Module in FS 21

(International Economics)

Module 2: The Ricardian Theory of Comparative Advantage

At the end of Module 2, learners are expected to:

1. Learn the five reasons why trade between countries may occur.

2. Recognize that separate models of trade incorporate different motivations for trade.

3. Learn how to define labor productivity and opportunity cost within the context of the Ricardian
model.

4. Learn to identify and distinguish absolute advantage and comparative advantage.

5. Learn to identify comparative advantage via two methods: (1) by comparing opportunity costs
and (2) by comparing relative productivities.

6. Learn how worker wages and the prices of the goods are related to each other in the
Ricardian model.

The first theory section of this course develops models that provide different
explanations or reasons why trade takes place between countries. The five basic reasons why
trade may take place are summarized below. The purpose of each model is to establish a basis
for trade and then to use that model to identify the expected effects of trade on prices, profits,
incomes, and individual welfare.
Reason for Trade #1: Differences in Technology
Advantageous trade can occur between countries if the countries differ in their
technological abilities to produce goods and services. Technology refers to the techniques used
to turn resources (labor, capital, land) into outputs (goods and services). The basis for trade in
the Ricardian model of comparative advantage in Chapter 2 "The Ricardian Theory of
Comparative Advantage" is differences in technology.
Reason for Trade #2: Differences in Resource Endowments
Advantageous trade can occur between countries if the countries differ in their
endowments of resources. Resource endowments refer to the skills and abilities of a country’s
workforce, the natural resources available within its borders (minerals, farmland, etc.), and the
sophistication of its capital stock (machinery, infrastructure, communications systems). The
basis for trade in both the pure exchange model in Chapter 3 "The Pure Exchange Model of
Trade" and the Heckscher-Ohlin model in Chapter 5 "The Heckscher-Ohlin (Factor Proportions)
Model" is differences in resource endowments.
Reason for Trade #3: Differences in Demand
Advantageous trade can occur between countries if demands or preferences differ
between countries. Individuals in different countries may have different preferences or demands
for various products. For example, the Chinese are likely to demand more rice than Americans,
even if consumers face the same price. Canadians may demand more beer, the Dutch more
wooden shoes, and the Japanese more fish than Americans would, even if they all faced the
same prices. There is no formal trade model with demand differences, although the
monopolistic competition model in Chapter 6 "Economies of Scale and International Trade"
does include a demand for variety that can be based on differences in tastes between
consumers.
Reason for Trade #4: Existence of Economies of Scale in Production
The existence of economies of scale in production is sufficient to generate
advantageous trade between two countries. Economies of scale refer to a production process in
which production costs fall as the scale of production rises. This feature of production is also
known as “increasing returns to scale.” Two models of trade incorporating economies of scale
are presented in Chapter 6 "Economies of Scale and International Trade".
Reason for Trade #5: Existence of Government Policies
Government tax and subsidy programs alter the prices charged for goods and services.
These changes can be sufficient to generate advantages in production of certain products. In
these circumstances, advantageous trade may arise solely due to differences in government
policies across countries.

Definitions: Absolute and Comparative Advantage

The basis for trade in the Ricardian model is differences in technology between
countries. Below we define two different ways to describe technology differences. The first
method, called absolute advantage, is the way most people understand technology
differences. The second method, called comparative advantage, is a much more difficult
concept. As a result, even those who learn about comparative advantage often will confuse it
with absolute advantage. It is quite common to see misapplications of the principle of
comparative advantage in newspaper and journal stories about trade. Many times authors write
“comparative advantage” when in actuality they are describing absolute advantage. This
misconception often leads to erroneous implications, such as a fear that technology advances in
other countries will cause our country to lose its comparative advantage in everything. As will be
shown, this is essentially impossible.
To define absolute advantage, it is useful to define labor productivity first. To define
comparative advantage, it is useful to first define opportunity cost. Next, each of these is defined
formally using the notation of the Ricardian model.

