Ch02 Hh Revised (1)

International International EconomicsEconomics

Tenth Edition

The Law of Comparative Advantage

Dominick SalvatoreJohn Wiley & Sons, Inc.

Salvatore: International Economics, 10th Edition © 2010 John Wiley & Sons, Inc.

CHAPTER T W O

22

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 Empirical Tests of the Ricardian Model


Introduction

Basic questions:

What is the basis for trade?

What are gains from trade?

What is the pattern of trade?

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



Mercantilism Export surpluses brought inflow of gold

and silver. Trade policy was to encourage exports

and restrict imports. One nation gained only at the expense

of another.



Mercantilists measured wealth of a nation by 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. The greater the stock of resources, the greater

the flow of goods and services to satisfy human wants, and the higher the standard of living.


Trade Based on Absolute Advantage: Adam Smith

A nation has absolute advantage over another nation if it can produce a commodity more efficiently.

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.



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.



Specialization and trade advantage both countries.

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

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




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.

Assuming each country has 2 unit labor hours and specialize on the product that has Absolute Advantage

US Specialize on Wheat then gain 2 additional Cloth UK Specialize on Cloth then gain 4 additional Wheat



No Trade Specialization Trade Trade Gain

U.S. U.K. U.S. U.K. U.S. U.K. U.S. U.K.

Wheat 6 1 12 0 6 5 - 5-1=4

Cloth 4 5 0 10 6 5 6-4=2

-

Trade Based on Comparative Advantage: David Ricardo

Law of Comparative Advantage Even if one nation is less efficient than

(has absolute disadvantage with respect to) the other nation in production of both commodities, there is still a basis for mutually beneficial trade.


Trade Based on Comparative Advantage: David Ricardo


U.K. has absolute disadvantage in both goods.

Since U.K. labor is half as productive in cloth but six times less productive in wheat compared to U.S., the U.K. has a comparative advantage in cloth.

U.S. has comparative advantage in wheat.

U.S. U.K.

Wheat (bushels/labor hour) 6 1

Cloth (yards/labor hour) 4 2

U.S. U.K.

Wheat UK has higher opportunity cost than US in Wheat production

Cloth US has higher opportunity cost than UK in Cloth production

Comparative Advantage and Opportunity Costs


The original idea of comparative advantage was based on the labor theory of value: The value or price of a commodity depends

exclusively on the amount of labor used to produce it.

Can use the opportunity cost theory to explain comparative advantage: The 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.

Comparative Advantage and Opportunity Costs


Production Possibilities Frontier A curve that shows alternative

combinations of the two commodities a nation can produce by fully using all resources with best available technology.

Constant opportunity costs arise when:1. Resources are either perfect substitutes

for each other or used in fixed proportion in production of both commodities, and

2. All units of the same factor are homogeneous.

FIGURE 2-1 The Production Possibility Frontiers of the United States and the United Kingdom.


The Basis for and the Gains from Trade under Constant Costs

In the absence of trade, a nation’s production possibilities frontier also represents its consumption frontier.

Increased output resulting from specialization and trade represents nations’ gains from trade, allowing nations to consume outside production possibilities frontier.


FIGURE 2-2 The Gains from Trade.


The Basis for and the Gains from Trade under Constant Costs

Under constant cost conditions, nations will completely specialize in their comparative advantage .

With complete specialization in both nations, the equilibrium-relative commodity price of each commodity lies between the pretrade relative commodity price in each nation.


FIGURE 2-3 Equilibrium-Relative Commodity Prices with Demand and Supply.


Empirical Tests of the Ricardian Model

McDougall (1951 and 1952)

Argued that costs of production would be lower in the U.S. in industries where U.S. labor was more than twice as productive as U.K. labor.

Found positive relationship between labor productivity and exports; industries with relatively productive labor in U.S. have higher ratios of U.S. to U.K. exports, supporting Ricardian theory of comparative advantage.

Results supported by Balassa, Stern and Golub in later studies.


FIGURE 2-4 Relative Labor Productivities and Comparative Advantage–United States and United Kingdom.


FIGURE 2-4-K Relative Labor Productivities and Comparative Advantage–Korea and Japan.


Chemical

Food

Office MachineryTextilesFuel

Basic Iron

WoodElectric Machinery

Paper

MetalTransport Machinery

Non- metal

General Machinery

Precision Machinery.

y = 0.2129x + 1.3368R2 = 0.4598

1.0

1.2

1.4

1.6

1.8

2.0

2.2

2.4

2.6

2.8

0.0 1.0 2.0 3.0 4.0 5.0 6.0

J PN Exports/ KOR Exports

Out

put

per

JPN

Wor

ker/

Out

put

per

KO

R W

orke

r

FIGURE 2-5 Relative Exports and Relative Unit Costs–United States and Japan.


Ch02 Hh Revised (1)

Documents

absolute advantage good

absolute disadvantage

trade policy

beneficial trade

pattern of trade

adam smitha nation

growing wheat

growing bananas