disadvantage in producing both
• US - 100 billion hours of labor available
• US can make 50 billion wheat units per year if it
produces only wheat or 25 billion cloth units per
year if instead it makes only cloth

• PPC - combinations of amounts of different

products that an economy can produce with full
employment of its resources
• number of wheat units each country would have
to give up to make each extra cloth unit
o 50/25 = 2 W/C for the US
o 67/100 = 2/3 W/C for ROTW
• each could consume and enjoy only
combinations of wheat and cloth that are on (or
below) its PPC
• When a nation sells its exports to get imports, it
ends up consuming a different set of goods
• If US making only wheat (S1), it can export wheat
for cloth imports at the world price ratio
o Giving up wheat and gaining cloth
imports means moving southeast
• If 1 W/C, the United States could consume
anywhere along thin colored line.
o For S0 (consumes what it produces),
there are better consumption points like
C (consuming more of everything by
(specializing and trading)
o United States gains from trade
• ROTW also wins specializing in cloth production
(S1), trading some of that cloth for wheat
• Constant MCs conclude each maximizes its gain
by specializing its production completely on CA
good
• The real world fails to show total specialization