Foundations of Modern Trade Theory: Comparative Advantage © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole

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Foundations of Modern Trade Theory:

Comparative Advantage

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password protected website for classroom use‐

PowerPoint slides prepared by:Andreea ChiritescuEastern Illinois University


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Historical Development of Modern Trade Theory

• The Mercantilists, 1500–1800• A strong foreign-trade sector• Favorable trade balance• Net payments - gold and silver• Increased spending• Rise in domestic output and employment

• Promote a favorable trade balance• Government regulation of trade• Tariffs, quotas, other commercial policies

• Static view of the world economy


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• The Mercantilists under attack• David Hume’s price-specie-flow doctrine• A favorable trade balance is possible only in the

short run• 1776, Adam Smith, The Wealth of Nations• World’s wealth is not a fixed quantity• International trade• Increase the general level of productivity within a

country• Increase world output (wealth)


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• Why Nations Trade: Absolute Advantage• Adam Smith – free trade advocate• Production costs differ among nations• Different productivities of factor inputs• Labor – homogenous

• Absolute cost advantage• Uses less labor to produce one unit of output


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• Principle of absolute advantage• A two-nation, two-product world• International specialization and trade• One nation - absolute cost advantage in one good• The other nation - absolute cost advantage in the

other good• Each nation must have a good that it is absolutely

more efficient in producing than its trading partner• Import goods – if absolute cost disadvantage• Export goods – if absolute cost advantage


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Absolute advantage; each nation is more efficient in producing one goodTABLE 2.1


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• Why Nations Trade: Comparative Advantage• 1800, David Ricardo (1772–1823)• Free trade• Mutually beneficial trade can occur whether or not

countries have any absolute advantage• Principle of comparative advantage• Emphasized comparative (relative) cost differences


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• Principle of comparative advantage• Even if a nation has an absolute cost

disadvantage in the production of both goods• The less efficient nation • Specialize in and export the good in which it is relatively

less inefficient• Where its absolute disadvantage is least

• The more efficient nation• Specialize in and export that good in which it is relatively

more efficient• Where its absolute advantage is greatest


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Examples of comparative advantages in international tradeTABLE 2.2


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• Principle of comparative advantage, simplified model - assumptions:1. The world consists of two nations• Each – use a single input, produce two commodities

2. In each nation, labor is the only input • Fixed endowment of labor• Labor is fully employed and homogeneous

3. Labor can move freely among industries• Within a nation• But is incapable of moving between nations


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• Principle of comparative advantage, simplified model - assumptions:4. Technology - fixed for both nations• Different nations may use different technologies• All firms within each nation - a common production

method for each commodity

5. Costs do not vary with the level of production• Proportional to the amount of labor used


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• Principle of comparative advantage, simplified model - assumptions:6. Perfect competition prevails in all markets• All are price takers• Identical products• Free entry to and exit from an industry• Price of each product = product’s marginal cost of

production

7. Free trade occurs between nations• No government barriers to trade


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• Principle of comparative advantage, simplified model - assumptions:8. Transportation costs are zero• Consumers - indifferent between domestically

produced and imported versions of a product if the domestic prices of the two products are identical

9. Firms make production decisions in an attempt to maximize profits• Consumers maximize satisfaction through their

consumption decisions


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• Principle of comparative advantage, simplified model - assumptions:10. There is no money illusion• When consumers make their consumption choices

and firms make their production decisions, they take into account the behavior of all prices

11. Trade is balanced • Exports must pay for imports• Ruling out flows of money between nations


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Comparative advantage, U.S. -absolute advantage in producing both goodsTABLE 2.3


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TRADE CONFLICTS David Ricardo, 1772–1823

• Leading British economist of the early 1800s• Theories of classical economics• Economic freedom through free trade and

competition• Successful businessman, financier, speculator• Stockbroker, loan broker

• 1819 – 1823, British parliament• Advocated the repeal of the Corn Laws (trade

barriers)


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TRADE CONFLICTS David Ricardo, 1772–1823

• Interest in economics• Adam Smith’s The Wealth of Nations• Newspaper articles on economic questions• 1817, The Principles of Political Economy and

Taxation• Laid out the theory of comparative advantage

• Advocate of free trade• Opponent of protectionism


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Production Possibilities Schedules• Modern trade theory• More generalized theory of comparative

advantage• Use a production possibilities schedule• Transformation schedule


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Production Possibilities Schedules• Production possibilities schedule• Various alternative combinations of two goods• A nation can produce • When all of its factor inputs • Land, labor, capital, entrepreneurship• Are used in their most efficient manner

• Maximum output possibilities of a nation


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With constant opportunity costs, a nation will specialize in the product of its comparative advantage. The principle of comparative advantage implies that with specialization and free trade, a nation enjoys production gains and consumption gains. A nation’s trade triangle denotes its exports, imports, and terms of trade. In a two nation, two product world, the trade triangle of one nation equals that of the other nation; one nation’s exports equal the other nation’s imports, and there is one equilibrium terms of trade.

