Lecture 2: The Law of Comparative

Advantage

NGUYỄN TIẾN DŨNG

UNIVERSITY OF ECONOMICS AND BUSINESS,

V I E T N A M N AT I O N A L U N I V E R S I T, H A N O I
 Objective

This chapter reviews the history of trade theory and

explain the basis for trade and the division of the gains
from trade across nations.
It seeks to answer three questions:
 What is the basis for trade?
 How the gains from trade are generated?
 How the gains from trade divided between nations?
 Content

The mercantilists’ views on trade

The absolute advantage theory developed by Adam smith
The comparative advantage theory by David Ricardo
The opportunity cost theory by Haberger
 Mercantilism
The mercantilists’ view on trade

The mercantilists maintained that nations should export

more than their imports to become richer and more
powerful.
 Trade surplus allows nations to accumulate precious metals such as
gold.
Thus the government should promote exports and
restrict imports at the same time.
In the mercantilists’ view, not all countries gain from
trade.
 A nation gains at the expense of other nations.
 Mercantilism
The mercantilism is still alive

 Despite the progress of mutilateral trade liberalization, nations

still impose various forms of restrictions on international trade.

 Industrial nations agricultural products, textile, shoes, steel and some hgh-tech
industries.
 The use of less explicit type of restrictions have been increased.

 Trade disputes have arisen over time.

 The theory of Absolute Advantage

Trade is based on absolute advantage (Adam Smith): a nation is

more efficient in the production of some commodities Absolute
advantage), but is less efficient in others (absolute disadvantage).
All nations gain from trade by specializing the production of the
commodities of their advantage and exchange for the
commodities of their disadvantage.
Trade allows for the utilization of available resources, thus
leading higher efficiency and output.
 Adam Smith advocates free trade
 The Theory of Absolute Advantage
Example
US UK
Wheat 6 1
(bushels/hour)
Cloth (Yards/hour) 4 5
The US has an absolute advantage in the production of wheat, and the UK has an
advantage in the production of cloth. Each nation specialize in the production of and
export the commodity of its absolute advantage. Suppose they exchange 6W for 6C. The
US gains 2C, or half labor hour. The gain for the UK is 24C or 4.8 labor hours.
 The theory of Comparative Advantage

 The theory of comparative advantage (David Ricardo) is based on

the following assumptions:
 Two nations and two commodities.
 Free trade.
 Labor is perfectly mobile within a nation but immobile across nations.
 Constant costs of production.
 No transportation costs.
 No technical change.
 The labor theory of value.
 The theory of Comparative Advantage

Comparative advantage: a nation is said to have a comparative

advantage in a commodity if it has a greater absolute advantage or
a smaller absolute disadvantage in that commodity.
A comparative disadvantage implies a smaller absolute advantage or a
greater absolute disadvantage.

The law of comparative advantage: nations specialize in the

production and export of the commodities at which they have a
comparative advantage), and import the commodities of their
comparative disadvantage.
Trade can take place even if a nation is less efficient in the production of
both commodities.(except for the case of no comparative advantage)
 The Theory of Comparative Advantage
Example
US UK
Wheat 6 1
(bushels/hour)
Cloth (Yards/hour) 4 2
The US is more efficient in the production of wheat and cloth. The UK has an absolute
disadvantage in both commodities. However, the UK has a comparative advantage
(smaller absolute disadvantage) in cloth. The US has a comparative advantage (greater
absolute disadvantage) in wheat. By exchanging 6W for 6C, the US gains 2C, or half labor
hour. The gain for the UK is 6C or 3 labor hours.
 The Theory of Comparative Advantage
Example
US UK
Wheat 6 1
(bushels/hour)
Cloth (Yards/hour) 4 2
The UK is around a half efficient as the US in the production of cloth, but six
times less efficient than the US in the production of wheat.
The UK is less productive than the US in both commodities, but is has a smaller
disadvantage in the production of cloth. The UK has a comparative advantage in
cloth.
The US has absolute advantage in both commodities, but it has a greater
advantage in the production of Wheat. So the US has a comparative advantage
in the production of Wheat.
 The theory of Comparative Advantage
The gain from trade and the rate of exchange
 Both nations gain from trade.
 By exchanging 6W for 6C, the US gains 2C ( or half an labor
hour)
 By exchanging 6C for 6W, the UK gains 6C (or 3 labor hour).
 There are a range of rate of exchange , for which mutually
beneficial trade can take place.
 The range of the rate of exchange for mutually beneficial trade is: 4C<6W<12C.
 The Theory of Comparative Advantage
The range of the rate of exchange
US UK
Wheat 6 1
(bushels/hour)
Cloth (Yards/hour) 4 2
• The US would not trade if it exchange 6W for less than 4C.
• The UK would not engage in trade if it exchange more than 12C for 6W
• The two nations gain when the rate of exchange is within the mutual
beneficial rate of exchange
• 4C < 6W <12C
 The theory of Comparative Advantage
The gain from trade and the rate of exchange
 The rate of exchange determines how the gain is shared
between the US and the UK.
 The total gain is 8C = 12C - 4C
 The closer the rate of exchange to the US internal rate (lower bound), the
smaller the gain for the US is and the larger the gain for the UK.
 The closer the rate of exchange to the UK internal rate (upper bound), the
smaller the gain for the UK is and the larger the gain for the US.
 How is the gain shared if the rate of exchange is 6W = 4C.
 How is the gain shared if the rate of exchange is 6W = 8C.
 How is the gain shared if the rate of exchange is 6W = 12C.
 The theory of Comparative Advantage
The case of no comparative advantage
 There is no mutually beneficial trade of the if the absolute
advantage one nation has over the other nation is in the same
proportion in two commodities.

