LEARNING GOALS

After reading this chapter, you should be able to: What is the basis for trade
•Understand the law of comparative advantage and what are the gains
•Understand the relationship between opportunity from trade?
costs and relative commodity prices
•Explain the basis for trade and show the gains from What is the pattern of
trade under constant costs conditions
trade?
 PREVIEW
1. The Mercantilists’ Views on Trade
2. Trade Based on Absolute Advantage: Adam Smith
3. Trade Based on Comparative Advantage: David Ricardo
4. Comparative Advantage and Opportunity Costs
5. Empirical Tests of the Ricardian Model

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 WHAT IS INTERNATIONAL
TRADE?
•In a narrow sense, international trade is the exchange of goods and
services across national borders.
•In a broader sense, international trade is the exchange of goods,
services and resources (capital and labor) across national borders.
INTERNATIONAL TRADE IN
INTERNATIONAL ECONOMICS

International trade International trade

theories instruments

Lecture 2: The law of

Lecture 4: Tariff
comparative advantage

Lecture 5: Non-tariff
Lecture 3: H-O model
barriers
INTERNATIONAL TRADE
THEORIES
Classical International Neo-classical International
Trade Theory Trade Theory

1. Mercantilism Opportunity cost and Comparative

2. Absolute Advantage Advantage
3. Comparative Advantage

Heckscher-Ohlin Theory

Factor Endowments and Comparative

Advantage
1. THE MERCANTILISTS’
VIEWS ON TRADE
 INTRODUCTION

• Economic philosophy in 17th

and 18th centuries
• In England, Spain, France,
Portugal and the
Netherlands.
• Thomas Munn (1571- 1641),
“England’s treasure by
Foreign Trade”
 MERCHANTILIST’S VIEW ON
A nation’s wealth is measured by TRADE
stock of gold and silver

Accumulate as much gold and Appreciate the role of money

silver as possible Consider gold and silver as the only
form of wealth
Becoming rich by trade Appreciate the role of trade
• Encouraging export
• Restricting/ prohibiting import
The State’s role in trade activities

One nation gains

at the expenses of other nations Zero-sum game; Involuntary trade
 CONTRIBUTIONS
•The oldest, pioneer thoughts on International Economics
•Recognize the importance of trade
•Emphasize the government’s role in regulating trade
•Some ideas are still valid today
 LIMITATIONS
•Nature of the wealth of a nation:
 Gold and silver - the only form of wealth
 How about other resources such as human, man-made and natural resources?
•Zero-sum game: Trade is beneficial for one nation at the expense of other
nations.
•Assume that wealth increases through circulation, not in production.
•Cannot explain the pattern of trade.
 2. TRADE BASED ON
THE ABSOLUTE ADVANTAGE
ABSOLUTE ADVANTAGE OF ADAM SMITH

Adam Smith (1723-1790)

“An inquiry into the nature and causes of
the wealth of Nations” (1776)
ASSUMPTION
2 countries, 2 goods
Labour is the only production factor
No barriers to trade
No transportation cost
Perfect competition in all markets
 THE BASIS FOR TRADE
The basis for trade: Absolute advantage

A nation has an absolute advantage in producing a particular good if

it can produce that good more efficiently than the other country.

More efficient: higher productivity of labor (or lower labor cost)

 THE PATTERN OF TRADE
• When one country has an absolute advantage in the 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 well and exchanging part of
the output for the commodity of its absolute disadvantage.

 Specialize in producing and exporting goods which a nation has an absolute

advantage and import goods which it has an absolute disadvantage.
THE ILLUSTRATION OF ABSOLUTE
ADVANTAGE
US UK
Wheat - W (unit/hour) 6 1
Cloth – C (unit/hour) 4 5

• Determine the absolute advantage of each country

• Analyze the pattern of trade according to Adam Smith’s theory
THE ILLUSTRATION OF ABSOLUTE
ADVANTAGE
US UK
Wheat - W (unit/hour) 6 1
Cloth – C (unit/hour) 4 5