Trading under constant opportunity costsFIGURE 2.1


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Production Possibilities Schedules• Marginal rate of transformation, MRT• The amount of one product a nation must

sacrifice to get one additional unit of the other product• Rate of sacrifice = opportunity cost of a product

• Absolute value of the slope of production possibilities schedule

• For Figure 2.1Wheat

MRTAutos


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Trading Under Constant-Cost Conditions

• Constant opportunity costs• Straight line production possibilities schedules• Factors of production • Perfect substitutes for each other

• All units of a given factor are of the same quality

• Autarky• Absence of trade


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• Basis for Trade • Principle of comparative advantage

• Direction of Trade• Specialize and export the good with the lowest

opportunity cost• Production Gains from Specialization• Production gains for both countries• Arise from the reallocation of existing resources• Static gains from specialization


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Gains from specialization & trade: constant opportunity costsTABLE 2.4


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• Consumption Gains from Trade• Trade = consumption gains for both countries• Consumption points • Outside domestic production possibilities schedules• Consume more of both goods

• Terms of trade• Rate at which a country’s export product is

traded for the other country’s export product• Define the relative prices of the two products


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• Domestic rate of transformation • Domestic terms of trade • Slope of the production possibilities schedule• Relative prices that two commodities can be

exchanged at home

• Terms of trade for exports• More favorable than domestic terms of trade


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• Trading possibilities line• International terms of trade for both countries

• Trade triangle for a country• Exports – along the horizontal axis• Imports – along the vertical axis• Terms of trade – the slope

• Complete specialization• Produce only one product


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• Domestic cost ratio• Negatively sloped production possibilities

schedule• Transform into a positively sloped cost-ratio line

• Outer limits for the equilibrium terms of trade• Becomes no-trade boundary

• Region of mutually beneficial trade• Bounded by the cost ratios of the two countries


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The supply-side analysis of Ricardo describes the outer limits within which the equilibrium terms of trade must fall. The domestic cost ratios set the outer limits for the equilibrium terms of trade. Mutually beneficial trade for both nations occurs if the equilibrium terms of trade lies between the two nations’ domestic cost ratios. According to the theory of reciprocal demand, the actual exchange ratio at which trade occurs depends on the trading partners’ interacting demands.

Equilibrium terms-of-trade limitsFIGURE 2.2


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• Equilibrium Terms of Trade, John Stuart Mill (1806–1873)• Add the intensity of the trading partners’

demands• Determine the actual terms of trade• The theory of reciprocal demand


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• Theory of reciprocal demand• Within the outer limits of the terms of trade• Actual terms of trade are determined by the

relative strength of each country’s demand for the other country’s product

• Production costs determine the outer limits of the terms of trade• Reciprocal demand determines what the actual

terms of trade will be within those limits


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• Theory of reciprocal demand• Best applies when both nations are of equal

economic size• The demand of each nation - noticeable effect on

market price• If two nations are of unequal economic size• The relative demand strength of the smaller nation

will be dwarfed by that of the larger nation• Domestic exchange ratio of the larger nation will prevail• The small nation can export as much of the commodity

as it desires


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• The importance of being unimportant• For two nations engaged in international trade• Same size, similar taste patterns• Gains from trade – shared equally between them

• One nation is significantly larger than the other• Larger nation - fewer gains from trade • Smaller nation - most of the gains from trade


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TRADE CONFLICTS

Babe Ruth and the principle of comparative advantage

• George Herman Ruth (1895–1948)• 1914 – 1920, Boston Red Sox, 158 games• Left-handed pitcher• Pitching record: 89 wins and 46 losses• 23 victories in 1916 • 24 victories in 1917

• Babe Ruth• Absolute advantage in pitching• Comparative advantage in hitting


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TRADE CONFLICTS


• 1920 – 1934, New York Yankees, Babe Ruth• Ended his pitching career - 2.28 earned run

average• Switched to only hitting• Dominated professional baseball• Teamed with Lou Gehrig• Greatest one-two hitting punch in baseball

• 1927 Yankees - the best in baseball history• Record of 60 home runs


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TRADE CONFLICTS


• 1920 – 1934, New York Yankees, Babe Ruth• 1923, Yankee Stadium – nicknamed “The House

That Ruth Built”• Baseball Hall of Fame, 1936• Win four World Series• Most renewed franchise


