International

Economics Tenth Edition

The Law of Comparative Advantage (Part 1)

Dominick Salvatore

John Wiley & Sons, Inc.

CHAPTER T W O

2

In this chapter:

Introduction

The Mercantilists’ Views on Trade

Trade Based on Absolute Advantage: Adam Smith

Trade Based on Comparative Advantage: David Ricardo

Comparative Advantage and Opportunity Costs

The Basis for and the Gains from Trade under Constant Costs

Introduction

Basic questions:

What is the basis for trade?

What determines which country exports each good?

What are gains from trade?

What benefits do countries get from international trade?

What is the pattern of trade?

Which goods are exported/imported by each country?

Assume two-nation, two-good world

The Mercantilists’ Views on Trade

Mercantilism

Economic philosophy in 17th and 18th centuries, in England, Spain, France, Portugal and the Netherlands.

Belief that a nation could become rich and powerful only by exporting more than it imported.

A nation’s wealth is measured by the amount of precious metals it owns.

The Mercantilists’ Views on Trade

Mercantilism

Export surpluses bring inflow of gold and silver.

Trade policy was to encourage exports and restrict imports.

Mercantilists advocate excessive government intervention to impose this trade policy.

Trade is a zero-sum game: One nation gains only at the expense of another. In other words, mutual benefits from trade are impossible!

The Mercantilists’ Views on Trade

Mercantilists measured the wealth of a nation by the stock of precious metals it possessed.

Today, we measure wealth of a nation by its stock of human, man-made and natural resources available for producing goods and services.

Trade Based on Absolute Advantage: Adam Smith

A nation has absolute advantage over another nation if it can produce a commodity more efficiently, i.e. at a lower labor cost (can produce more per labor hour).

When one nation has absolute advantage in production of a commodity, but an absolute disadvantage with respect to the other nation in a second commodity, both nations can gain by specializing in their absolute advantage good and exchanging part of the output for the commodity of its absolute disadvantage.

Trade Based on Absolute Advantage: Adam Smith

Example:

Canada is efficient in growing wheat, inefficient in growing bananas.

Nicaragua is efficient in growing bananas, inefficient in growing wheat.

Canada has absolute advantage in wheat, Nicaragua has absolute advantage in bananas.

Mutually beneficial trade can take place if both countries specialize in their absolute advantage.

Trade Based on Absolute Advantage: Adam Smith

Specialization and trade advantage both countries.

Adam Smith (and other classical economists) advocated policy of laissez-faire, or minimal government intervention with economic activity.

Free trade would cause world resources to be utilized most efficiently, maximizing world welfare.

Trade Based on Absolute Advantage: Adam Smith

Production & Consumption before Specialization & Trade

U.S. U.K.

Wheat (bushels/labor hour) 6 1

Cloth (yards/labor hour) 4 5

U.S. has absolute advantage over U.K. in wheat.

U.K. has absolute advantage over U.S. in cloth.

Both nations can gain from specialization in

production and trade if U.S. specializes in

producing and exporting wheat while U.K.

specializes in producing and exporting cloth.

Trade Based on Absolute Advantage: Adam Smith

Production After Specialization

U.S. U.K.

Wheat (bushels/labor hour) 12 0

Cloth (yards/labor hour) 0 10

Consumption After Trade U.S. U.K.

Wheat 12 – 5 = 7 0 + 5 = 5

Cloth 0 + 5 = 5 10 – 5 = 5

Assume that U.S. exchanges 5W for 5C with U.K.

Trade Based on Absolute Advantage: Adam Smith

Gains from Trade:

Gains from trade are the increased consumption after

specialization in production and trade.

The U.S. gains 1W and 1C from trade. The value of

these gains in the U.S., in terms of labor hours, are 1/6

hour (for the extra unit of wheat) and 1/4 hour (for the

additional unit of cloth). The U.S. saves 25 minutes of

labor time (for every 2 hours) after trade.

Gains from Trade U.S. U.K.

Wheat 7 – 6 = +1 5 – 1 = +4

Cloth 5 – 4 = +1 5 – 5 = 0

Trade Based on Absolute Advantage: Adam Smith

Gains from Trade:

The U.K. gains 4W from trade. The value of this

gains in the U.K. are 4 labor hours, since it takes one

hour to produce each unit domestically. These 4 hours

can produce 20 units of cloth in the U.K.!

Consumption After Trade U.S. U.K.

Wheat +1 +4

Cloth +1 0

Trade Based on Absolute Advantage: Adam Smith

Consumption After Trade U.S. U.K.

Wheat 12 – 6 = 6 0 + 6 = 6

Cloth 0 + 6 = 6 10 – 6 = 4

Assume that U.S. exchanges 6W for 6C with U.K.

Gains from Trade U.S. U.K.

Wheat 6 – 6 = 0 6 – 1 = +5

Cloth 6 – 4 = +2 4 – 5 = -1

Trade Based on Absolute Advantage: Adam Smith

Gains from Trade:

The U.S. gains 2C from trade. The value of these

gains in the U.S. are ½ labor hour (since it takes 1 hour

to produce 4C). The U.S. saves 30 minutes of labor

time (for every 2 hours) after trade.

Trade Based on Absolute Advantage: Adam Smith

Gains from Trade:

The U.K. gains 5W but loses 1C after trade. The

gained 5W are worth 5 labor hours (since it takes 1

hour to produce 1W in the U.K.). The lost 1C is worth

only 1/5 labor hours (or 12 minutes of labor time).

Therefore, the U.K. gains 4.8 labor hours after trade.

The gained 5W could be exchanged domestically in

the U.K. for 25C. Since the U.K. loses 1C, the net gain

to the U.K. is equivalent to 24C (which requires 4.8

labor hours to produce in the U.K.!)