• The US has an absolute advantage over the UK in wheat production (US labor
productivity in producing Wheat is higher than that of the UK)
• The UK has an absolute advantage over the US in cloth production (UK labor
productivity in producing Cloth is higher than that of the US)
=> The US would specialize in producing wheat; the UK specialize in producing
cloth and then trade with each other.
 GAINS FROM TRADE
Auturky US: 6W=4C UK: 1W=5C

Specialization US produces wheat US produces cloth

Demand Exchanging W to C Exchanging C to W

Exchange rate 6W=6C

Benefits for US: 6–4=2C Benefits for UK: 5x6 – 6 = 24C

Gains from trade
↔ 1⁄2 h of producing C ↔ 4.8 h of producing C
 CONTRIBUTIONS
• Specialization and trade benefit both countries
• Adam Smith and other classical economists advocated a policy of laissez-faire,
or minimal government interference with economic activity.
• Free trade would cause world resources to be utilized most efficiently,
maximizing the world welfare.
 LIMITATIONS
US UK
Wheat - W (unit/hour) 6 1
Cloth – C (unit/hour) 4 2

• It cannot explain the trade in the case that one country has an absolute advantage
in both goods and the other does not have an absolute advantage in any goods.
• The US has an absolute advantage in producing both wheat and cloth.
• The UK does have absolute advantage in producing any goods.
 3. TRADE BASED ON
COMPARATIVE ADVANTAGE
 COMPARATIVE ADVANTAGE AND OPPORTUNITY
COST
• Ricardian model: differences in productivity of L between countries cause
productive differences, leading to gains from trade.
• The Ricardian model uses the concepts of opportunity cost and comparative
advantage.
• The opportunity cost of producing good X is the cost of not being able to
produce good Y because resources have already been used to produce good X.

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 COMPARATIVE ADVANTAGE AND OPPORTUNITY
COST
• A country faces opportunity costs when it uses resources to produce goods and services.
• E.g., a limited number of workers could be employed to produce roses or PCs.
◦ The opportunity cost of producing PCs is the number of roses not produced
◦ The opportunity cost of producing roses is the amount of PCs not produced
 How many PCs or roses should a country produce with the limited resources it has?

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COMPARATIVE ADVANTAGE AND OPPORTUNITY
COST
•Suppose the U.S. can produce 10 million roses with the same resources that could
produce 100,000 PCs.
•Ecuador can produce 10 million roses with the same resources that could produce
30,000 PCs.
•Workers in Ecuador are less productive than those in the U.S. in manufacturing PCs.
 Question: what is the opportunity cost of roses in Ecuador?

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 COMPARATIVE ADVANTAGE AND OPPORTUNITY
COST

•Ecuador has a lower opportunity cost of producing roses.

• The U.S has a lower opportunity cost of producing PCs.
◦ Ecuador: 10 million roses or 30,000 PCs
◦ US: 10 million roses or 100,000 PCs

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 COMPARATIVE ADVANTAGE AND OPPORTUNITY
COST
•A country has a comparative advantage in producing a good if the opportunity cost
of producing that good is lower in the country than it is in other countries.

•A country with a comparative advantage in producing a good uses its resources

most efficiently when it produces that good compared to producing other goods.

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 COMPARATIVE ADVANTAGE AND OPPORTUNITY
COST (cont.)
• The US has a comparative advantage in the production of PCs.
• Ecuador has a comparative advantage in the production of roses.
• Suppose initially that Ecuador produces PCs and the US produces roses, and that
both countries want to consume PCs and roses.
• Can both countries be made better off?

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 Comparative Advantage and Trade
Millions of Thousands of
Roses Computers
U.S. -10 +100
Ecuador +10 -30
Change 0 +70

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 Comparative Advantage and Trade (cont.)
• An example shows that when countries specialize in the good in which they
have a comparative advantage, more goods can be produced and consumed.
◦ Initially, both countries could only consume 10 million roses and 30,000 PCs.
◦ With specialization, they could still consume 10 million roses but could
consume 70,000 more PCs.

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A ONE FACTOR RICARDIAN MODEL

David Ricardo “The principles of political economy, and

(1772-1823) taxation” (1817)
 ASSUMPTION
•An example with roses and PCs explains the intuition behind the Ricardian
model.
•The Ricardian model assumes:
1. L is the only resource for production.
2. The supply of L in each country is fixed.
3. Only 2 goods are produced and consumed: WHEAT and CLOTH.
4. L is not specific to either industry.
5. Only 2 countries: HOME and FOREIGN.