Labor Productivity
Labor productivity is defined as the quantity of output that can be produced with a unit of
labor. Since aLC represents hours of labor needed to produce one pound of cheese, its
reciprocal, 1/aLC, represents the labor productivity of cheese production in the United States.
Similarly, 1/aLW represents the labor productivity of wine production in the United States.

Absolute Advantage
Absolute advantage is the ability of an individual, company, region, or country to produce a
greater quantity of a good or service with the same quantity of inputs per unit of time, or to
produce the same quantity of a good or service per unit of time using a lesser quantity of inputs,
than another entity that produces the same good or service.

An entity with an absolute advantage can produce a product or service at a lower absolute cost
per unit using a smaller number of inputs or a more efficient process than another entity
producing the same good or service.

KEY TAKEAWAYS

 Absolute advantage is when a producer can produce a good or service in greater

quantity for the same cost, or the same quantity at a lower cost, than other producers.
 Absolute advantage can be the basis for large gains from trade between producers of
different goods with different absolute advantages.
 By specialization, division of labor, and trade, producers with different absolute
advantages can always gain more than producing in isolation.
 Absolute advantage is related to comparative advantage, which can open up even more
widespread opportunities for the division of labor and gains from trade.

View: https://www.youtube.com/watch?v=5CrygjvyUPU

Understanding Absolute Advantage

The concept of absolute advantage was developed by Adam Smith in his book “Wealth of
Nations” to show how countries can gain from trade by specializing in producing and exporting
the goods that they can produce more efficiently than other countries.
Countries with an absolute advantage can decide to specialize in producing and selling a
specific good or service and use the funds that good or service generates to purchase goods
and services from other countries.

By Smith’s argument, specializing in the products that they each have an absolute advantage in
and then trading the products, can make all countries better off, as long as they each have at
least one product for which they hold an absolute advantage over other nations.

Absolute Advantage vs. Comparative Advantage

Absolute advantage can be contrasted to comparative advantage, which is when a producer

has a lower opportunity cost to produce a good or service than another producer.

Absolute advantage leads to unambiguous gains from specialization and trade only in cases
where each producer has an absolute advantage in producing some good. If a producer lacks
any absolute advantage then Adam Smith’s argument would not necessarily apply.

However, the producer and its trading partners might still be able to realize gains from trade if
they can specialize based on their respective comparative advantages instead.

Example of Absolute Advantage

Consider two hypothetical countries, Atlantica and Krasnovia, with equivalent populations and
resource endowments, with each producing two products: guns and bacon. Each year, Atlantica
can produce either 12 guns or six slabs of bacon, while Krasnovia can produce either six guns
or 12 slabs of bacon.

Each country needs a minimum of four guns and four slabs of bacon to survive. In a state of
autarky, producing solely on their own for their own needs, Atlantica can spend one-third of the
year making guns and two-thirds of the year making bacon, for a total of four guns and four
slabs of bacon.

Krasnovia can spend one-third of the year making bacon and two-thirds making guns to
produce the same: four guns and four slabs of bacon. This leaves each country at the brink of
survival, with barely enough guns and bacon to go around. However, note that Atlantica has an
absolute advantage in producing guns and Krasnovia has an absolute advantage in producing
bacon.

Absolute advantage also explains why it makes sense for individuals, businesses, and countries
to trade. Since each has advantages in producing certain goods and services, both entities can
benefit from trade.

If each country were to specialize in their absolute advantage, Atlantica could make 12 guns
and no bacon in a year, while Krasnovia makes no guns and 12 slabs of bacon. By specializing,
the two countries divide the tasks of their labor between them.
Opportunity Cost
What Is Opportunity Cost?
Opportunity costs represent the potential benefits an individual, investor, or business misses
out on when choosing one alternative over another. The idea of opportunity costs is a major
concept in economics.

Because by definition they are unseen, opportunity costs can be easily overlooked if one is not
careful. Understanding the potential missed opportunities foregone by choosing one investment
over another allows for better decision-making.

While financial reports do not show opportunity costs, business owners often use the concept to
make educated decisions when they have multiple options before them. Bottlenecks, for
instance, are often a result of opportunity costs.

