THE LAW OF COMPARATIVE ADVANTAGE

Introduction
The basic questions that we seek to answer in this
chapter are:
1) What are the basis for trade and what are the
gains from trade?
A nation will be in trade if it gains from trade.
 How are gains generated?
 How large are the gains from trade?

2) What is the pattern of trade?

What are the commodities that are traded?
Which nation will export or import which commodity?
Early Trade Theories
1) The Mercantilists’ Views on Trade
2) Trade Based on Absolute Advantage:
Adam Smith
3) Trade Based on Comparative Advantage:
David Ricardo
1) The Mercantilists’ Views on Trade

During 17th and 18th century, a group of men

wrote essays and pamphlets on international
trade that advocated an economic philosophy
known as Mercantilism.

The only way to become rich and powerful for a

country is to export more than it imported.

Accumulate more of precious metals.

1) The Mercantilists’ Views on Trade
(contd.)
Emphasid on zero sum game.

The wealth of a nation is measured by the stock

of precious metals it possessed.

They advocated strict government control of all

economic activity.
1) The Mercantilists’ Views on Trade
(contd.)
Mercantilist views are important for 2 reasons:
1) Other ideas came forward as a reaction to
view of trade and
on the role of government control.
2) Today, as nations plagued by high levels of
unemployment seek to restrict imports is in fact
an effort to stimulate domestic production and
employment.
 Trade Based on Absolute Advantage:
Adam Smith
He started with the truth that for two nations to
trade with each other voluntarily, both nations must
gain.
If one nation gained nothing or lost, it would simply
refuse to trade.
But how does this mutually beneficial trade takes
place, and from where do these gains from trade
come from?
Trade between two nations is based on absolute
advantage.
 Absolute Advantage by Adam Smith
When one nation has an absolute advantage over
another in the production of one commodity but
has a absolute disadvantage with respect to the
other nation in producing a second commodity,

then both nations can gain by each specializing in the

production of the commodity of its absolute advantage
exchanging part of it for the output with the other nation for
the commodity of its absolute disadvantage.

Resources are utilized efficiently in both the nations.

Output of both the nations increases because of
specialization.
Eg. China (wheat) and Brazil (sugar)
Absolute Advantage by Adam Smith
Adam Smith was in favor of
Policy of Laissez – faire
Free trade
Illustration of Absolute Advantage
US UK
Wheat (bushels/man-hour) 6 1
Cloth (Yards/man-hour) 4 5

US has absolute advantage in Wheat

UK has absolute advantage in Cloth
US export W and import C
UK export C and import W
With an exchange rate of 6W = 6C,
Remark on Adam Smith’s theory
It is obvious that when one country is having absolute
advantage in one line and other is having in other
line, trade is possible.
But, what if one country is more productive than
another country in all lines of production?
Is trade possible in the above case?
David Ricardo answer YES.
 Law of Comparative Advantage
Even if one nation is less efficient compared to
other nation in both the lines of production,
still there is possibility of mutual
advantageous trade between the nations.
If a lawyer earns Rs.1000 per hour but can also type
twice faster than her typist who earn Rs.100
per hour, does it pay the lawyer to do her typing?
No
So, even if the nation has absolute disadvantage in
the production of both the commodities with
respect to other nation, mutual advantageous trade
is still possible.
Comparative Advantage
The less efficient nation should specialize in the
production of that good in which the absolute
disadvantage is less – the good in which it has
comparative advantage.
So, they will specialize in the production of that good and
export.
On the other hand, the country should import the good
in which the absolute disadvantage is greater – the
good in which it has comparative disadvantage.
Law of Comparative Advantage
Absolute disadvantage is smaller – comparative
advantage – produce it – Export.
Absolute disadvantage is more – comparative
disadvantage – Import

Again
Absolute advantage is greater–
comparative advantage – Export
Absolute advantage is smaller–
comparative disadvantage – Import
Illustration of Comparative Advantage
US UK
-------------------------------------------------------------
Wheat(bushels/man-hour) 6 1
Cloth (Yard /man-hour) 4 2
---------------------------------------------------------------------
US has absolute advantage in both W and C
UK has absolute disadvantage in both W and C.
For US, 6:1 > 4:2.
(comparative advantage in wheat)
However, UK’s disadvantage is smaller in Cloth.
(2:4 > 1:6)
 Law of Comparative Advantage
In two-two model, once it is determined that one
nation has comparative advantage in one commodity,
then the other nation must have comparative
advantage in other commodity.