US UK

Wheat 6 3
(bushels/hour)
Cloth 4 2
(Yards/hour)
 The theory of Comparative Advantage
Comparative advantage with money
 The wage rates and exchange rate can influence the money
prices and the comparative advantage.
 Because the UK is less efficient in the production, it must have low
wages. The lower UK wages make UK goods cheaper in term of money
and make its possible for the UK to export.
 The exchange rate also needs to adjust to maintain the
balanced trade.
 The theory of Comparative Advantage
Comparative advantage with money
US UK
Wheat (bushels/hour) 6 1
Cloth (Yards/hour) 4 2

Comparative advantage with money

US UK
Wheat ($) 1 2
Cloth ($) 1.5 1
Suppose the US wage rate is $6/hour; The UK rate is ₤1/hour. The
exchange rate is ₤1 = $2.
 The theory of Comparative Advantage
Comparative advantage with money
US UK
The exchange rate is ₤1 = $1
Wheat ($) 1 1
Cloth ($) 1.5 0.5

The exchange rate is ₤1 = $3

Wheat ($) 1 3
Cloth ($) 1.5 1.5
Suppose the US wage rate is $6/hour; The UK rate is ₤1/hour.
 Comparative Advantage and Opportunity Costs
The Theory of opportunity costs
 The theory of comparative advantage assumes the labor theory of
value: labor is the only factor of production or is used in fixed
proportion; and (2) labor is homogenous.
 The labor theory of value is not satisfactory because:
 In reality, labor is not the only factor of production, and there is the substitutability
between factor of production;
 Labor is not homogenous.
 Labor is not used in the same fixed proportion in the production of all commodities.
 The opportunity cost theory (Haberger, 1956) explains the comparative
advantage based on the opportunity cost theory (the law of
comparative costs).
 Comparative Advantage and Opportunity Costs
The Theory of opportunity costs
 The opportunity cost of a commodity is the amount of the
second commodity that must be given up to release just enough
resources to produce one additional unit of the first commodity.
 A nation with a lower opportunity cost of a commodity has a
comparative advantage in that commodity and a comparative
disadvantage in the other commodity.
 In the above example, the opportunity cost of wheat is 1W = 2/3C in the US
and 1W = 2C in the UK. So the US has a comparative advantage in wheat.
 Comparative Advantage and Opportunity Costs
The Theory of opportunity costs
 The production possibility frontier (transformation curve, PPF)
shows the combination of the two commodities a nation can
produce by fully utilizing its available resources and technology.
 Points inside the production frontier is possible but not efficient. Points above
the production frontier is impossible.

 The opportunity costs are constant within a nation, but differ

between nations providing the basis for trade.
 The constant opportunity cost implicit assumes that production factors are
perfect substitutes and/or they are homogenous.
Comparative Advantage and Opportunity Costs
The Theory of opportunity costs
 Comparative Advantage and Opportunity Costs
Opportunity costs and Relative Prices
 The production possibility frontier (PPF) curve is a straight line
and negatively sloped.
 The straight line implies a constant opportunity cost.

 The opportunity costs differ between nations, but are constant

within a nation.
 Constant opportunity costs arise because: (1) factors of
production are perfect substitutes or they are used in the same
fixed proportion in the production of all commodities; (2) each
unit of factors of production is homogenous of the same quality.
 Comparative Advantage and Opportunity Costs
Opportunity costs and Relative Prices

The absolute slope of the PPF curve measures the opportunity cost of
the commodity shown on the horizontal axis (wheat) in terms of the
commodity that is shown on the vertical axis (cloth)
The absolute slope of the PPF curve is equal to the relative price
PW/PC.
Comparative Advantage and Opportunity Costs
Opportunity costs and Relative Prices
 Comparative Advantage and Opportunity Costs
Trade under constant costs
In absence of trade, the US produce and consume at A,
and the UK produce and consume at A’.
With trade, the US specializes in the production of wheat
(point B), and the UK specializes in the production of
cloth.
By exchanging 70W for 70 C, the US consumes at E, and
the UK consumes at E’.
Both nations gain thank to the increased output resulting
from specialization.
Comparative Advantage and Opportunity Costs
Opportunity costs and Relative Prices
 Comparative Advantage and Opportunity Costs
Equilibrium
 The equilibrium relative commodity price is determined by the
combined supply and demand curve of the two countries.

 The equilibrium relative commodity price is between the pre-trade

relative prices in the two nations.

 Small country case: a small country completely specialize in the

commodity of comparative advantage, specialization is incomplete in
the large country.

 The small country grasp all the gain from trade (the importance of being unimportant)
Comparative Advantage and Opportunity Costs
Equilibrium
Comparative Advantage: Empirical Tests