KEY TAKEAWAYS

 Opportunity cost is the forgone benefit that would have been derived by an option not
chosen.
 To properly evaluate opportunity costs, the costs and benefits of every option available
must be considered and weighed against the others.
 Considering the value of opportunity costs can guide individuals and organizations to
more profitable decision-making.

View: https://www.youtube.com/watch?v=NfNrjJdcTG8

Opportunity Cost=FO−CO

where:FO=Return on best foregone option

CO=Return on chosen option

The formula for calculating an opportunity cost is simply the difference between the expected
returns of each option. Say that you have option A: to invest in the stock market hoping to
generate capital gain returns. Option B, on the other hand is: to reinvest your money back into
the business, expecting that newer equipment will increase production efficiency, leading to
lower operational expenses and a higher profit margin.

Assume the expected return on investment in the stock market is 12 percent over the next year,
and your company expects the equipment update to generate a 10 percent return over the
same period. The opportunity cost of choosing the equipment over the stock market is (12% -
10%), which equals two percentage points. In other words, by investing in the business, you
would forgo the opportunity to earn a higher return.

Opportunity Cost and Capital Structure

Opportunity cost analysis also plays a crucial role in determining a business's capital structure. 
A firm incurs an expense in issuing both debt and equity capital to compensate lenders and
shareholders for the risk of investment, yet each also carries an opportunity cost. Funds used to
make payments on loans, for example, cannot be invested in stocks or bonds, which offer the
potential for investment income. The company must decide if the expansion made by the
leveraging power of debt will generate greater profits than it could make through investments. A
firm tries to weight the costs and benefits of issuing debt and stock, including both monetary and
non-monetary considerations, in order to arrive at an optimal balance that minimizes opportunity
costs. Because opportunity cost is a forward-looking consideration, the actual rate of return for
both options is unknown today, making this evaluation in practice tricky.

Assume the company in the above example foregoes new equipment and instead invests in the
stock market. If the selected securities decrease in value, the company could end up losing
money rather than enjoying the expected 12 percent return.

For the sake of simplicity, assume the investment yields a return of 0%, meaning the company
gets out exactly what it put in. The opportunity cost of choosing this option is 10% - 0%, or 10%.
It is equally possible that, had the company chosen new equipment, there would be no effect on
production efficiency, and profits would remain stable. The opportunity cost of choosing this
option is then 12% rather than the expected 2%.

It is important to compare investment options that have a similar risk. Comparing a Treasury bill,
which is virtually risk-free, to investment in a highly volatile stock can cause a misleading
calculation. Both options may have expected returns of 5%, but the U.S. Government backs the
rate of return of the T-bill, while there is no such guarantee in the stock market. While the
opportunity cost of either option is 0 percent, the T-bill is the safer bet when you consider the
relative risk of each investment.

Comparing Investments
When assessing the potential profitability of various investments, businesses look for the option
that is likely to yield the greatest return. Often, they can determine this by looking at the
expected rate of return for an investment vehicle. However, businesses must also consider the
opportunity cost of each option.

Assume that, given a set amount of money for investment, a business must choose between
investing funds in securities or using it to purchase new equipment. No matter which option the
business chooses, the potential profit it gives up by not investing in the other option is the
opportunity cost. Indeed, it is unavoidable.

Opportunity Cost vs. Sunk Cost

The difference between an opportunity cost and a sunk cost is the difference between money
already spent in the past and potential returns not earned in the future on an investment
because the capital was invested elsewhere. Buying 1,000 shares of company A at $10 a share,
for instance, represents a sunk cost of $10,000. This is the amount of money paid out to make
an investment, and getting that money back requires liquidating stock at or above the purchase
price. But the opportunity cost instead asks where could have that $10,000 been put to use in a
better way.

From an accounting perspective, a sunk cost could also refer to the initial outlay to purchase an
expensive piece of heavy equipment, which might be amortized over time, but which is sunk in
the sense that you won't be getting it back. An opportunity cost would be to consider the forgone
returns possibly earned elsewhere when you buy a piece of heavy equipment with an expected
return on investment (ROI) of 5% vs. one with an ROI of 4%.