In the above case,

UK should Export C and Import W
US should Export W and Import C.
Gains from Trade
US would be indifferent if they receive only 4C in
exchange for 6W.
UK will not be in trade if they have to sacrifice
more than 2C for 1W.
The range of mutually advantageous trade
4C < 6W < 12C
If the exchange rate is 6W = 6C
US gains 2C : ½ man labour hour
UK gains 6C : 3 man labour hours
The spread between 4C and 12C is 8C;
represents the total gains from trade.
Gains from Trade
The closer the exchange rate to 4C = 6W,
the lesser will be the gains shared by U.S relative
to U.K.
The closer the exchange rate to 12C = 6W,
less is the share of gain to UK relative to US.
If the exchange rate is 6 W = 10 C;
US gains 6 C and
UK gains 2C
If the exchange rate is 6 W = 8 C;
US gains 4 C and
UK gains 4C
Exceptions to the Law of Comparative
Advantage
1 exception to this law.
This occurs when absolute disadvantage that one
nation has with respect to another nation is the same in
both the commodities.
The UK would be exactly half as productive as the US
in both wheat and cloth production.
 Illustration of Comparative
Advantage
US UK
--------------------------------------------------------------------
Wheat (bushels/man-hour) 6 3
Cloth (Yard /man-hour) 4 2
--------------------------------------------------------------------------
UK has absolute disadvantage in both W and C.
Again, absolute disadvantage is same in both the
commodities.
Absence of comparative advantage in both the
commodities.
No mutual beneficial trade could take place.
 Reason:
1) US is willing to exchange 6W for more than 4C.
(domestic exchange rate)
2) But UK is not willing to sacrifice more than 4C to
get 6W.
As sacrifice of 4C (2 man- labor hour) can produce 6W
domestically.
Hence no mutual trade is possible.
Modification of the statement of the law of
comparative advantage is required.
 Changed Definition:
Even one nation has an absolute disadvantage with
respect to other nation on both the commodities,
there is still a basis for beneficial trade unless the
absolute disadvantages (that one nation has with
respect to the other nation) is in the same proportion
for both the commodities.
Comparative Advantage with Money
US UK
-------------------------------------------------------------
Wheat (bushels / man-hour) 6 1
Cloth (Yard /man-hour) 4 2
---------------------------------------------------------------------
According to the law of comparative advantage, even if UK
has an absolute disadvantage in the production of both W
and C with respect to US, there is still a basis for mutually
beneficial trade.
HOW ?
Wages in the UK should be sufficiently lower than wages
in the US.
Comparative Advantage with Money
Inefficiencies are more than compensated by the
lower wage rate.
Suppose wage rate in US is $6 per hour
And the wage rate in UK is £1 per hour.
Exchange rate is £1 =$2.
US UK
-------------------------------------------------------------------
Price of one bushel of Wheat (Pw) $1.00 $2.00
Price of one yard of Cloth(Pc) $1.50 $1.00
--------------------------------------------------------------------------
Comparative Advantage with Money
(contd.)
Even though UK labor is 1/2 as productive as US labor in
cloth production (4:2),
 UK labor receives only 1/3rd of the US wage rate (£1 =$2 as
opposed to $6 in the US).

The inefficiency of the UK’s labor relative to US labor in cloth

production is more than compensated by the lower wages in
the UK.

 This is always the case as long as the UK wage rate is

between 1/6 and ½ of the US wage rate
Comparative Advantage with
Money
(contd.)
 If Exchange rate is £1 =$1(so that UK wage rate was exactly
1/6 the US wage rate)
US UK
----------------------------------------------------------------------------
Price of one bushel of Wheat (Pw) $1.00 $1.00
Price of one yard of Cloth(Pc) 1.50 0.50
-----------------------------------------------------------------------------
 Assumptions of Comparative Advantage by
Ricardo
Ricardo based his theory on a number of simplifying
assumptions:
1) Only 2 nations and 2 commodities
2) Free trade
3) Perfect mobility of labor within each nation but immobility
between the nations
4) constant costs of production
5) no transportation costs
6) no technical change
7) the labor theory of value.
1 – 6 assumptions can be relaxed but 7 is not valid and
should not be used.
Comparative Advantage and the Labor
theory of Value

Under this theory, the value or price of

a commodity depends exclusively on
the amount of labor going into
production of the commodity.
Rather it can be explained on the basis
of opportunity cost theory (which is
accepted)
 Comparative Advantage and
The Opportunity Cost Theory
Developed by Haberler in 1936.
In this form, the law of comparative advantage is also
sometimes referred to as the law of comparative cost.
The opportunity cost theory:
The cost of a commodity is the amount of a second
commodity that must be given up to release just enough
resources to produce one more extra unit of the first
commodity.

No such assumption like that of labor theory.

A nation with a lower opportunity cost in the production of a
commodity means it has a comparative advantage in that
commodity and vice versa.
 Comparative Advantage and
Opportunity Cost Theory
Without trade,
 If US must give up 2/3rd amount of C to release just
enough resources to produce one extra unit of W.

US, the opportunity cost of 1W = 2/3 C

UK the opportunity cost of 1W = 2 C

US has less opportunity cost of producing wheat –

comparative advantage and produce and export.

This is same as given in the law of comparative advantage

based on labor theory of value.
 The Production Possibility Frontier under
Constant Costs
Opportunity costs can be illustrated with the PPF or
the transformation curve.