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 BASIS FOR TRADE

• Even if a nation is less efficient than the other nation in the

production of both commodities, there is still a basis for mutually
beneficial trade.
• The basis for trade: Comparative advantage
• A country has a comparative advantage in producing one good
when its absolute advantage in producing this good is greater, or
its absolute disadvantage is smaller.
– Higher relative productivity or lower relative cost
 THE PATTERN OF TRADE

• A nation should specialize in the production and export of

the commodity that it has comparative advantage and
import the commodity that it has comparative
disadvantage.
 Illustration of comparative advantage
Good US UK
Wheat – W (unit/hour) 6 1
Cloth – C (unit/hour) 4 2

1. Determine the absolute advantage of the US and the UK.

2. What is the pattern of trade based on the concept of absolute
advantage?
3. Determine the comparative advantage of US and UK.
4. What is the pattern of trade based on the concept of comparative
advantage?
Illustration of Good US UK

comparative Wheat – W (unit/hour) 6 1

advantage Cloth – C (unit/hour) 4 2

1. UK has an absolute disadvantage in both goods -> cannot determine the pattern of
trade based on the concept of absolute advantage
2. US has a comparative advantage in Wheat production
(US labor is 06 times as productive in wheat but only 02 times productive in cloth
compared to UK)
3. UK has a comparative advantage in Cloth production
(UK labor is half as productive in cloth but 06 times les productive in wheat compared
to US)
4. US would specialize in production of wheat, UK would specialize in production of
cloth and then exchange with each other.
 GAINS FROM TRADE
Auturky US: 6W=4C UK: 1W=2C

Specialization US produces wheat UK produces cloth

Demand Exchanging W to C Exchanging C to W

Exchange rate 6W=6C

Benefits for US: 6–4=2C Benefits for UK: 2x6 – 6 = 6C

Gains from trade
↔ 1⁄2h of producing C ↔ 3h of producing C
GAINS FROM TRADE (CONT.)
The gains from trade by the rate of exchange  The range of exchange rate
The rate of Gains from trade Note for mutually beneficial trade
exchange is between the pre-trade
between W US UK World
&C (pre-trade (pre-trade price exchange rates of the two
price 6W:4C)
6W:12C) countries
6W:3C No trade
4 C < 6 W < 12 C
6W:4C 0C 8C 8C No trade
6W:5C 1C 7C 8C With trade  No guarantee for equal gain
6W:6C 2C 6C 8C With trade from trade: The further the
6W:7C 3C 5C 8C With trade rate of exchange is from pre-
6W:8C 4C 4C 8C Equal gain trade, the more benefits that
6W:9C 5C 3C 8C With trade
a country gains from trade
6W:10C 6C 2C 8C With trade  The more different the
6W:11C 7C 1C 8C With trade countries participating in
6W:12C 8C 0C 8C No trade international trade, the
greater the benefits from
6W:13C No trade
international trade.
 EXCEPTIO
N
Good US UK
Wheat – W (unit/hour) 6 3
Cloth – C (unit/hour) 4 2

No comparative advantage occurs when the absolute disadvantage

that one nation has with respect to another nation is the same in
both commodities.
(The UK is half as productive as the US in both wheat and cloth)
 CONTRIBUTIONS

• One of the most important theories with many practical

applications.
• Explain the pattern and gains of trade even when one nation is less
efficient than the other nation in the production of both
commodities.
 LIMITATION
S
• Determining comparative advantage based on the labour theory
of value
– Labour is the only factor in production
– Labour is used in the same fixed proportion in the production
of all commodities
– Labour is homogeneous
• Have not explained the sources of comparative advantages
4. COMPARATIVE ADVANTAGE
AND OPPORTUNITY COSTS
COMPARATIVE
ADVANTAGE AND
OPPORTUNITY
COSTS

