INTERNATIONAL TRADE AND AGREEMENTS

TOPIC INTERNATIONAL TRADE

II: (Labor
THEORY Productivity and Comparative Advantage: )The Ricardian
Model

1 | T o p i cI: Int roduction to International Trade

 INTERNATIONAL TRADE AND AGREEMENTS

TOPIC II
INTERNATIONAL TRADE THEORY (Labor Productivity and Comparative Advantage:
The Ricardian Model)

A. OVERVIEW

In this chapter, we begin with a general introduction to the concept of comparative

advantage then proceed to develop a specific model of how comparative advantage
determines the pattern of international trade.

• Comparative Advantage
• Absolute Advantage
• Opportunity Cost
• Production Possibility Frontier
• Gains from Trade
• Misconceptions about comparative advantage

B. OBJECTIVES

1. Define terminologies and understand the concept of comparative advantage and the
different empirical evidence on the Ricardian model.
2. Understand existing patterns of international trade using the Ricardian model.
3. Be guided with the content of the succeeding topics.

C. LEARNING OBJECTIVES
Learners will exhibit understanding of International Trade through the
appreciation of traditional and Ricardian models. As a first step toward understanding the
causes and effects of trade, this topic will be useful to look at simplified models and tools
to understand how differences between countries give rise to trade between them.

D. INSTRUCTIONS
1. Kindly read and comprehend Topic II: International Trade Policy
2. Watch the video suggestions or read suggested materials indicated on Suggested
Readings/ Video Materials.
3. Should you have any questions or concerns, do not hesitate to message me.
4. Stay Safe!
 INTERNATIONAL TRADE AND AGREEMENTS

E. DISCUSSION

INTERNATIONAL TRADE THEORY

(Labor Productivity and Comparative Advantage: The Ricardian Model)

2 Basic Reasons why countries engage in INTERNATIONAL TRADE

1. Countries benefit from their differences by reaching an arrangement in which one

does the things it does relatively well.

2. Countries trade to achieve economies of scale. That is, if each country produces only
a limited range of goods.

*Economies of Scale- cost advantages that a business can exploit by

expanding their scale of production. The effect is to reduce the average (unit)
costs of production.1

Figure1. Economies of Scale. Unit costs fall from AC1 to AC2 when output increases from
Q1 to Q2.
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THE CONCEPT OF COMPARATIVE ADVANTAGE

Comparative Advantage is a term associated with the 19 th century English Economist David
Ricardo. Ricardo considered what goods and services countries should produce and suggested
that they should specialize by allocating their scarce resources to produce goods and services for
which they have a comparative advantage.

Example. Considering two countries producing only two goods- motor cars and
commercial trucks. Country A can produce 30m cars or 6m trucks, and country B can
produce 35m cars and 21m trucks.
In this case, country B has the absolute advantage in producing both products, but it has a
comparative advantage in trucks because it is relatively better at producing them. Country
B is 3.5 times better at trucks and only 1.17 times better at cars.
Table 1. Maximum outputs of Country A and Country B
 INTERNATIONAL TRADE AND AGREEMENTS

Advantage lies with truck

production. Country B should
specialize in producing trucks
leaving country A to produce cars.

Figure 2. Graph showing the comparative advantage of

producing trucks over cars.

International trade allows each country to specialize in producing the good in which it
has a comparative advantage. A country has a comparative advantage in producing a good if the
opportunity cost of producing that good in terms of other goods is lower in that country than it is
in other countries.
*Comparative The ability to produce a good at a lower opportunity cost
Advantage- than another producer. 2

*Opportunity Cost- Whatever must be given up to obtain some item. The opportunity
cost measures the trade-off between the two
goods that each producer faces.2

When each person specializes in producing the good for which he or she has a
comparative advantage, total production in the economy rises. Trade can benefit everyone in
society because it allows people to specialize in activities in which they have a comparative
advantage.
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“Trade between two countries can benefit both countries if each country exports the goods
in which it has a comparative advantage.”

ONE FACTOR ECONOMY

(Dealing with an economy that has only one factor of production)
Introducing the role of Comparative Advantage in determining the pattern of International
Trade, we first set an example of a country that has only one factor of production. (In later chapters,
we extend the analysis to models which there are several factors.)

For example, it might require 1 hour of labor to produce a pound of cheese, 2 hours to
produce a gallon of wine.

Let’s say:

𝑎𝐿𝑊 = unit labor requirements in wine production

𝑎𝐿𝐶 = unit labor requirements in cheese production 1 hour = pound of cheese
L = total labor supply
𝑄𝐶 = economy’s production of cheese 12 hour= pound of cheese hours = gallon of wine
𝑄𝑊 = economy’s production of wine
𝑎𝐿𝑊𝑄𝑊 = labor used in production of wine 1 hour= pound of cheese
𝑎𝐿𝐶𝑄𝐶 = labor used in production of cheese

PRODUCTION POSSIBILITIES

Because any economy has limited resources, there are limits on what it can produce and
there are always trade-offs. To produce more of one good, the economy must sacrifice some
production of another good. Trade-offs are usually illustrated graphically by a production
possibility frontier, a graph that shows the combinations of output that the economy can
possibly produce given the available factors of production. When there is only one factor of
production the production possibility frontier of an economy is simply a straight line, thus the
opportunity cost of a pound of cheese in terms of wine is constant.

