FACULTY OF ECONOMICS

Kardan University

International
Economics
Chapter 05: International Trade Theories III
Comparative Advantage Theory

Ahsanullah Mohsen M.Sc.

a.mohsen@Kardan.edu.af
Ahsanullah.Mohsen@rub.de

Kardan.edu.af
FACULTY OF ECONOMICS

Theory of Comparative Advantage

• David Ricardo: Principles of Political Economy (1817)

• Extended free trade argument

• Should import even if the country is more efficient in the

product’s production than country from which it is buying.

• Look to see how much more efficient. If only comparatively

efficient, then import.
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Assumptions
• (1) only two nations and two commodities,
• (2) free trade, without restriction
• (3) perfect mobility of labor within each nation but immobility between the
two nations,
• (4) constant costs of production,
• (5) no transportation costs,
• (6) no technical change, and
• (7) the labor theory of value: It suggested the value of a commodity could
be measured objectively by the average number of labor hours necessary
to produce it

Read more: Labor Theory Of Value 

https://www.investopedia.com/terms/l/labor-theory-of-value.asp#ixzz5Cjx
qAOp2
 
FACULTY OF ECONOMICS

Comparative advantage

The law of comparative advantage shows how mutually

beneficial specialization and trade may be driven by
relative advantages in production rather than absolute
advantages in production.

– Given the somewhat counter-intuitive nature of the law of

comparative advantage its implications are best seen
through example.
FACULTY OF ECONOMICS

An example of comparative advantage

• Countries Units produced per hour

– Scotland
10
– Mexico
9
• Goods 8
– Coffee beans 7
6 Coffee
– Wool beans
5
• The difference lies in 4
Wool

the relative 3
productivity of the 2
1
countries 0
– In this case, Mexico is Scotland Mexico
more productive at
generating both
goods.
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An example of comparative advantage

• How does Units produced per hour
specialization and
10
trade advantage 9
Mexico? 8
– By reducing wool 7
production, resources 6 Coffee
beans
are freed for 5
Wool
producing more coffee 4
beans 3
– Each hour of 2
1
production change
0
costs 5 units of wool
Scotland Mexico
but gains 10 units of
coffee beans
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An example of comparative advantage

• How does Gains per hour of

specialization and production moved
trade advantage 10
Mexico? 9
– Mexico can send 9 8
7
units of coffee beans Coffee
6
to Scotland and 5
beans
receive 7 units of wool 4
Wool
back 3
– Thus, by specializing 2
1
in production Mexico
0
gains 1 unit of coffee
Scotland Mexico
beans and 2 units of
wool per hour of
production moved
FACULTY OF ECONOMICS

An example of comparative advantage

• Does specialization Units produced per hour

and trade also
10
advantage Scotland? 9
– It does. To see this 8
consider consider 7
Scotland trading two 6 Coffee
beans
hours of output. 5
Wool
– Two hours of 4
production change 3
from coffee beans to 2
wool costs 2 units of 1

coffee beans but gains 0

Scotland Mexico
8 units of wool
– The gain is 7 coffee, 1
wool
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Implications of comparative advantage

• Laissez-faire still holds: it means very less government

interference in the trading activities
• Gains need not be equal: one country can gain more than
the other
• Hours of work traded need not be equal but the advantage
still exists
• Trade is based on the existence of relative – not absolute –
production advantages
 FACULTY OF ECONOMICS

Money does not alter the story

• Suppose the costs of production are as given below

Peso price per unit of
• Mexico: 100 pesos/hour
output
• Scotland: 4 pounds/hour
40
• Suppose the exchange rate between pesos and
35
pounds is 1£ = 10P
30
• This gives the unit costs indicated in the chart 25 Coffee
beans
20
Wool
15
10
4£ ÷ 1 unit = 4£ per unit 5

4£ x 10P/£ = 40P per unit 0

Scotland Mexico
 FACULTY OF ECONOMICS

Money does not alter the story

• Suppose the costs of production are as given below

Peso price per unit of
• Mexico: 100 pesos/hour
output
• Scotland: 4 pounds/hour
40
• Suppose the exchange rate between pesos and
35
pounds is 1£ = 10P
30
• This gives the unit costs indicated in the chart 25 Coffee
beans
20
Wool
15
10
4£ ÷ 4 units = 1£ per unit 5
1£ x 10P/£ = 10P per unit 0
Scotland Mexico
 FACULTY OF ECONOMICS

