International Trade

L3
Comparative advantage

• Given: Labor productivity table

• US has absolute advantage in
producing both goods
• Trade ?
• Comparative advantage (CA): If
difference in Opportunity Cost (OC) ,
then trade mutually beneficial
Example

Producers Wheat Cloth Opportunity Opportunity

bushels yards cost (Cloth) cost (Wheat)
per 1 hour per
1hour

US 6 4 3/2 unit of 2/3 unit of

wheat cloth
• Labor productivity table
UK 1 2 1/2 unit of 2 cloth
• Check for lower OC for identifying CA wheat

Lower OC UK has lower US has lower

? OC in OC in
producing producing
cloth in terms wheat in terms
of wheat of cloth
Theory of comparative advantage
• UK has low OC in producing cloth in terms of wheat
• Similarly, US has low OC in producing wheat (in terms of
cloth) relative to UK.
• Lower OC implies higher labor productivity and thus has
comparative advantage in producing that product
• The comparative advantage theory states that countries (with
or without absolute advantage) should specialize in those
products in which they have comparative advantage and then
both countries could gain from trade.
• CA: mutually beneficial trade can take place even if one
nation is less efficient than the other in the production of both
commodities.
Comparative advantage
Exchange rate: 6 bushels of wheat for 6 yards of cloth

With other exchange rates too mutually beneficial trade can take place.

Domestic exchange rate for US: 1 hour=6W=4C

Hence US would gain if it could exchange 6W for more than 4C from UK (as in domestic market it will get only 4C
for 6W)
For UK, domestic exchange rate : 1 hour= 1W=2C. Hence 6W=12C

Anything less than 12 C if UK is giving up for trade with 6W, then it is beneficial for UK (In UK domestic market for
exchange of 12C one can get 6W).
That means UK traders will give up 12C only if they get more than 6W. In other words, they will buy 6W from US
only if they have to give less than 12C.
Comparative advantage
• Domestic exchange rate for US: 1 hour=6W=4C
• Hence US would gain if it could exchange 6W for more than 4C from UK.
• For UK, domestic exchange rate : 1 hour= 1W=2C. Hence 6W=12C
• Anything less than 12 C if UK is giving up for 6W from trade, then it is
beneficial for UK
• Thus, range for mutually advantageous trade is: 4C <6W<12C
• The spread = 12C-4C=8C is the total gains from trade available to be
shared by the two nations by trading 6W
Comparative advantage
• Thus, range for mutually advantageous trade is: 4C <6W<12C
• The closer the rate of exchange is to 4C (=6W), the smaller is the share of gain going to US and
larger share is for UK
• The closer the rate of exchange is to 6W=12C, larger share of the gain for US and smaller for UK
• Then if the trade is at exchange rate 6W=10C. What is the gain for both countries?
• The rate of exchange will also determine how the total gains from trade are actually shared by the trading
nations
• CA: mutually beneficial trade can take place even if one nation is less efficient than the other in the
production of both commodities.
Case of No Comparative Advantage

• There is one (not very common) case where there is no comparative

advantage. This occurs when the absolute disadvantage that one nation has
with respect to another nation is the same in both commodities.
• For Ex: UK 1 hour =3W =2C
• US 1 hour =6W=4C
• UK is exactly half productive as US
Example for No comparative advantage

Producers Wheat Cloth Opportunity cost Opportunity cost

(Cloth) (Wheat)

US 6 4 3/2 unit of wheat 2/3 unit of cloth

UK 3 2 3/2 unit of wheat 2/3 cloth

Lower OC ? Both country same Both same OC

OC
Case of No Comparative Advantage

• There is one (not very common) case where there is no comparative advantage. This occurs when the
absolute disadvantage that one nation has with respect to another nation is the same in both commodities.
• For Ex: UK 1 hour =3W =2C
• US 1 hour =6W=4C
• UK is exactly half productive as US
• Opp. Cost same for both countries .
• US will only exchange 6W if it can get more than 4C from trade
• And UK is not willing to give up 4C for 6W (as 2h it can produce 4C or 6W). It needs more than 6W to
engage in trade with US.
Comparative advantage