PPF / PPC shows the alternative combinations of

two commodities that a nation can produce by fully
utilizing all its resources with best technology
available to it.
 The production possibility Schedules for
W and C in the US and UK
In US, In UK,
1W = 2C (constant)
1W = 2/3C (constant)
10W = 20C
30W = 20C

United States United Kingdom

W C W C
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
The Production Possibility Frontiers
 The Production Possibility
Frontiers
PPF s are downward sloping.
Straight line PPF s reflect constant
opportunity costs.
Why does Constant opportunity costs
arise?
 Opportunity Cost and Relative Commodity
Prices
Opportunity cost of W =
the amount of C that the nation must give up to release just
enough resources to produce each additional unit of W.
It is given by the absolute slope of the PPF.

For US, it is 120 / 180 = 2 / 3 (opportunity cost of wheat)

For UK, it is 120 / 60 =2 (opportunity cost of wheat)

Based on the assumption

that prices equals the cost of production
The opportunity cost of wheat is equal to the price of
wheat relative to the price of cloth (Pw / Pc)
 Opportunity Cost and Relative
Commodity Prices
Pw / Pc P c / Pw
---------------------------------------------------------
US 2 / 3 3 / 2 = 1.5
UK 2 1 / 2 = 0.5
---------------------------------------------------
 Pw / Pc is lower in US is a reflection of the fact that US having
comparative advantage in wheat.

 Pc / Pw is lower in UK is a reflection of the UK having comparative

advantage in cloth.

 Difference in relative commodity prices between 2 nations

( given by the difference in slope) is a reflection of their
comparative advantage and provides the basis for mutual
beneficial trade.
The Basis for and the Gains from Trade
under Constant Costs
In autarky, a nation can consume the commodities
that it produces.

The nation’s PPF become its consumption frontier.

Which combination of commodities the nation

actually chooses to produce and consume depends
on the people’s tastes.
The Gains from Trade.
Relative Commodity Prices with
trade
Here both supply and demand curves are
used.
It shows how the equilibrium relative
commodity price with specialization and
trade is determined.
Equilibrium-Relative Commodity Prices with
Demand and Supply.
APPENDIX
Generalization of the theory of
Comparative Advantage:
1) Comparative Advantage with
more than two Commodities
2) Comparative Advantage with
more than two Nations
Comparative Advantage with
more than two Commodities
Commodity prices in the US and UK
Commodity Price in the U.S. Price in the U.K.
A $2 £6
B 4 4
C 6 3
D 8 2
E 10 1

We determine the commodities to be Exported /

Imported in terms of same currency.
Comparative Advantage with more
than two Commodities (contd.)
Suppose £ 1 = $ 2.
Commodity Price in Price in Price in Export Import
the U.S. the U.K. the U.K.
A $2 £6 $ 12 US UK
B 4 4 8 US UK
C 6 3 6 Not traded
D 8 2 4 UK US
E 10 1 2 UK US
Comparative Advantage with more
than two Commodities (contd.)
Suppose £ 1 = $ 3.
Commodity Price in Price in Price in the Export Import
the U.S. the U.K. U.K.
A $2 £6 $ 18 US UK
B 4 4 12 US UK
C 6 3 9 US UK
D 8 2 6 UK US
E 10 1 3 UK US
Comparative Advantage with more
than two Commodities (contd.)
Finally, Suppose £ 1 = $ 1.
Commodity Price in Price in Price in the Export Import
the U.S. the U.K. U.K.
A $2 £6 $6 US UK
B 4 4 4 Not traded
C 6 3 3 UK US
D 8 2 2 UK US
E 10 1 1 UK US
 Comparative Advantage with more
than two Commodities (contd.)
U.S. comparative advantage is greatest in commodity A.
U.S. must at least export A.
For this to be possible, exchange rate must be £1 >
$0.33.
U.K. comparative advantage is greatest in commodity E.
U.K. must at least export E.
For this exchange rate must be £ 1 < $ 10.
This can be generalized to cover many other
commodities.
 Comparative Advantage with more
than two Nations
Suppose that instead of 2 countries and 5 commodities,
We have 2 commodities (W and C) and 5 countries (A , B, C, D and E)

Ranking of nations in terms of internal PW /PC

Nation A B C D E
WithPtrade, the equilibrium 2PW /PC will3settle somewhere
W /PC 1 4 5
between 1 and 5.
If the equilibrium PW /PC = 3, then nation A and B will export W
to nation D and E in exchange for cloth.
Nation C will not be engaged in trade as pre trade P W /PC =
equilibrium PW /PC.
Comparative Advantage with
more than two Nations
If the equilibrium PW /PC = 4, then nation A,B and C
will export W to nation E in exchange for cloth.
Nation D will not be engaged in trade as pre trade
PW /PC = equilibrium PW /PC.
If the equilibrium PW /PC = 2, then nation A will export
W to nation C, D and E in exchange for cloth.
Nation B will not be engaged in trade as pre trade P W
/PC = equilibrium PW /PC.