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• Terms-of-Trade Estimates• Commodity terms of trade• Barter terms of trade• Measure of the international exchange ratio• Measures the relation between the prices a nation

gets for its exports and the prices it pays for its imports

100Export Price Index

Terms of trade = Import Price Index


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• Improvement in a nation’s terms of trade• Rise in its export prices • Relative to its import prices

• A smaller quantity of export goods sold abroad• Required to obtain a given quantity of imports

• Deterioration in a nation’s terms of trade• Rise in its import prices • Relative to its export prices

• Purchase of a given quantity of imports • Sacrifice of a greater quantity of exports


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Commodity terms of trade, 2008 (2000 = 100)TABLE 2.5


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Dynamic Gains From Trade• Dynamic gains from international trade• More efficient use of an economy’s resources• Higher output and income• More saving, More investment• Higher rate of economic growth• Higher productivity• Economies of large-scale production• Increased competition


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Changing Comparative Advantage• Patterns of comparative advantage change

over time• Productivity increases• Production possibilities schedule changes• More output can be produced - with the same

amount of resources• Producers - need to hone their skills to

compete in more profitable areas


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If productivity in the Japanese computer industry grows faster than it does in the U.S. computer industry, the opportunity cost of each computer produced in the United States increases relative to the opportunity cost of the Japanese. For the United States, comparative advantage shifts from computers to autos.

Changing comparative advantageFIGURE 2.3


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Trading Under Increasing-Cost Conditions

• Increasing opportunity costs• Concave production possibilities schedule• Bowed outward from the diagram’s origin

• Inputs are imperfect substitutes for each other• MRT rises• Absolute slope of the production possibilities

schedule


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Increasing opportunity costs lead to a production possibilities schedule that is concave, viewed from the diagram’s origin. The marginal rate of transformation equals the (absolute) slope of the production possibilities schedule at a particular point along the schedule.

Production possibilities schedule; increasing-cost conditionsFIGURE 2.4


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• Increasing-Cost Trading Case• One country specializes in producing one good• The other country specializes in producing the

other good• Specialization continues in both nations until• Relative cost of one good is identical in both

nations• One country’s exports of one good are precisely

equal to the other country’s imports of the good• Same domestic rates of transformation


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With increasing opportunity costs, comparative product prices in each country are determined by both supply and demand factors. A country tends to partially specialize in the product of its comparative advantage under increasing cost conditions.

Trading under increasing opportunity costsFIGURE 2.5


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• Production gains• More of each good is being produced

• Consumption gains• Both countries consume more of at least one

good• The trade triangle• Exports, imports, and terms of trade• Same for both countries


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Gains from specialization and trade: increasing opportunity costsTABLE 2.6


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• Partial Specialization• Each country specialize only partially • In the production of the good in which it has a

comparative advantage• Increasing costs - mechanism that forces costs

in two trading nations to converge• Basis for further specialization ceases to exist• Both nations will produce some of each good


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• Partial Specialization• Not all goods and services are traded

internationally• Differing tastes for products• Most products are differentiated


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The Impact of Trade on Jobs• Extent to which an economy is open• Influences the mix of jobs within an economy• Can cause dislocation in certain areas or

industries• Little effect on the overall level of employment


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Increased international trade tends to neither inhibit overall job creation nor contribute to an increase in the overall rate of unemployment. As seen in the figure, the increase in U.S. imports as a percentage of GDP over the past several decades has not led to any significant trend in the overall unemployment for Americans.

The impact of trade on jobsFIGURE 2.6


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Comparative Advantage Extended to Many Products and Countries

• More Than Two Products• Comparative advantage• Rank the goods by the degree of comparative cost

• Each country exports the product(s) • Has the greatest comparative advantage

• Each country imports the product(s) • Has greatest comparative disadvantage

• Cutoff point between exports and imports• Relative strength of international demand


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When a large number of goods is produced by two countries, operation of the comparative-advantage principle requires the goods to be ranked by the degree of comparative cost. Each country exports the product(s) in which its comparative advantage is strongest. Each country imports the product(s) in which its comparative advantage is weakest.

Hypothetical spectrum of comparative advantages, U.S. and JapanFIGURE 2.7


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Comparative Advantage Extended to Many Products and Countries

• More Than Two Countries• Multilateral trading relations• Bilateral balance should not pertain to any two

trading partners• Trade surplus• With trading partners that buy a lot of the things

that it supplies at low cost• Trade deficit• With trading partners that are low-cost suppliers of

goods that it imports intensely


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When many countries are involved in international trade, the home country will likely find it advantageous to enter into multilateral trading relations with a number of countries. This figure illustrates the process of multilateral trade for the United States, Japan, and OPEC.