Again, an opportunity cost describes the returns that one could have earned the money were
instead invested in another instrument. Thus, while 1,000 shares in company A might eventually
sell for $12 a share, netting a profit of $2,000, during the same period, company B increased in
value from $10 a share to $15. In this scenario, investing $10,000 in company A returned
$2,000, while the same amount invested in company B would have returned a larger $5,000.
The $3,000 difference is the opportunity cost of choosing company A over company B.

As an investor that has already sunk money into investments, you might find another investment
that promises greater returns. The opportunity cost of holding the underperforming asset may
rise to where the rational investment option is to sell and invest in the more promising
investment.

Risk vs. Opportunity Cost

In economics, risk describes the possibility that an investment's actual and projected returns are
different and that the investor loses some or all of the principal. Opportunity cost concerns the
possibility that the returns of a chosen investment are lower than the returns of a forgone
investment. The key difference is that risk compares the actual performance of an investment
against the projected performance of the same investment, while opportunity cost compares the
actual performance of an investment against the actual performance of a different investment.

Still, one could consider opportunity costs when deciding between two risk profiles. If investment
A is risky but has an ROI of 25% while investment B is far less risky but only has an ROI of 5%,
even though investment A may succeed, it may not. And if it fails, then the opportunity cost of
going with option B will be salient.

Example of Opportunity Cost

When making big decisions like buying a home or starting a business, you will probably
scrupulously research the pros and cons of your financial decision, but most day-to-day choices
aren't made with a full understanding of the potential opportunity costs. If they're cautious about
a purchase, many people just look at their savings account and check their balance before
spending money. Often, people don't think about the things they must give up when they make
those decisions.

The problem comes up when you never look at what else you could do with your money or buy
things without considering the lost opportunities. Having takeout for lunch occasionally can be a
wise decision, especially if it gets you out of the office for a much-needed break.

However, buying one cheeseburger every day for the next 25 years could lead to several
missed opportunities. Aside from the missed opportunity for better health, spending that $4.50
on a burger could add up to just over $52,000 in that time frame, assuming a very achievable
5% rate of return.

This is a simple example, but the core message holds true for a variety of situations. It may
sound like overkill to think about opportunity costs every time you want to buy a candy bar or go
on vacation. Even clipping coupons versus going to the supermarket empty-handed is an
example of an opportunity cost unless the time used to clip coupons is better spent working in a
more profitable venture than the savings promised by the coupons. Opportunity costs are
everywhere and occur with every decision made, big or small.

What is a simple definition of opportunity cost?

Opportunity cost is a very important concept in economics, but it is often overlooked by
investors. In essence, it refers to the hidden cost associated with not taking an alternative
course of action. If, for example, a company pursues a particular business strategy without first
considering the merits of alternative strategies available to them, they might therefore fail to
appreciate their opportunity costs. Although the company’s chosen strategy might turn out to be
the best one available, it is also possible that they could have done even better had they chosen
another path.

Is opportunity cost a real cost?

Some would argue that opportunity cost is not a “real” cost because it does not show up directly
on a company’s financial statements. But economically speaking, opportunity costs are still very
real. Nevertheless, because opportunity cost is a relatively abstract concept, many companies,
executives, and investors fail to account for it in their everyday decision-making. In the long run,
however, opportunity costs can have a very substantial effect on the outcomes achieved by
individuals or companies.

What is an example of opportunity cost?

Consider the case of an investor who, at the age of 18, was encouraged by their parents to
always put 100% of their disposable income into bonds. Over the next 50 years, this investor
dutifully invested $5,000 per year in bonds, achieving an average annual return of 2.50% and
retiring with a portfolio worth nearly $500,000. Although this result might seem impressive, it is
less so when one considers the investor’s opportunity cost. If, for example, they had instead
invested half of their money in the stock market and received an average blended return of
5.00%, then their retirement portfolio would have been worth over $1 million.