Determined comparative
advantage based on
opportunity cost (OC), not on
labor productivity
 OPPORTUNITY COSTS
•The opportunity cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources
to produce one additional unit of the first commodity.
•Limited resources -> The trade-off
 BASIS FOR TRADE
The basis for trade: Comparative advantage
A nation has a comparative advantage in a commodity if it can produce this commodity at a lower
opportunity cost than the other nation.
US UK US UK
W (unit/hour) 6 1 OC of Wheat 2/3C 2C
C (unit/hour) 4 2 OC of Cloth 3/2W 1/2W

-> US has a comparative advantage in the production of wheat

-> UK has a comparative advantage in the production of cloth
PATTERN OF TRADE
•The US should specialize in producing wheat and export wheat to
the UK.
•The UK should specialize in producing cloth and export cloth to the
US.
THE PRODUCTION POSSIBILITY
FRONTIER (PPF)
•PPF is a curve that shows the alternative combinations of the two commodities that a
nation can produce by fully utilizing all of its resources with the best technology available to
it.

•What do points outside the PPF curve (C) represent?

•What do points inside the PPF curve (A) represent?
 THE PRODUCTION POSSIBILITY FRONTIER (PPF)
US UK
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20

Please draw the 120 40 40 40

PPF curve of the US 90 60 30 60
and the UK 60 80 20 80
30 100 10 100
0 120 0 120
 PPF UNDER THE CONSTANT
COST

• US has comparative advantage in Wheat

• UK has comparative advantage in Cloth
 B*

GAINS
FROM
TRADE
BEFORE TRADE AFTER TRADE
Production Consumption Production Consumption
The US
The UK
The World
 B*

GAINS
FROM
TRADE

BEFORE TRADE AFTER TRADE

Production Consumption Production Consumption
The US A (80W, 60C) A (80W, 60C) B (180W, 0C) E (110W, 70C)
The UK A* (40W, 40C) A* (40W, 40C) B* (0W, 120C) E* (70W, 50C)
The World 120W, 100C 120W, 100C 180W, 120C 180W, 120C
 CONTRIBUTIONS AND
LIMITATIONS
•CONTRIBUTIONS
Determining comparative advantage based on opportunity cost (labor is not
necessarily the only factor of production)
PPF curve and demonstrating the benefits from trade

•LIMITATIONS
Constant opportunity cost
Have not explained the sources of comparative advantages
 SUMMARY
This chapter examined the development of trade theory from the mercantilists
to Smith, Ricardo, and Haberler and sought to answer two basic questions:
◦ (a) What is the basis for and what are the gains from trade? and
◦ (b) What is the pattern of trade?
The mercantilists: a nation could gain in international trade only at the expense
of other nations’  restrictions on imports, incentives for exports, and strict
government regulation of all economic activities.
 SUMMARY
•Adam Smith: trade is based on absolute advantage and benefits for both nations  trade is a
positive sum game. Due to some limitations, absolute advantage explains only a small portion of
international trade today.
•David Ricardo introduced the law of comparative advantage: even if one nation is less efficient
than the other nation in the production of both commodities, there is still a basis for mutually
beneficial trade. Ricardo, however, explained the law of comparative advantage in terms of the
labour theory of value, which is unacceptable.
 SUMMARY
•Gottfried Haberler: explaining the law of comparative advantage in terms of the
opportunity cost theory.
•A straight-line production possibility frontier reflects constant opportunity costs.
•With trade, each nation can specialize in producing the commodity of its
comparative advantage and exchange part of its output with the other nation for
the commodity of its comparative disadvantage  both nations end up
consuming more of both commodities than without trade.
 A LOOK AHEAD
In the following lecture, we extend our trade model to more than one factor of production that
helps properly examine the basics of trade and gains from trade.

H-O MODEL
 KEY TERMS
Absolute advantage, p. 34 Mercantilism, p. 32

Basis for trade, p. 31 Complete Opportunity cost

specialization, p. 47 theory, p. 42

Constant opportunity costs, p. 43 Pattern of trade, p. 31

Gains from trade, p. 31 Production possibility frontier, p. 42

Labor theory of value, p. 41 Relative commodity prices, p. 44

Laissez-faire, p. 35 Small-country case, p. 47

Law of comparative advantage, p. 36