Chapter 3Why Everybody Trades: Comparative Advantage

© 2016 McGraw-Hill Education. All Rights Reserved. 2

Adam Smith’s Theory of Absolute Advantage

In his Wealth of Nations, Adam Smith promoted free trade by comparing nations to households. Every household finds it worthwhile to produce only some of the products it consumes, and to buy other products using the proceeds from what the household can sell to others. The same should apply to nations.

© 2016 McGraw-Hill Education. All Rights Reserved. 3

A country is expected to export those goods in which it has an absolute cost advantage and import goods in which it has an absolute cost disadvantage

Labor hours to make:

US Rest of the World (ROW)

1 unit of cloth 4.0 1.0

1 unit of wheat 2.0 2.5

Principle of Absolute Advantage

© 2016 McGraw-Hill Education. All Rights Reserved. 4

Absolute Advantage

© 2016 McGraw-Hill Education. All Rights Reserved. 5

David Ricardo’s Theory of Comparative Advantage

• Mutually beneficial trade can occur even when one nation (say, ROW) is absolutely better at producing all goods

• Although ROW is absolutely better, the key is relative prices (or costs) and not absolute prices (or costs) of products.

• In other words, it is the opportunity cost of producing each product in each country that will determine the basis for trade among nations.

© 2016 McGraw-Hill Education. All Rights Reserved. 6

Ricardo’s Theory of Trade • Comparative advantage

A country will export products that it can produce at a low opportunity cost (in terms of other goods that could be produced within the country).

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

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

(resource) productivity.

© 2016 McGraw-Hill Education. All Rights Reserved. 7

Comparative Advantage

© 2016 McGraw-Hill Education. All Rights Reserved. 8

Relative Price

© 2016 McGraw-Hill Education. All Rights Reserved. 9

The Ricardian Model • Hence, U.S. has a comparative advantage in

production of wheat, and a comparative disadvantage in production of cloth.

• The rest of the world has a comparative advantage in production of cloth, and a comparative disadvantage in production of wheat.

• With free trade the U.S. will export wheat and import cloth.

© 2016 McGraw-Hill Education. All Rights Reserved. 10

Ricardo’s Constant Costs and The Production-Possibilities Curve

• Production-possibility curve (ppc) shows all combinations of amounts of different products that an economy can produce with full employment of its resources and maximum feasible productivity of these resources.

© 2016 McGraw-Hill Education. All Rights Reserved. 11

Ricardo’s Constant Costs and the Effects of Trade

• With no trade, each nation’s choices for the consumption of wheat and cloth is limited to a point along its production possibilities curve.

• With free trade between the two countries, each country specializes (at point S1) in producing its comparative-advantage product.

• With free trade consumers in each country can consume at any point along the new trade line (for example, at point C) and enjoy a higher standard of living.

© 2016 McGraw-Hill Education. All Rights Reserved. 12

The Gains from Trade

© 2016 McGraw-Hill Education. All Rights Reserved. 13

Question: Does it make sense for a country to pursue a policy of self-sufficiency in, for example, food, or energy? Why or why not?

© 2016 McGraw-Hill Education. All Rights Reserved. 14

Some Implications of the Theory of Comparative Advantage

• According to the Ricardian model, relative price differences arise from productivity differences that are in turn due to exogenous differences in technology among nations.

• Although comparative advantage determines the pattern of trade among nations, absolute advantage is important in determining the income in each country.

© 2016 McGraw-Hill Education. All Rights Reserved. 15

Does absolute advantage matter?

If free trade is so good, why do so many peoplefear it? Activists and protesters have recentlybeen complaining loudly that trade has bad effects on • Workers in developing countries. • Workers in the industrialized countries. • The natural environment.Analysis of absolute advantage and comparativeadvantage focuses on a resource called labor, solet’s focus on trade and workers.

© 2016 McGraw-Hill Education. All Rights Reserved. 16

Does absolute advantage matter? • A big part of the answer to these questions is that

absolute advantage does matter . But it matters not for determining the trade pattern but rather for determining national wage levels and national living standards .

• Workers can receive high wages and enjoy high living standards if they are highly productive. Workers with low productivity are paid low wages.

© 2016 McGraw-Hill Education. All Rights Reserved. 17

Average Labor Productivity and Average Wage in Manufacturing, 2006