Chapter Three

Why Everybody Trades: Comparative Advantage

Adam Smith’s Theory Of Absolute Advantage

In the late 18th and early 19th centuries, Adam Smith and David Ricardo explored the basis for
international trade as part of their efforts to make a case for free trade. Their writings were
responses to the doctrine of mercantilism prevailing at the time.

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:
It is the maxim of every prudent master of a family, never to attempt to make at home what it will
cost... more to make than to buy. The tailor does not attempt to make his own shoes, but buys them
from the shoemaker . . . What is prudence in the conduct of every private family, can scarce be
folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than
we ourselves can make it, better buy it from them with some part of the product of our own
industry, employed in a way in which we have some advantage.
Take two commodities: Cloth (manufacturing) and wheat (Agricultural)
Suppose that the United States is better than the rest of the world at producing wheat, and the rest
of the world is better than the United States at producing cloth. It is probably not a surprise that
international trade can create benefits because the United States can focus on producing what it
does best (wheat) and exporting it, and the rest of the world can focus on producing what it does
best (cloth) and exporting it.

What do we mean by “better at producing”?

We can indicate each country’s ability to produce each product in one of two equivalent ways.
• Labor productivity—the number of units of output that a worker can produce in one
hour.
• The number of hours that it takes a worker to produce one unit of output—this is just
the reciprocal of labor productivity.

Here are some numbers for our example:

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In this numerical example, the United States has an absolute advantage in producing wheat because
the U.S. labor productivity in wheat is higher than the rest of the world’s labor productivity in
wheat. Similarly, the rest of the world has an absolute advantage in producing cloth.

If there is no trade, then each country will have to produce both products to satisfy its demand for
the products.

International trade makes these shifts in production possible even if consumers in each country
want to buy something different from what is produced in the country. For instance, in the United
States the apparent shortage of (or apparent excess demand for) cloth (as cloth production
decreases) is met by imports of cloth from the rest of the world. The United States pays for these
imports of cloth by exporting some of the extra wheat produced.

Thus, Adam Smith showed the benefits of free trade by showing that global production efficiency
is enhanced because trade allows each country to exploit its absolute advantage in producing some
product(s). At least one country is better off with trade, and this country’s gain is not at the expense
of the other country. In many cases, both countries will gain from trade by splitting the benefits of
the enhanced global production.

What if our country has no absolute advantage? What if the foreigners are better at producing
everything than we are? Will they want to trade? If they do, should we want to?

Ricardo’s Theory of Comparative Advantage

The opportunity cost of producing more of a product in a country is the amount of production of
the other product that is given up. The opportunity cost exists because production resources must
be shifted from the other product to this product.
Ricardo’s writings in the early 19th century demonstrated the principle of comparative advantage:
A country will export the goods and services that it can produce at a low opportunity cost and
import the goods and services that it would otherwise produce at a high opportunity cost.
The key word here is comparative, meaning “relative” and “not necessarily absolute.” Even if one
country is absolutely more productive at producing everything and the other country is absolutely
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less productive, they both can gain by trading with each other as long as their relative
(dis)advantages in making different goods are different.
Ricardo drove home the point with a simple numerical example of gains from trading two products
(cloth and wine) between two countries (England and Portugal).
Similar illustration, using wheat and cloth in the United States and the rest of the world:

Here, one country has inferior productivity in both goods. The United States has absolute
disadvantages in both goods—lower productivity or larger numbers of hours to produce one unit
of each good. What products (if any) will the United States export or import? Can trade bring net
national gains to both countries?
With no trade, the prices of the two products within each country will be determined by conditions
within each country.
In this example, rather than looking at money prices (dollars per cloth unit or dollars per wheat
unit), we will use the relative price—the ratio of one product price to another product price. It’s as
if we are in a world without money, a world of barter between real products like wheat and cloth.
With no trade, four hours of labor in the United States could produce either 2 wheat units or 1 cloth
unit. The price of 1 cloth unit is then 2 wheat units in the United States.

(Two wheat units is also the opportunity cost of producing cloth in the United States—product
prices reflect costs.) In the rest of the world, one hour of labor could produce 1 cloth unit or 2/3
wheat unit.