In this example, the opportunity cost is defined as the number of gallons of wine the
economy would have to give up in order to produce an extra pound of cheese.
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The opportunity cost

of cheese in terms of wine is
𝑎𝐿𝐶 / 𝑎𝐿𝑊. If it takes one person-
hour to make a pound of
cheese and two hours to
produce a gallon of wine,
the opportunity cost of
cheese in terms of wine is
onehalf. As figure 3
shows, the opportunity
cost is equal to the
absolute value of the slope
of the production
possibility frontier.

Figure 3. Line PF shows the maximum amount of cheese

an economy can produce given any production of wine,
vice versa.

RELATIVE PRICES AND SUPPLY

We need to know the relative price of the economy’s two goods, that is, the price of one good in
terms of the other. In the example, labor is the only factor of production, the supply of cheese
and wine will be determined by the movement of labor to whichever sector pays the higher
wage.

Let’s say:

𝑎𝐿𝑊 = unit labor requirements in wine production

𝑎𝐿𝐶 = unit labor requirements in cheese production
𝑃𝐶 = prices of cheese
𝑃𝑊 = prices of wine
𝑃𝐶 / 𝑎𝐿𝐶 = hourly wage rate in cheese sector
𝑃𝑊 / 𝑎𝐿𝑊 = hourly wage rate in wine sector

• Wages in the cheese sector will be higher if 𝑃𝐶/𝑃𝑊 > 𝑎𝐿𝐶 / 𝑎𝐿𝑊.
• Wages in the wine sector will be higher if 𝑃𝐶/𝑃𝑊 < 𝑎𝐿𝐶 / 𝑎𝐿𝑊.
Since everyone will want to work in whichever industry offers the higher wage, the economy
will specialize in:
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o the production of cheese if 𝑃𝐶/𝑃𝑊 > 𝑎𝐿𝐶 / 𝑎𝐿𝑊 o

the production of wine if 𝑃𝐶/𝑃𝑊 < 𝑎𝐿𝐶 / 𝑎𝐿𝑊

Only when 𝑃𝐶/𝑃𝑊 = 𝑎𝐿𝐶 / 𝑎𝐿𝑊 will both goods be produced.

The economy will specialize in the production of cheese if the relative price of cheese
exceeds its opportunity cost; it will specialize in the production of wine of the relative price of
cheese is less than the opportunity cost.

“In the absence of International Trade, the relative prices of goods are
equal to their relative unit labor requirements.”

THE GAINS FROM TRADE

Specialization and trade are beneficial.

• Country A could produce wine directly, but trade with Country B allows it to ‘produce’
wine by producing cheese and then trading the cheese for wine.
• Country A can ‘produce’ wine more efficiently by making cheese and trading it than by
producing wine directly for itself.
• Country B can ‘produce’ cheese more efficiently by making wine and trading it.

MISCONCEPTIONS ABOUT COMPARATIVE ADVANTAGE Productivity and

Competitiveness
Myth 1: Free trade is beneficial only if your country is strong enough to stand up to foreign
competition.
This argument fails to recognize that trade is based on comparative advantage.

The Pauper Labor Argument

Myth 2: Foreign competition is unfair and hurts other countries when it is based on low wages.
This is a political argument which claims that foreign competition based on low wages harms the
domestic economy. This is usually used by employee organizations such as labor unions to
promote protectionist trade policies restricting imports from abroad.

Exploitation
Myth 3: Trade exploits a country and makes it worse off if its workers receive much lower wages
than workers in other nations.
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In the absence of trade, these workers would be worse off. Denying the opportunity is to
condemn poor people to continue to be poor.

ADDING TRANSPORT COSTS AND NONTRADED GOODS

There are three main reasons why specialization in the real international economy is not
extreme:
• The existence of more than one factor of production.
• Countries sometimes protect industries from foreign competition.
• It is costly to transport goods and services.

The result of introducing transport costs makes some goods nontraded. In some cases,
transportation is virtually impossible. Example such as services like haircuts and auto repair
cannot be traded internationally.

F. SUGGESTED READINGS/ VIDEO MATERIALS

• Specialization and Trade: Crash Course Economics #2
https://www.youtube.com/watch?
v=NI9TLDIPVcs&list=PL1oDmcs0xTDdJN1PL2N1urX0EKupBJCQ&index=3

G. ASSIGNMENT
Either choose Nos. 1 and 3 or Nos. 2 and 3.

1. List some products that the Philippines exports or imports that demonstrate the
theory of comparative advantage and explain.

2. Economist Russell Roberts once wrote, "Self-sufficiency is the road to poverty."

Discuss how the principle of specialization and trade based on comparative
advantage supports this claim.

3. The table below shows the production possibilities of two countries, Philippines
and China, of two goods, Coconut and Tupperware, given a fixed amount of
resources.

Coconuts Tupperwares
Philippines 39 13
China 48 24

a. Which country has the absolute advantage in coconuts and which has the
absolute advantage in tupperwares?
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b. Calculate Philippines’ opportunity cost of coconuts in terms of tupperwares.

c. If the two countries were to specialize and trade with one another, which
country would import coconuts?

H. REFERENCES
1
“Economies of Scale” (2020). Retrieved from
https://www.tutor2u.net/business/reference/economies-of-scale.

2
Mankiw, N. (2012). Principles of Economic. Pasig City: Cengage Learning Asia Pte Ltd.
Philippine Branch.

Paul R. Krugman, M. O. (2003). International Economics Theory and Policy, 6th Edition. 75
Arlington St., Suite 300, Boston, MA 02116: Pearson Education, Inc.