McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3: Chapter 3: Why Everybody Trades: Why Everybody Trades:

Comparative Comparative AdvantageAdvantage

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ContentsContents

MercantilismMercantilism Absolute AdvantageAbsolute Advantage Comparative AdvantageComparative Advantage

Production Possibility CurveProduction Possibility Curve

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Adam Smith’s theory of the Adam Smith’s theory of the absolute advantageabsolute advantage

Assumptions:Assumptions: Two countries – the US and the rest of Two countries – the US and the rest of

the worldthe world Two products – wheat and clothTwo products – wheat and cloth Each product uses one resource – Each product uses one resource –

labourlabour Two ways to show each country’s Two ways to show each country’s

ability to produceability to produce Quantity of output per labour hourQuantity of output per labour hour Labour hours needed to produce a Labour hours needed to produce a

unit of outputunit of output

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Adam Smith’s ExampleAdam Smith’s ExampleAbsolute AdvantageAbsolute Advantage

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The US has higher productivity on The US has higher productivity on wheat and hence an absolute wheat and hence an absolute advantage in wheatadvantage in wheat

What about the rest of the world?What about the rest of the world? What are the changes in world What are the changes in world

production if 1 hr of labour is shifted production if 1 hr of labour is shifted from cloth to wheat in the US? From from cloth to wheat in the US? From wheat to cloth in the rest of the wheat to cloth in the rest of the world?world? US: -0.25 cloth; +0.5 wheatUS: -0.25 cloth; +0.5 wheat ROW: +1 cloth; -0.4 wheatROW: +1 cloth; -0.4 wheat World: +.75 cloth; +0.1 wheatWorld: +.75 cloth; +0.1 wheat

Global production efficiency is Global production efficiency is increased due to tradeincreased due to trade

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Ricardo’s Example:Ricardo’s Example:Comparative AdvantageComparative Advantage

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Ricardo’s theory of Ricardo’s theory of comparative advantagecomparative advantage

What if a country has absolute What if a country has absolute advantage in both products? Will this advantage in both products? Will this country benefit from trade?country benefit from trade?

The principle of the comparative The principle of the comparative advantageadvantage A country will EXPORT the goods that it A country will EXPORT the goods that it

can produce at a LOWER OPPORTUNITY can produce at a LOWER OPPORTUNITY COST and COST and

IMPORT the goods that it would IMPORT the goods that it would otherwise produce at a HIGHER otherwise produce at a HIGHER OPPORTUNITY COSTOPPORTUNITY COST

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Ricardo focused on labor productivity Ricardo focused on labor productivity (or resource productivity more (or resource productivity more generally) for different products in generally) for different products in different countriesdifferent countries

Basis for trade: Relative differences Basis for trade: Relative differences in labor (resource) productivity.in labor (resource) productivity.

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Which country has an absolute Which country has an absolute advantage in wheat? advantage in wheat?

In cloth?In cloth? The opportunity cost (price) of cloth The opportunity cost (price) of cloth

in the US is the amount of wheat that in the US is the amount of wheat that we have to give up in order to we have to give up in order to produce a unit of cloth produce a unit of cloth

The opportunity cost of cloth is 2 The opportunity cost of cloth is 2 W/C [0.5/0.25] or [4/2]W/C [0.5/0.25] or [4/2]

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The opportunity cost (price) of 1 unit The opportunity cost (price) of 1 unit of cloth in ROW is the amount of of cloth in ROW is the amount of wheat that they have to give up, wheat that they have to give up,

The opportunity cost of cloth in ROW The opportunity cost of cloth in ROW is 0.67W/C [0.67/1]or [1/1.5]is 0.67W/C [0.67/1]or [1/1.5]

What about the prices of wheat?What about the prices of wheat? Wheat in US 0.5 C/W [.25/.5] or [2/4]Wheat in US 0.5 C/W [.25/.5] or [2/4] Wheat in ROW 1.5 C/W [1/.67] or [1.5/1]Wheat in ROW 1.5 C/W [1/.67] or [1.5/1]

Which product is cheaper in the US? Which product is cheaper in the US? In ROW? In ROW?