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The price (and the opportunity cost) of a cloth unit is 0.67 wheat units in the rest of the world.
Thus, within the two isolated economies, national prices would follow the relative labor costs of
cloth and wheat:

We will use the notation W to refer to wheat units and C to refer to cloth units. The relative price
of cloth is measured as wheat units per unit of cloth (W/C), and the relative price of wheat as C/W.
Note that there is really only one ratio in each country because the price of wheat is just the
reciprocal of the price of cloth.
Now let trade be possible between the United States and the rest of the world. Somebody will
notice the difference between the national prices for each good and will try to profit from that
difference. The principle is simple and universal: As long as prices differ in two places (by more
than any cost of transporting between the places), there is a way to profit through arbitrage—
buying at the low price in one place and selling at the high price in the other place
The opening of profitable international trade will start pushing the two separate national price
ratios toward a new worldwide equilibrium.
As people remove cloth from the rest of the world by exporting it, cloth becomes more expensive
relative to wheat in the rest of the world. Meanwhile, cloth becomes cheaper in the United States,
thanks to the additional supply of cloth imported from the rest of the world. So, cloth tends to get
more expensive where it was cheap at first, and cheaper where it was more expensive. (A similar
process occurs for wheat.)
The tendencies continue until the two national relative prices become one world equilibrium
relative price. Normal trade on an ongoing basis will be conducted at this equilibrium relative
price.
Notes:
• The relative price is equal to the opportunity cost (i.e the ratio of unit resource requirement)
o The idea is as follows:
o As long as the relative price (Pc/Pw) > the opportunity cost ( aLc/aLw) → produce
more
o For relative price < the opportunity cost (produce less)
o When the two ratios are equal → Maximization
• Under comparative advantage, PPF is a straight line → slope (or opportunity cost) is
constant. Resources are substituted at a constant rate.
What will the equilibrium international price be?

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We do know something—the equilibrium International price ratio must fall within the range of
the two price ratios that prevailed in each country before trade began

Why? Consider what would happen if this were not true. For instance, consider an international
price of only 0.4 W/C. At this low price of cloth, the rest of the world would want to import cloth
and export wheat because the price of cloth on the international market is now below the cost of
producing cloth at home (0.67 W/C ). No deal could be made, though. At this low cloth price the
United States would also want to import cloth and export wheat. No equilibrium is possible, and
the cloth price would be pushed up as a result of the excess demand for cloth. (Similar reasoning
applies to show the lack of an equilibrium if the cloth price is above 2 W/C.) The only way for the
two sides to agree on trading is to have the cloth price somewhere in the range of 0.67 to 2.0 W/C.

Suppose that the strengths of demand for the products lead to an equilibrium international cloth
price that has the convenient value of 1 W/C. Then both countries gain from international trade.
The United States gains:

• It produces a unit of wheat by giving up only 0.5 units of cloth.

• It can export this wheat unit and receive 1 unit of cloth

The rest of the world gains:

• It produces a unit of cloth by giving up only 0.67 units of wheat.

• It can export this cloth unit and receive 1 unit of wheat.

Comparative advantage is more general and powerful. What matters is that the two countries have
different price ratios if there is no trade. A country will have a comparative advantage even if it
has no absolute advantage

So is comparative advantage everything? Not exactly. While absolute advantage does not
determine the trade pattern in cases like this, it is a key to differences in living standards. Having
an absolute disadvantage in all products means that the country is less productive than other
countries. Low-productivity countries have low real wages and are poor countries. High-
productivity countries have high real wages and are rich countries.

Ricardo’s Constant Costs And The Production-Possibility Curve

For example, consider that the United States has 100 billion hours of labor available during the
year and that labor productivities are as shown in the Ricardian numerical example (0.5 wheat unit
per hour and 0.25 cloth unit per hour). Then, the United States can make 50 billion wheat units per
year if it produces only wheat—or it can make 25 billion cloth units per year if instead it makes
only cloth. The United States can also produce a mix of wheat and cloth, say, 20 billion wheat
units and 15 billion cloth units. If we graph all of these points, we have the country’s production-
possibility curve (ppc), which shows all combinations of amounts of different products that an

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economy can produce with full employment of its resources and maximum feasible productivity
of these resources.