Comparative Advantage
What Is Comparative Advantage?
Comparative advantage is an economy's ability to produce a particular good or service
at a lower opportunity cost than its trading partners. A comparative advantage gives a
company the ability to sell goods and services at a lower price than its competitors and
realize stronger sales margins.

The law of comparative advantage is popularly attributed to English political economist

David Ricardo and his book “On the Principles of Political Economy and Taxation”
written in 1817, although it is likely that Ricardo's mentor, James Mill, originated the
analysis.

KEY TAKEAWAYS

 Comparative advantage is an economy's ability to produce a particular good or service

at a lower opportunity cost than its trading partners.
 The theory of comparative advantage introduces opportunity cost as a factor for analysis
in choosing between different options for production.
  Comparative advantage suggests that countries will engage in trade with one another,
exporting the goods that they have a relative advantage in.
 Absolute advantage refers to the uncontested superiority of a country to produce a
particular good better.

View: https://www.youtube.com/watch?v=jNESLIbM8Ns

Understanding Comparative Advantage

Comparative advantage is one of the most important concepts in economic theory and a
fundamental tenet of the argument that all actors, at all times, can mutually benefit from
cooperation and voluntary trade. It is also a foundational principle in the theory of
inte3rnational trade.

The key to understanding comparative advantage is a solid grasp of opportunity cost.

Put simply, an opportunity cost is a potential benefit that someone loses out on when
selecting a particular option over another.

In the case of comparative advantage, the opportunity cost (that is to say, the potential
benefit which has been forfeited) for one company is lower than that of another. The
company with the lower opportunity cost, and thus the smallest potential benefit which
was lost, holds this type of advantage.

Another way to think of comparative advantage is as the best option given a trade-off. If
you're comparing two different options, each of which has a trade-off (some benefits as
well as some disadvantages), the one with the best overall package is the one with the
comparative advantage.

Diversity of Skills

People learn their comparative advantages through wages. This drives people into
those jobs that they are comparatively best at. If a skilled mathematician earns more
money as an engineer than as a teacher, they and everyone they trade with are better
off when they practice engineering.

Wider gaps in opportunity costs allow for higher levels of value production by organizing
labor more efficiently. The greater the diversity in people and their skills, the greater the
opportunity for beneficial trade through comparative advantage.

As an example, consider a famous athlete like Michael Jordan. As a renowned

basketball and baseball star, Michael Jordan is an exceptional athlete whose physical
abilities surpass those of most other individuals. Michael Jordan would likely be able to,
say, paint his house quickly, owing to his abilities as well as his impressive height.
Hypothetically, say that Michael Jordan could paint his house in eight hours. In those
same eight hours, though, he could also take part in the filming of a television
commercial which would earn him $50,000. By contrast, Jordan's neighbor Joe could
paint the house in 10 hours. In that same period of time, he could work at a fastfood
restaurant and earn $100.

In this example, Joe has a comparative advantage, even though Michael Jordan could
paint the house faster and better. The best trade would be for Michael Jordan to film a
television commercial and pay Joe to paint his house. So long as Michael Jordan makes
the expected $50,000 and Joe earns more than $100, the trade is a winner. Owing to
their diversity of skills, Michael Jordan and Joe would likely find this to be the best
arrangement for their mutual benefit.

Comparative Advantage vs. Absolute Advantage

Comparative advantage is contrasted with absolute advantage. Absolute advantage

refers to the ability to produce more or better goods and services than somebody else.
Comparative advantage refers to the ability to produce goods and services at a lower
opportunity cost, not necessarily at a greater volume or quality.

 Comparative advantage is a key insight that trade will still occur even if one country has an
absolute advantage in all products.

To see the difference, consider an attorney and their secretary. The attorney is better at
producing legal services than the secretary and is also a faster typist and organizer. In
this case, the attorney has an absolute advantage in both the production of legal
services and secretarial work.