Money does not alter the story

• Suppose the costs of production are as given below

Peso price per unit of
• Mexico: 100 pesos/hour
output
• Scotland: 4 pounds/hour
40
• Suppose the exchange rate between pesos and
35
pounds is 1£ = 10P
30
• This gives the unit costs indicated in the chart 25 Coffee
beans
20
Wool
15
10
5
100P ÷ 10 units = 10P per unit 0
Scotland Mexico
FACULTY OF ECONOMICS

Money does not alter the story

Peso price per unit of

output
• Suppose the costs of production are
as given below 40
• Mexico: 100 pesos/hour 35
• Scotland: 4 pounds/hour 30
25 Coffee
• Suppose the exchange rate between beans
20
pesos and pounds is 1£ = 10P Wool
15
• This gives the unit costs indicated in 10
the chart 5
0
Scotland Mexico
100P ÷ 5 units = 20P per unit
 FACULTY OF ECONOMICS

Money does not alter the story

• At these prices goods will naturally flow from the Peso price per unit of
output
cheaper market (Scotland for wool, Mexico for
coffee beans) to the more expensive market. 40

• Again, this demonstrates the law of comparative 35

advantage but through prices not relative outputs. 30

25 Coffee
beans
20
Wool
15
10
5
0
Scotland Mexico
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The Source Of The Productive Difference Does Not Matter

• The original idea of comparative advantage was

based on the labor theory of value.
• The labor theory of value holds that costs and prices are solely determined by the labor
content of an item.

• The examples given above rely on opportunity

cost.
• Opportunity cost holds that the cost of an item is the amount of another item the must be
given up to release sufficient resources to produce one more unit of the first item.
 FACULTY OF ECONOMICS

The production possibility frontier

United States
• The production possibility frontier (PPF) identifies
the maximum combinations of two products that a Wheat Cloth
nation can produce by fully utilizing all factors of 180 0
production with the best technology available.
150 20
• Consider the production possibilities schedule for an
example: 120 40
90 60
60 80
30 100
0 120
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Constructing the PPF

140 United States

120

100
Wheat Cloth
80 180 0

Cloth
60

40
150 20
20 120 40
0
0 50 100 150 200 90 60
Wheat
60 80
30 100
0 120
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Regions of the PPF

140 Productive maximum

120

100

80

Cloth
60 Unattainable with existing
40 resources and technology
Underutilized resources 20

0
0 50 100 150 200
Wheat
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Trade with the PPF model

US
140
120
100

Cloth
80
60
• Suppose the US and the UK have the PPFs given to 40
20
the right 0
0 20 40 60 80 100 120 140 160 180 200
Wheat

UK
140
120
100

Cloth
80
60
40
20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat
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Trade with the PPF model

US
140
120
100
• Suppose the US and the UK have the PPFs given to (90W, 60C)

Cloth
80
60
40
the right 20
0

• Further suppose that each country produces and 0 20 40 60 80 100 120 140 160 180 200
Wheat
consumes at the marked spot in the absence of
international trade UK
140
120
100

Cloth
80
60 (40W, 40C)
40
20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat
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Trade with the PPF model

US
140
120
100
(90W, 60C)

Cloth
80
60
• Can specialization and trade lead to more aggregate 40
20
production and consumption? 0
0 20 40 60 80 100 120 140 160 180 200

• If the US specialized in wheat production and the UK Wheat

in cloth production, aggregate production would

UK
increase from 130W to 180W and from 100C to 140
120C. 120
100

Cloth
80
60 (40W, 40C)
40
20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat
 FACULTY OF ECONOMICS

Trade with the PPF model

US
140
120
• This increased production would allow each country 100 (110W, 70C)

Cloth
80
60 Production
to consume at a point outside of its PPF as indicated 40
20
by the blue lines in the graphs. 0
0 20 40 60 80 100 120 140 160 180 200

• The increased consumption is the gains from trade. Wheat

Production UK
140
120
100

Cloth
80 (70W, 50C)
60
40
20
0
0 20 40 60 80 100 120 140 160 180 200
Wheat