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Ricardo’s Example:Ricardo’s Example:No-Trade Relative PricesNo-Trade Relative Prices

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Arbitrage (trade) is possible – buy Arbitrage (trade) is possible – buy cloth in ROW for 0.67W/C and sell in cloth in ROW for 0.67W/C and sell in the US for 2W/Cthe US for 2W/C

Eventually, the world price for cloth Eventually, the world price for cloth will be established between 0.67 and will be established between 0.67 and 2W/C. Suppose it is 1W/C2W/C. Suppose it is 1W/C

And the world price of wheat And the world price of wheat between 0.5 and 1.5 C/Wbetween 0.5 and 1.5 C/W

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Gains from trade:Gains from trade: USUS

give up ½ unit of cloth to produce 1 unit of wheat give up ½ unit of cloth to produce 1 unit of wheat for export (domestic substitution and for export (domestic substitution and specialization) specialization)

import 1 unit of cloth in exchange for exporting 1 import 1 unit of cloth in exchange for exporting 1 unit of wheatunit of wheat

US is better-off by ½ unit of cloth after trade US is better-off by ½ unit of cloth after trade ROWROW

give up 2/3 unit of wheat to produce a unit of give up 2/3 unit of wheat to produce a unit of cloth for exportcloth for export

import 1 unit of wheat in exchange for exporting 1 import 1 unit of wheat in exchange for exporting 1 unit of clothunit of cloth

ROW is better-off by 1/3 unit of wheat after tradeROW is better-off by 1/3 unit of wheat after trade

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Figure 3.1 – The Gains from Figure 3.1 – The Gains from Trade, Shown for Ricardo’s Trade, Shown for Ricardo’s

Constant-Cost CaseConstant-Cost Case

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The PPC with constant The PPC with constant costscosts

If the US has 100 billion labour If the US has 100 billion labour hours and it produces only wheat, hours and it produces only wheat, how much wheat will it produce? how much wheat will it produce?

50 billion units of wheat50 billion units of wheat How much cloth will the US How much cloth will the US

produce with 100 billion labour produce with 100 billion labour hours (if only producing cloth)?hours (if only producing cloth)?

25 billion units of cloth25 billion units of cloth

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The PPC with constant The PPC with constant costscosts

If the ROW has 100 billion labour If the ROW has 100 billion labour hours and it only produces cloth, hours and it only produces cloth, how much cloth will it produce?how much cloth will it produce?

100 billion units of cloth100 billion units of cloth How much wheat (assuming only How much wheat (assuming only

wheat is produced)?wheat is produced)? 67 billion units of wheat67 billion units of wheat

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The US PPC has a constant slope of The US PPC has a constant slope of 50/25=2W/C50/25=2W/C

The ROW PPC has a constant slope The ROW PPC has a constant slope of 67/100=0.67W/Cof 67/100=0.67W/C

Suppose that without trade each Suppose that without trade each country produces in p.So on its PPCcountry produces in p.So on its PPC

The trade line has a slope of 1W/CThe trade line has a slope of 1W/C Thus each country can consume at Thus each country can consume at

point C on its trade linepoint C on its trade line

The PPC with constant The PPC with constant costscosts

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USUS Now produces 30 units of wheat and Now produces 30 units of wheat and

exports 10exports 10 After producing 30 units of wheat (60 After producing 30 units of wheat (60

labour hours), the US can produce 10 units labour hours), the US can produce 10 units of cloth domestically (40 labour hours) of cloth domestically (40 labour hours)

Import 10 units of cloth from ROW at a Import 10 units of cloth from ROW at a price of 1price of 1

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The PPC with constant The PPC with constant costscosts

USUS Now produces 30 units of wheatNow produces 30 units of wheat After producing 30 units of wheat (60 After producing 30 units of wheat (60

labour hours), the US can produce 10 units labour hours), the US can produce 10 units of cloth domestically (40 labour hours) of cloth domestically (40 labour hours)

ROW ROW ROW now produces 80 units of cloth using ROW now produces 80 units of cloth using

80 labour hours80 labour hours The remaining 20 labour hours are used to The remaining 20 labour hours are used to

produce wheatproduce wheat

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Ricardo’s Theory of Ricardo’s Theory of Trade Trade

Comparative advantageComparative advantage A country will export products that it can A country will export products that it can

produce at a low opportunity cost (in produce at a low opportunity cost (in terms of other goods that could be terms of other goods that could be produced within the country).produced within the country).

A country will import products that it A country will import products that it would otherwise produce at a high would otherwise produce at a high opportunity cost.opportunity cost.

Ricardo focused on labor productivity (or Ricardo focused on labor productivity (or resource productivity more generally) for resource productivity more generally) for different products in different countries.different products in different countries. Basis for trade: Relative differences in Basis for trade: Relative differences in

labor (resource) productivity.labor (resource) productivity.

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SummarySummary

MercantilismMercantilism Absolute AdvantageAbsolute Advantage Comparative AdvantageComparative Advantage The Ricardian ModelThe Ricardian Model