Nevertheless, they benefit from trade thanks to their comparative advantages and
disadvantages. Suppose the attorney produces $175 per hour in legal services and $25
per hour in secretarial duties. The secretary can produce $0 in legal services and $20 in
secretarial duties in an hour. Here, the role of opportunity cost is crucial.

To produce $25 in income from secretarial work, the attorney must lose $175 in income
by not practicing law. Their opportunity cost of secretarial work is high. They are better
off by producing an hour's worth of legal services and hiring the secretary to type and
organize. The secretary is much better off typing and organizing for the attorney; their
opportunity cost of doing so is low. It’s where their comparative advantage lies.

Comparative Advantage vs. Competitive Advantage

Comparative advantage refers to a company, economy, country, or individual's ability to

provide a stronger value to consumers as compared with its competitors. It is similar to,
but distinct from, comparative advantage.
In order to assume a competitive advantage over others in the same field or area, it's
necessary to accomplish at least one of three things: the company should be the low-
cost provider of its goods or services, it should offer superior goods or services than its
competitors, and/or it should focus on a particular segment of the consumer pool.

Comparative Advantage in International Trade

David Ricardo famously showed how England and Portugal both benefit by specializing
and trading according to their comparative advantages. In this case, Portugal was able
to make wine at a low cost, while England was able to cheaply manufacture cloth.
Ricardo predicted that each country would eventually recognize these facts and stop
attempting to make the product that was more costly to generate.

Indeed, as time went on, England stopped producing wine, and Portugal stopped
manufacturing cloth. Both countries saw that it was to their advantage to stop their
efforts at producing these items at home and, instead, to trade with each other in order
to acquire them.

Comparative advantage is closely associated with free trade, which is seen as

beneficial, whereas tariffs closely correspond to restricted trade and a zero-sum game.
A contemporary example: China’s comparative advantage with the United States is in
the form of cheap labor. Chinese workers produce simple consumer goods at a much
lower opportunity cost. The United States’ comparative advantage is in specialized,
capital-intensive labor. American workers produce sophisticated goods or investment
opportunities at lower opportunity costs. Specializing and trading along these lines
benefit each.

The theory of comparative advantage helps to explain why protectionism is typically

unsuccessful. Adherents to this analytical approach believe that countries engaged in
international trade will have already worked toward finding partners with comparative
advantages.

If a country removes itself from an international trade agreement, if a government

imposes tariffs, and so on, it may produce a local benefit in the form of new jobs and
industry. However, this is not a long-term solution to a trade problem. Eventually, that
country will be at a disadvantage relative to its neighbors: countries that were already
better able to produce these items at a lower opportunity cost.

Criticisms of Comparative Advantage

Why doesn't the world have open trading between countries? When there is free trade,
why do some countries remain poor at the expense of others? Perhaps comparative
advantage does not work as suggested. There are many reasons this could be the
case, but the most influential is something that economists call rent seeking. Rent
seeking occurs when one group organizes and lobbies the government to protect its
interests.

Say, for example, the producers of American shoes understand and agree with the free-
trade argument but they also know that their narrow interests would be negatively
impacted by cheaper foreign shoes. Even if laborers would be most productive by
switching from making shoes to making computers, nobody in the shoe industry wants
to lose their job or see profits decrease in the short run.

This desire leads the shoemakers to lobby for, say, special tax breaks for their products
and/or extra duties (or even outright bans) on foreign footwear. Appeals to save
American jobs and preserve a time-honored American craft abound, even though, in the
long run, American laborers would be made relatively less productive and American
consumers relatively poorer by such protectionist tactics.

References:

Blyth, Mark. Routledge handbook of international political economy (IPE): IPE as a global
conversation. London; New York: Routledge, 2009

Howlett, Michael. The political economy of Canada: an introduction. Don Mills, Ont.:Oxford
University PressCanada. 1999

Palan, Ronen. Global political economy: contemporary theories. New York: Routledge, 2013

Saros, Daniel E. Principles of Political Economy - Third Edition. Valparaiso University. Copyright
Year: 2019

Weingast, Barry R. and Wittman, Donald A. The Oxford handbook of political economy. Oxford
University Press, 2006