• Even if one nation has an absolute disadvantage with respect to the other
nation in the production of both commodities, there is still a basis for
mutually beneficial trade, unless the absolute disadvantage (that one nation
has with respect to the other nation) is in the same proportion for the two
commodities.
Comparative advantage

• Even if one nation has an absolute disadvantage with respect to the other
nation in the production of both commodities, there is still a basis for
mutually beneficial trade, unless the absolute disadvantage (that one nation
has with respect to the other nation) is in the same proportion for the two
commodities.
• How?
Comparative advantage trade

• How?
• The answer is that wages in the United Kingdom will be sufficiently lower
than wages in the United States so as to make the price of cloth (the
commodity in which the United Kingdom has a comparative advantage)
lower in the United Kingdom, and the price of wheat lower in the United
States when both commodities are expressed in terms of the currency of
either nation.
Comparative advantage
• Suppose wage rate in US is 6$ per hour.
• US: 1 hour produces 6W or 4C
• Price of a bushel of wheat is Pw = wage per hour /product per hour
=$
Price of a yard of cloth is Pc=$
• UK wage rate is £1 per hour
• UK: 1 hour produces 1W or 2C
• Price of a bushel of wheat is Pw = wage per hour /product per hour
=£
Price of a yard of cloth is Pc= £
• Suppose wage rate in US is 6$ per hour.
• US: 1 hour produces 6W or 4C
• Price of a bushel of wheat is Pw = wage per hour /product per hour
=$ 1 (6/6)
Price of a yard of cloth is Pc=$
• UK wage rate is £1 per hour
• UK: 1 hour produces 1W or 2C
• Price of a bushel of wheat is Pw = wage per hour /product per hour
=£
Price of a yard of cloth is Pc= £
• Suppose wage rate in US is 6$ per hour.
• US: 1 hour produces 6W or 4C
• Price of a bushel of wheat is Pw = wage per hour /product per hour
=$1 (6/6)
Price of a yard of cloth is Pc=$1.5 (6/4)
• UK wage rate is £1 per hour
• UK: 1 hour produces 1W or 2C
• Price of a bushel of wheat is Pw = wage per hour /product per hour
= £ 1 (1/1)
Price of a yard of cloth is Pc= £ 0.5 (1/2)
Price in Dollar terms

• If exchange rate b/w pound and dollar

is £1=$2
• Then PW = ￡1 = $2 and
• PC = ￡0.5 = $1
• in the United Kingdom.
Producers Wheat Cloth
Exchange rate dollar Dollar
is £1=$2 price price

US $1 $1.5

UK $2 $1

Lower dollar US UK
price
Comparative advantage- lower wage

• we can see that the dollar price of wheat (the commodity in which the United States has a comparative
advantage) is lower in the United States than in the United Kingdom. On the other hand, the dollar price
of cloth (the commodity in which the United Kingdom has a comparative advantage) is lower in the United
Kingdom. The result would be the same if the price of both commodities had been expressed in pounds.
• Hence traders would buy wheat from US and sell it in the United Kingdom, where they would buy cloth to
sell in the United States.
• Wage rate in UK in terms of dollar price per 1 hour £1=$2, which is one- third of US wage $6 per hour.
This is the reason why cloth in which UK has a CA is cheaper in UK and vice versa.
• Thus , the inefficiency of U.K. labor relative to U.S. labor in cloth production is more than compensated
for by the lower wages in the United Kingdom. As a result, the dollar price of cloth is less in the United
Kingdom, so the United Kingdom can export cloth to the United States.
Lower bound for wage difference

• If exchange rate b/w pound and dollar is £1=$1 Producers US CA UK CA

• i.e. Wage in UK (￡1=$1) is 1/6 of wage in US Exchange rate Wheat Cloth
($6)
is £1=$1 dollar Dollar
• Then PW = ￡1 = $1 and
price price
• PC = ￡0.5 = $0.5
• in the United Kingdom. US $1 $1.5
• Then US wont export wheat to UK at this
exchange rate, as US is not gaining anything from UK $1 $0.5
trade.
• But UK will be interested to export more cloth Lower dollar Both same UK
to US. price
• Trade would be unbalanced in favour of UK
Upper Bound for wage difference

• If exchange rate b/w pound and dollar is £1=$3 Producers US CA UK CA

• i.e. Wage in UK (￡1=$3) is 1/2 of wage in US Exchange rate Wheat Cloth
($6)
is £1=$1 dollar Dollar
• Then PW = ￡1 = $3 and
price price
• PC = ￡0.5 = $1.5
• in the United Kingdom. US $1 $1.5
• Then UK wont export cloth to US at this
exchange rate, as UK is not gaining anything from UK $3 $1.5
trade.
• But US will be interested to export more wheat Lower dollar US Both
to UK. price same
• Trade would be unbalanced in favour of US
Comparative advantage

• Spread of UK wage in terms of US wage for trade to occur= between 1/6

and ½
• Thus , sufficient lower wages in comparative advantage product ensure
mutual beneficial trade between countries.
• Disruptions: Tariffs varied from countries to countries (and from industries to
industries) to offset the differences in labour productivity and gains from CA.
Key points

• CA arise from differences in labor productivity

• CA measured in terms of opportunity cost
• Mutually beneficial trade based on CA depends on-
o exchange rate
o wages
o Prices
o tariff policies
Empirical test • If we allow for different labor
productivities in various industries in

of Ricardian
different nations, can the Ricardian CA trade
model does a reasonably good job at
explaining the pattern of trade ?
Model
Empirical test
• If we allow for different labor productivities in various
industries in different nations, can the Ricardian CA trade
model does a reasonably good job at explaining the

of Ricardian pattern of trade ?

• The first such empirical test of the Ricardian trade model

Model
was conducted by MacDougall in 1951 and 1952, using
labor productivity and export data for 25 industries in the
United States and the United Kingdom for the year 1937.
• Since wages were twice as high in the United States as in
the United Kingdom, Mac-Dougall argued that costs of
production would be lower in the United States in those
industries where American labor was more than twice as
productive as British labor. These would be industries
where US has a comparative advantage with respect to UK
Ricardian CA Trade
model
• Vertical axis: ratio of output per US
worker to output per UK worker
• Higher this ratio implies greater
the relative productivity of US
worker
• Horizontal axis: Ratio of US to UK
exports to third markets
• Higher this ratio implies the larger
are US exports in relation to UK
exports
Ricardian CA Trade
model

• The points in the figure exhibit a clear

positive relationship (shown by the
colored line) between labor productivity
and exports.
• That is, those industries where the
productivity of labor is relatively higher
in the US than in the UK are the
industries with the higher ratios of U.S. to
U.K. exports to other countries
• This was true for the 20 industries (out of
the total of 25 industries studied)
CA: Empirical test

• The other empirical studies followed all seem to support the Ricardian theory
of comparative advantage. That is, the actual pattern of trade seems to be
based on the different labor productivities in different industries in the two
nations.
• Production costs other than labor costs, demand considerations, political ties,
and various obstructions to the flow of international trade did not break the
link between relative labor productivity and export shares.
Comparative Advantage

• Why did a country cannot capture the entire export market in which it can
have CA?
• Because of product differentiation- products are not homogeneous
• Eg: American car is not identical to Japanese car
• Even if it is cheaper , some customers will prefer brand value
• However, if price differences grows ,then CA country (high productivity,
low wage and cheaper price) could gain more market