INTERNATIONAL TRADE

Dr. Nahla Azzam

Lecturer of economics
Faculty of Economic Studies
and Political Science (ESPS)
Alexandria University

Email:
[email protected]
Lecture (4+5)
22/10/2023

2023/2024
29/10/2023
Part 1: International Trade Theory
Chapter (2)

The Law of Comparative Advantage

(Continued )
➢ Exception to the law of comparative advantage:
U.S. U.K. Productivity of U.K. to U.S.
Wheat (bushels/labor hour) 6 3 3/6 = 50 %
Cloth (yards/labor hour) 4 2 2/4 = 50 %

• In this case the absolute advantage of U.K. with respect to U.S. is the same for
both commodities.
• Therefore, both nations have a comparative advantage in neither
commodities, and no mutually beneficial trade could take place.
• As U.S. is willing to trade 6W only in exchange for more than 4C, however,
U.K. is not willing to give up more than 4C in exchange for the 6W, because
U.K. can produce either 6W or 4C domestically with 2 labor hours i.e., it is
willing to get 6W only for less than 4C.
• Law of comparative advantage can be restated as:
“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, unless the absolute
disadvantage is in the same proportions for the two commodities.

• In real world this is a rare coincidence.

5. Comparative Advantage and Opportunity Costs:
Ricardo based his law of comparative advantage on a number of simplifying
assumptions:
1. Only 2 nations & 2 commodities.
2. Free trade.
3. Perfect mobility of labor within each nation, but immobility between the 2
nations.
4. Perfect competition in all commodity and factor markets, i.e., all products and
factors are homogeneous.
5. Constant cost of production.
6. No transportation costs.
7. No technical change.
8. Labor theory of value.
❖ All can be easily relaxed except assumption 7. why?
5.1 Comparative advantage and the labor theory of value:

• According to the labor theory of value, the value or price of a commodity

depends exclusively on the amount of labor going into the production of
that commodity.
• However, since this assumption is not
true, therefore, we cannot base the
explanation of comparative advantage on
the labor theory of value.

• Instead, it can be explained on the basis of

the opportunity cost theory, and hence it is
referred to as The Law Of Comparative
Costs.
5.2 The opportunity cost theory:
• In 1936, Haberler explained the theory of comparative advantage based on
the opportunity cost theory.
• According to the opp.cost theory, 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 1st commodity.
• Therefore, the nation with the lower opp.cost in producing one commodity
has a comparative advantage in that commodity, and a comparative
disadvantage in the other commodity.
• Example:
U.S. U.K.
Wheat 6 1
cloth 4 2
 In U.S:
1W = 2/3 C The opp.cost of wheat in terms of cloth
6W = 4C
1C = 1 ½ W The opp.cost of cloth in terms of wheat

In U.K: 1W
1W == 22 C
C The opp.cost of wheat in terms of cloth
1W = 2C
1C = 1/2 W The opp.cost of cloth in terms of wheat