Multilateral trade: U.S., Japan, and OPECFIGURE 2.8


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Exit Barriers• Open trading system• Channeling resources from uses of low

productivity to those of high productivity• Competition• High cost plants exit• Low cost plants operate in the long run


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Exit Barriers• Restructuring of inefficient companies • Long time• Cling to capacity• Existence of exit barriers• Various cost conditions -make lengthy exit a

rational response by companies• Hinder the market adjustments


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Empirical Evidence on Comparative Advantage

• The Ricardian model• Nations export goods - their labor productivity

is relatively high• Testing the Ricardian model • G.D.A. MacDougall, 1951• Export patterns of 25 separate industries; United

States and United Kingdom, 1937• 20 industries fit the predicted pattern

• Balassa and Stern• Also supported Ricardo’s conclusions


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Empirical Evidence on Comparative Advantage

• Testing the Ricardian model • Stephen Golub• Relative unit labor costs and trade for United States • United Kingdom, Japan, Germany, Canada, Australia

• Relative unit labor cost helps to explain trade patterns for these nations

• Limitations of the Ricardian model• Labor is not the only factor input• Production and distribution costs• Differences in product quality


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The figure displays a scatter plot of U.S./Japan export data for 33 industries. It shows a clear negative correlation between relative exports and relative unit labor costs. A rightward movement along the figure’s horizontal axis indicates a rise in U.S. unit labor costs relative to Japanese unit labor costs; this correlates with a decline in U.S. exports relative to Japanese exports, a downward movement along the figure’s vertical axis.

Relative exports & relative unit labor costs: U.S./Japan, 1990FIGURE 2.9


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Does Comparative Advantage Apply in the Face of Job Outsourcing?

• Comparative advantage• Weakened if resources can move to wherever

they are most productive• Relatively few nations with abundant cheap labor

• No longer shared gains• Some nations win and others lose


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• Major change in the world economy • Strong educational systems • Millions of skilled workers in developing nations,

China and India• As capable as the most highly educated workers in

advanced nations• Much lower cost

• Inexpensive Internet technology • Many workers to be located anywhere

• New political stability • Technology and capital to move more freely around

the globe


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U.S. occupations regarded as highly likely to go offshoreTABLE 2.7


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• Advantages of Outsourcing• Reduced costs and increased competitiveness• New exports• Repatriated earnings• Job losses tend to be temporary• The creation of new industries and new products• More lucrative jobs for Americans


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• Outsourcing and the U.S. Automobile Industry• Early 1900s, Ford Motor Company – Model T:

700 parts• Gains of large-scale mass production• Gains of a high degree of specialization within a

single plant• More sophisticated cars and competition• Ford – outsource production• Keep strategically important tasks & production in-house• Noncore tasks purchased from external suppliers


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GLOBALIZATIONOutsourcing of Boeing 787 Dreamliner

triggers machinist’s strike

• 2007, Boeing 787 Dreamliner, $150 million • 3 Japanese firms, 35% of the design and

manufacturing work• Boeing - final assembly in three days• Italy, China, and Australia


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• Gains from globalization• Decrease the time required to build its jets by

more than 50 percent• Decrease costs - Foreign suppliers to absorb

some of the costs of developing the plane• Spreading the risk• Engineering talent and technical capacity• Maintain close relationships with its customers


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• Boeing’s suppliers fell behind • Production -more than a year behind schedule• Language barriers• Some contractors outsourced chunks of work

• Boeing’s union workforce• Anger and anxiety• Fear of losing their jobs to outsourcing• Strike in 2008• Nearly 27,000 machinists walked off their jobs


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Producing the Boeing 787: how Boeing outsources its workTABLE 2.8


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• Outsourcing and the U.S. Automobile Industry• Increasing numbers of parts and services –

noncore• Today - about 70% of a typical Ford vehicle• Parts, components, and services purchased from

external suppliers


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• Burdens of Outsourcing• Americans who lose their jobs or find lower-

wage ones• Wages of low-skilled American workers• High school education or less• Decreased in real terms• Decreased relative to the wages of skilled

workers (college education or higher)


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• Technological change and outsourcing • Declining demand for low-skilled American

workers• Outsourcing of high-skilled jobs • Shift demand to cheaper substitutes in Asia• May yield economic benefits for the nation• Losers – the displaced workers


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• Address the plight of the displaced worker• Generous severance packages, insurance

programs• Revamp the U.S. education system• Prepare workers for jobs that cannot easily go

overseas• Revise the tax code • Reward firms that produce jobs that stay in the

United States


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• Some U.S. Manufacturers Prosper by Keeping Production in the United States• Increase the skill level• Perform tasks more efficiently• Cost-cutting programs to improve

competitiveness• Gained efficiencies• Contracting single suppliers of packing materials

and components

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Foundations of Modern Trade Theory: Comparative Advantage © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole