20120223100254ECO 652 Chapter 2

t h e l a w o f a b s o l u t e a n d c o m p a r a t i v e a d v a n t a g e | 9

10 | t h e l a w o f a b s o l u t e a n d c o m p a r a t i v e a d v a n t a g e


2.1 INTRODUCTION In this topic we will look into the two main basic questions in trade.

What is the basis of trade and what are the gains from trade?

What is the pattern of trade?

The gains from trade and the pattern of trade which are what commodities are traded and

which commodities are exported and imported by each nation is explained in this topic by

using David Ricardo’s law of comparative advantage. This chapter also examine how

Ricardo’s theory of comparative advantage based on the labor theory of value was later

rejected and G. Haberler later explained the comparative advantage theory based on the

opportunity cost theory as reflected in the production possibility frontiers.

2.2 MERCANTILISM Before we examine the theory of absolute and comparative advantage, it is best that we

begin with the idea of mercantilism. The idea of mercantilism originated in the seventeenth

century by mercantilists who were concerned with the process of nation building.

Mercantilism is the belief that the way for a nation to become rich and powerful was to have

more exports than imports. This is because an export surplus will lead to inflows of bullion,

or precious metals (gold and silver) and so a country will be rich and powerful. Because the

amount of gold and silver was fixed and all nations cannot have export surplus at the same

time, this means that one nation could gain only at the expense of other nations, suggesting

that the world’s wealth was fixed.

The mercantilists were attacked for their ‘static view’ of the world economy by Adam Smith.

Adam Smith’s ‘Wealth of Nations’ (1776) came up with a dynamic view suggesting that both

trading nations could actually simultaneously enjoy higher level of production and

consumption with trade. Adam Smith believed that all nations would gain from free trade

through a Laissez-faire system. We will now look into the idea of free trade proposed by

Adam Smith in his theory of absolute advantage.


2.3 THE THEORY OF ABSOLUTE ADVANTAGE: ADAM

SMITH Absolute advantage is the ability of a country/nation to produce a good using fewer

resources than another country. According to Adam Smith’s theory of absolute advantage,

two nations would benefit if each specialized in the production of the commodity that it has

absolute advantage in and then traded with the other nation. In other words, when one

nation is less efficient in producing a commodity, it has absolute cost disadvantage with

respect to that product and so it should import those goods and it will export those goods

that it has an absolute cost advantage. This will then increase the output of both

commodities through specialization. To illustrate Adam Smith’s idea of absolute advantage,

we will refer to the Table 2.1 below.

Table 2.1 Absolute Advantage

The table shows that one hour of labor in the U.S produces 6 bushels of wheat (6W/hr) but

the U.K only produces 1W/hr of labor. So, the U.S is more efficient than the U.K in producing

wheat which means the U.S has an absolute advantage in the production of wheat.

Meanwhile, the U.S can only produce 4C/hr but the U.K can produce more yards of cloth i.e

5C/hr of labor. So, the U.K has an absolute advantage in the production of cloth.

Now, assume that the U.S exchange 6W for 6C, the US gains 2C or saves 30 min of labor

time. The U.K also gain since the 6W received from the U.S would require six hrs of labor

time to produce in U.K. These same six hours can produce 30C in UK (6 hrs x 5 yards of

cloth per hr). By exchanging 6C for 6W the U.K gains 24C. Although the U.K gains more

than the U.S, more importantly is that both nations can gain from specialization and trading

with each other. Thus, while mercantilism believed that one nation could gain only at the

expense of another nation, Adam Smith believed that all nations would gain from free trade.


At this point you should be able to: Understand what mercantilism is.

Recognize the different views of trade between mercantilism and Adam Smith.

Show a simple numerical example to illustrate the theory of absolute advantage.

2.4 THE THEORY OF COMPARATIVE ADVANTAGE:

DAVID RICARDO Expanding upon Adam Smith’s theory of absolute advantage, David Ricardo formulated the

theory of comparative advantage. Comparative advantage refers to the ability of a country

to produce a good at lower opportunity cost than another country.

According to the law of comp. advantage, even if one nation is less efficient than the other

nation in the production of both commodities, trading can still benefit both countries. A

nation should specialize and export the commodity that it has smaller absolute disadvantage

(has comp. advantage) and import the commodity that it has greater absolute disadvantage

(has comp. disadvantage). We will now look into the assumptions before we illustrate the

law of comparative advantage in Table 2.2.

Assumptions of law of comp. advantage: 1) Only two nations and two commodities

2) Free trade

3) Perfect mobility of labor within each nation but immobility between the

two nations

4) Constant costs of production

5) No transportation costs

6) No technical change

7) The labor theory of value


Table 2.2 Comparative Advantage

The table above shows that the U.K has absolute disadvantage in the production of both

wheat and cloth. However, since U.K labor is half as productive in cloth but six times less

productive in wheat with respect to U.S, the U.K has a comparative advantage in cloth. On

the other hand, the U.S has absolute advantage in both wheat and cloth. However, since its

absolute advantage is greater in wheat (6:1) than in cloth (4:2), the U.S has a comparative

advantage in wheat.

This means, both nations can gain if the U.S specialize in the production of wheat and

exports some of it in exchange for cloth from U.K. On the other hand, the U.K will specialize

& export cloth in exchange for wheat from the U.S. The following Table 2.3 shows some

examples of comparative advantage for some countries.


Table 2.3 Examples of Comparative Advantage in International Trade

Source:

Carbaugh, J. C. (2006). International Economics. Canada: Thomson South-Western, p. 30.

2.4.1 The Gains from Trade Table 2.2 shows that the U.S can specialize and export wheat while the U.K

can specialize and export cloth. Since the U.S can produce 4C domestically

by giving up 6W, it will not trade if it gets less than 4C for 6W.

To show that both countries can gain, let’s say that the U.S could exchange

6W for 6C with the U.K. This means that:

The gain to the U.S is 2C i.e. save half hour of labor time

(since 4C = 1 hr).


The gain to the U.K is 6C i.e. save 3 hours of labor.

This is because the 6W received from the U.S would require 6 hours

to produce in the U.K. These 6 hours could be used to produce 12 C

and give up only 6C to the U.S.

Total gain from both nations = 8C (2C+6C)

Although the U.K gains more, more importantly both nations can gain from

trade even if one of them is less efficient than the other in the production of

both commodities.

2.4.2 Rate of Exchange In our previous example, the U.S would gain if it could exchange 6W for more

than 4C from the U.K. While the U.K would gain if it can exchange anything

less than 12C (since 1W : 2C so 6W = 12C). Therefore, the mutually

beneficial range of trade is:

4C < 6W < 12C

The closer the rate is to 4C = 6W (the domestic rate in the U.S), the smaller

the gain goes to the U.S and the larger is the gain to the U.K. Conversely,

the closer the rate to the 6W = 12C, the greater is the gain to the U.S and

less to the U.K. For example, if the rate of exchange is 6W = 10C then the

U.S would gain more than the U.S.

At this point you should be able to: Differentiate between the theory of absolute and comparative advantage.

Illustrate in simple numerical example of how comparative advantage differ with

absolute advantage.

Determine the rate of exchange between trading countries.


2.4.3 Exception to the Law of Comparative Advantage The law of comparative advantage will not hold if the absolute advantage that

one nation has with respect to another country is the same in both

commodities. For example, in Table 2.2 if one hour produced 3W instead of

1W in the UK, the UK would be exactly half as productive as the U.S in both

wheat and cloth. Both countries then have comparative advantage in neither

commodity and therefore no mutually beneficial trade could take place.

2.4.4 Comparative Advantage with Money This section will show to us the importance of the exchange rate (the price of

a currency) in international trade. In our example, even if the UK is less

efficient in the production of both commodities, it can only export its cloth to

the U.S provided that the wage in the U.K is lower than the U.S to make the

price of its cloth cheaper.

Let us say that the wage in the U.S is $6/hr and one hour produces 6W. So,

price of wheat/bushel is PW = $1($6/6W). If one hour produces 4C, so price

of cloth/yard is PC=$1.50 ($6/4C). Meanwhile, let us say that the wage in the

U.K is £1/hr and one hour produces 1W. So PW=£1. If one hour produces

2C, so PC = £0.5 (£1/2C).

Assuming that the exchange rate (ER) is £1= $1.50 then the dollar price is

shown in Table 2.4 below. We can see that the dollar price of wheat in the

US is lower and the dollar price of cloth is lower in the UK which means that

the US can export wheat and import cloth from the UK and vice-versa.


Table 2.4 Dollar Price of Wheat and Cloth in the US and UK

2.4.5 Comparative Advantage and Opportunity Costs One of the assumptions of the law of comparative advantage is the labor

theory of value. The labor theory of value states that the value or price of a

commodity depends solely on the amount of labor employed in the production

of a good. This means 1) that either labor is the only resource used or labor

is used in the same fixed proportion in the production of all commodities and

2) labor is homogeneous.

Neither of these two assumptions is true. This is because labor is not the

only factor of production. Labor is also not used in the same fixed proportion

in the production of all commodities. Labor is also not homogeneous

because they are different in training, productivity and wages. This means

that we cannot explain the theory of comparative advantage based on the

labor theory of value. Instead it can be explained on the basis of the

opportunity cost theory which was developed by an economist, G. Haberler.

According to the opportunity cost theory, the cost of a commodity is the

amount of a second commodity that must be given up to release sufficient

resources to produce one additional unit of the first commodity. Hence, a

nation with the lower opportunity cost in the production of a commodity has a

comparative advantage in that commodity (and a comparative disadvantage

in the second commodity). The opportunity cost theory can be illustrated

using the production possibility frontier.


2.5 THE PRODUCTION POSSIBILITY FRONTIER (PPF)

UNDER CONSTANT COST PPF (or transformation curve) is a curve that shows the alternative combinations of two

commodities that a nation can produce by fully utilizing all of its resources given the

available technology.

Table 2.5 Production Possibility Schedules for Wheat and Cloth in the US

and the UK

Table 2.5 shows that for the U.S, each 30W given up, just enough resources are released to

produce additional 20C (i.e 30W = 20C), so the opportunity cost of 1W=2/3C. Meanwhile for

the UK, the opportunity cost of 1W=2C. The data can be used to construct a PPF as shown

in Fig. 2.1


Figure 2.1 The PPF of the U.S and U.K

Figure 2.1 shows that any point inside (below) PPF is possible but inefficiency exists. It

shows that idle resources exist. Any point above PPF cannot be achieved with the given

technology and resources. The negative slope of the PPC shows that if the nations want to

produce more wheat, they must give up some cloth production and vice-versa. In this case

PPF for both nations are straight line which shows constant opportunity costs.

Constant opportunity costs arise when: resources are either perfect substitutes for each other or used in fixed

proportion in the production of the commodities and

all units of the same factor are homogeneous or exactly the same quality.

Constant opportunity costs therefore are not realistic.

●

0 30 60 90 120 150 180

Wheat

●

●

●

●

● 120

100

80

U.S U.K

60

40

20

●

20

40

60

80

100

120

Cloth

●

●

●

●

●

●

● 0 20 40 60

Wheat

Cloth


2.6 OPPORTUNITY COSTS AND RELATIVE COMMODITY

PRICES The slope of PPF (transformation curve) is referred to as the marginal rate of transformation.

In Figure 2.1, the slope of the US transformation curve (or the opportunity cost of wheat) is

120/180 = 2/3 (= Pw/Pc =2/3). Meanwhile, the slope of the UK transformation curve is

120/60=2 (= Pw/Pc = 2/1= 2).

The lower Pw/Pc in the US shows that the US has comparative advantage in wheat (lower

Pc/Pw in UK shows its comparative advantage in cloth). Under constant cost, Pw/Pc is

determined solely by production or supply consideration & demand do not determine the

relative commodity prices. Relative commodity price is the price of one commodity divided

by the price of another commodity. (i.e the slope of the PPF)

To summarize, the difference in relative commodity prices between two nations (given by the

slope of their transformation curves) is a reflection of their comparative advantage and

provides the basis of their mutually beneficial trade.

2.7 GAINS FROM TRADE (CONSTANT COST) From Figure 2.2 below, we can analyze the gains of trade between the U.S and the U.K.

Figure 2.2 The Gains from Trade

A ●

0 90 110 180

wheat

● 120

70

U.S U.K

60

B

120 ● B’

50

Cloth

● E’

A’ ●

● 0 40 60 70

wheat

Cloth

● E

40

B’


The gains of trade for the two nations can be summarized below:

without trade, let’s say production and consumption:

US ---- 90W & 60C (pt A)

UK ---- 40W & 40C (pt A’)

with specialization:

US ---- 180W & 0C (pt B)

UK ---- 0W & 120C (pt B’)

with exchanging 70W for & 70C:

US ---- 110W & 70C (pt E)

UK ---- 70W & 50C (pt E’)

gains from specialization & trade to:

US ---- 20W & 10C

UK ---- 30W & 10C

Hence, we can see that when each nation specialize and exchange part of its output that it

has comparative advantage in with other nation, both nations can consume more of both

commodities than without trade.


PART A: DEFINITION

Define the following terms: 1. Mercantilism

2. Law of absolute advantage

3. Law of comparative advantage

4. Rate of exchange

5. Labor theory of value

6. Opportunity costs

7. Production possibility frontier

8. Constant costs

9. Relative commodity prices

PART B: SHORT ANSWER

Answer the following questions: 1. Based on the tables below answer the following questions

Determine the absolute advantage and comparative advantage in the

production of both goods for both country A and country B in each case 1 and

case 2.


2. The table below shows the production of good X and good Y for both Nation 1

and Nation 2. Are there any incentives for trade? Explain your answer.

3. The table below shows the outputs per laborer per day for Tanzania and Zaire

for fish and lumber.

a) Explain where absolute advantage lies for each product.

b) What is the opportunity cost of Lumber in Tanzania and in Zaire?

c) Explain where comparative advantage lies for each product.

d) Suppose 300 total labor-days available in Zaire, and 200 total labor-

days are available in Tanzania. Assuming the numbers in the above

table are constant at all levels of production, draw the production

possibility frontier for Tanzania and Zaire.

e) Is it in the interest of Tanzania and Zaire to completely specialize in

the good in which each has the comparative advantage?

f) Suppose each nation does completely specialize in the good in which

it has a comparative advantage. Use “P” to indicate these production

points in your diagram in (e).


PART C: PAST-YEARS FINAL EXAM QUESTIONS

Answer the following questions: 1 a) The table below shows Nation 1, Nation 2 and the world production for

bicycles and computers. Based on the table, answer the questions that

follow.

i) Define absolute advantage and comparative advantage. Determine

the commodity in which each nation has an absolute advantage and

comparative advantage. (Show your workings)

ii) In a table, show the changes in the production of output for both

commodities for both nations and the world assuming that one unit of

labor is transferred in each nation towards the good in which it has the

comparative advantage.

b) Explain why Ricardo’s assumption of labor theory of value to explain the law

of comparative advantage is not valid and should not be used in explaining

the law.


2a) Explain how did Smith’s and David Hume’s views on international trade differ

from those of the mercantilists.

b) Using numerical example, describe how a nation could have an absolute

disadvantage in the production of two goods and could still have a

comparative advantage in the production of one of them.

3a) With numerical analysis and assumptions, highlight the fundamental

difference between Adam Smith’s theory of absolute cost advantage and

Ricardo’s theory of comparative cost advantage. Why is Ricardo’s theory

considered more superior than Smith’s theory of absolute cost advantage?

b) What are the main weaknesses of Ricardo’s theory? How did Haberler refine

it by using the opportunity cost approach?

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20120223100254ECO 652 Chapter 2

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