Notice that:
• The opp.cost of wheat in terms of cloth is lower in U.S. than in U.K., hence,
U.S. has a comparative advantage in W over U.K.
• The opp.cost of cloth in terms of wheat is lower in U.K. than in U.S., hence,
U.K. has a comparative advantage in C over U.S.
⸫ U.S. specializes in wheat, and U.K. in cloth.
 5.3 The Production Possibility Frontier under constant costs:
❖ Production Possibilities Frontier (PPF):
• A curve that shows alternative combinations of the two commodities a
nation can produce by fully using all resources with best available
technology.
• The following table shows the PPF schedules of wheat and cloth for both
U.S & U.K:
U.S. U.K.
Wheat Cloth Wheat Cloth
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
• In U.S: For every 30W given up, resources released are only enough to
produce an additional 20C; hence, 30W = 20C ; the opp.cost of 1W in the
U.S. is 1W = 2/3 C and it remains constant.
• In U.K: for every 10W given up, resources released are only enough to
produce an additional 20C; hence, 10W = 20C ; the opp.cost of 1W in the
U.K. is 1W = 2 C and it remains constant.
➢ Recall that:
✓ Points inside or below the PPF are possible but inefficient, since the nation has
idle resources or is not using the best technology available to it.
✓ Points above the PPF can’t be achieved with the currently available resources
and technology.
✓ The downward slope of the PPF indicates that for a nation to produce one more
unit of wheat it must give up some of the cloth production and vice versa.
❖ Constant opportunity costs arise when:
1. Resources or FOP 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 (of the same quality).
• Constant opportunity cost is represented by a straight line PPF, with a constant
slope.
• The marginal rate of transformation (MRT):
Is the amount of cloth that the nation must give up to release just enough resources to
produce one additional unit of wheat (the opp. cost of wheat); this represents the slope
𝚫𝒄
of the PPF i.e., .
𝚫𝒘
❖ Opportunity Costs and Relative Commodity Prices:
• On the assumption that prices equal costs of production and that the nation does
produce some units of wheat and some units of cloth, then:
❑ The opp. Cost of wheat is equal to the price of wheat relative to the price of
cloth.
𝚫𝒄 𝑷𝒘 𝟐 𝚫𝒄 𝑷𝒘
⸫ In U.S: Opp.cost of W = = = while, in U.k Opp.cost of W = = =𝟐
𝚫𝒘 𝑷𝒄 𝟑 𝚫𝒘 𝑷𝒄
𝑷𝒘
✓ The lower in the U.S. (2/3 opposed to 2), is a reflection of U.S.
𝑷𝒄
comparative advantage in W.
Similarly
❑ The opp. Cost of cloth is equal to the price of cloth relative to the price of
wheat.
𝚫𝒘 𝑷𝒄 𝟑 𝟏 𝚫𝒘 𝑷𝒄 𝟏
⸫ In U.S: Opp. cost of C = = = = 𝟏 𝐰𝐡𝐢𝐥𝐞, in U.K. Opp. cost of C = =𝑷 =
𝚫𝒄 𝑷𝒘 𝟐 𝟐 𝚫𝒄 𝒘 𝟐
𝑷𝒄
✓ The lower in the U.K.(1/2 opposed to 1 ½), is a reflection of U.K.
𝑷𝒘
comparative advantage in C.
❑ The difference in relative commodity prices between the two nations (given
by the difference in the slope of their PPF), is a reflection of their
comparative advantage and provides the basis for mutually beneficial trade.

Note:
• Under constant costs relative prices are determined exclusively by production
(supply side) considerations in each nation, i.e., demand considerations do
not enter in the determination of relative prices.
 6. The Basis for and the Gains from Trade under Constant Costs:
✓In the absence of trade :
• Nations can consume only the
commodities that it produces, so
the nation’s PPF represents also its
consumption frontier.
• The combination of commodities
the nation actually chooses to
produce and consume depends on
people’s taste or demand
considerations.
• This is determined by the point of
tangency between the indifference
curves map of the nation and its
PPF, such that: production =
consumption.
• Therefore, in autarky (in isolation before trade):
➢ U.S. produces and consumes at pt. (A) (90 W & 60 C).
➢ U.K. produces and consumes at pt. (A’) (40 W & 40 C).

• With trade:
➢ U.S. having a comparative advantage in W, will specialize in the
production of W at point (B) (180 W & zero C).
➢ U.K. having a comparative advantage in C, will specialize in the production
of C at point (B’) (120 C & zero W)

• If the international exchange rate is 70W for 70C, then:

➢ U.S. ends up consuming at point (E) (110 W & 70C), i.e., consuming more
of both commodities.
⸫ U.S. gains 20W and 10C (comparing between points (A) and (E))
➢ U.K. ends up consuming at point (E’) (70 W & 50 C), i.e., consuming
more of both commodities.
⸫ U.K. gains 30 W and 10 C (comparing between points (A’) and (E’)).

To sum up:
• Total gains from trade results from complete specialization in production
in both nations and consuming at a higher indifference curve such that:
Before trade After trade Total gains
Total production 90(U.S.) + 40 (U.K.) = 130 180 (U.S.) 50 ( 20 U.S. + 30 U.K.)
of wheat
Total production 60 (U.S) + 40 ( U.K) = 100 120 (U.K.) 20 ( 10 U.S. + 10 U.K.)
of Cloth
• What are the amounts exported and imported of the 2 commodities in
both nations?

This is obtained by the difference between production and consumption of each

nation after trade, such that:

production – consumption = Exports (Imports)

In U.S. (W) 180 - 110 = 70 (exports)

(C) 0 - 70 = -70 ( imports)

In U.K. (W) 0 - 70 = -70 (imports)

(C) 120 - 50 = 70 (exports)
 exports
imports

imports
exports
True or False:

1. The principle of comparative advantage asserts that a nation should

specialize in and export the good in which its absolute advantage is smallest
or its absolute disadvantage is greatest.

2. A nation’s trade triangle denotes its exports, imports, and terms of trade.

3. International trade leads to increased welfare if after trade the nation

consumes at a point under its PPF.