Foundations of

Modern Trade Theory:

Comparative Advantage
Chapter 2

Copyright © 2009 South-Western, a division of Cengage Learning. All rights reserved.

Mercantilists
o popular from 1500-1800 in Europe
o assumption that a trade surplus (exports >
imports) would lead to a nation obtaining more
gold which would lead to increased domestic
production and employment
o policy implication was for domestic
government to limit trade through tariffs, import
quotas, and other methods
Price-Specie-Flow Doctrine
o David Hume
o counter argument to mercantilism
o trade surplus possible only in short run
o inflow of gold or other form of wealth will
lead to an increase in the price of domestic
goods
o higher prices for domestic goods will
eventually lead to increased imports and
decreased exports
Absolute Advantage
o Adam Smith – Wealth of Nations
o cost differences determine the patterns of
international trade
o based on natural and acquired resources
o labor theory of value – amount of labor
required determines the cost of any good
o principle of absolute advantage – trade is
beneficial when each country is a least cost
producer of one of the goods being traded
 Absolute Advantage - Example

Since the U.S. can produce more cloth, we should

produce cloth and trade it to the U.K. for wine, for
which the U.K. has greater capacity.
Comparative Advantage
o David Ricardo
o trade as mutually beneficial even if one
country is more efficient than another
o principle of comparative advantage –
each nation should specialize in production
of those goods for which it is relatively more
efficient with a lower opportunity cost
o not possible for one country to have a
comparative advantage in everything
Comparative Advantage - Example

The U.S. can produce twice as much wine as the

U.K. but four times as much cloth. Therefore the U.S.
should specialize in producing cloth while the U.K.
specializes in producing wine.
Production Possibilities Schedule (PPS)
PPS - various combinations
of two goods that a nation
can produce using all
available factor inputs.

Figure 2.1 illustrates hypothetical

production possibilities schedules for
the
United States and Canada. By fully
using all available inputs with the best
available technology during a given
time period, the United States can
produce either 60 bushels of wheat,
or 120 autos, or certain combinations
of the two products. Similarly,
Canada can produce either 160
bushels of wheat, or 80 autos, or
certain combinations of the two
products.
Marginal Rate of Substitution (MRT)
o amount of one good a country must sacrifice to
get one more unit of another good
o synonymous with opportunity cost
o equal to the absolute value of the slope of the
production possibilities schedule

o MRT = ∆ good Y
∆ good X
 MRT (cont.)
In this graph the MRT
equals 0.5 because
wheat output falls by
20 when auto rises by
40
Concerning the United States,
movement
from the top endpoint on its
production possibilities schedule to
the bottom
endpoint shows that the relative cost
of producing 120 additional autos is
the sacrifice of 60 bushels of wheat.
This sacrifice means that the relative
cost of each auto produced is 0.5
bushels of wheat sacrificed (60/120
=0.5); that is, the MRT= 0.5
Basis for Trade
o The MRT or opportunity cost for each nation
will indicate the direction of trade.
o The MRT or opportunity cost can also indicate
the potential gains from trade.
o We begin with an assumption of constant
opportunity costs.
o Benefits will be measured in terms of both
improved production and consumption.
• Figure 2.1, assume that in autarky (the absence of trade) the United
States prefers to produce and consume at point A on its production
possibilities schedule, with 40 autos and

• The slopes of the two countries’ production possibilities schedules give

the relative cost of one product in terms of the other. The relative cost of
producing an additional auto is only 0.5 bushels of wheat for the United
States but it is 2 bushels of wheat for Canada.
• According to the principle of comparative advantage, this situation
provides a basis for mutually favorable specialization and trade owing to
the differences in the countries’ relative costs. As for the direction of
trade, we find the United States specializing in and exporting autos and
Canada specializing in and exporting wheat.
 Gains from Specialization

1 additional auto in the U.S. => loss of 0.5 bushel of wheat

1 additional auto in Canada => loss of 2 bushels of wheat
• In Figure 2.1, the United States moves from production point
A to production point B, totally specializing in auto
production.
• Canada totally specializes in wheat production by moving
from production point A to production point B in the figure.
Taking advantage of specialization can result in production
gains for both countries
 Gains from Specialization (cont.)

Since the U.S. has a lower opportunity cost of auto production,

it will be mutually beneficial for the U.S. to produce autos and
trade them to Canada for wheat.
 Production Gains

o Without trade or specialization, world production is

80 autos and 120 bushels of wheat.
o If both nations specialized based on their
comparative advantages, world production would
increase to 120 autos and 160 bushels of wheat.
• We find that prior to specialization, the United States
produces 40 autos and 40 bushels of wheat. But with
complete specialization, the United States produces 120
autos and no wheat.
• As for Canada, its production point in the absence of
specialization is at 40 autos and 80 bushels of wheat, whereas
its production point under complete specialization is at 160
bushels of wheat and no autos.
• Combining these results, we find that both nations together have
experienced a net production gain of 40 autos and 40 bushels of wheat
under conditions of complete specialization.
• Table 2.4(a) summarizes these production gains.
 Consumption Gains

o If the U.S. trades 60 autos for 60 bushels of wheat,

then consumption will increase in each country.
• With specialization and trade, the two nations can achieve
post-trade consumption points outside their domestic
production possibilities schedules;
• that is, they can thus consume more wheat and more autos
than they could consume in the absence of trade. Thus, trade
can result in consumption gains for both countries
 Consumption Gains (cont.)

Graphically consumption could increase from A to C

for the U.S. and A to C  for Canada or
elsewhere along the Trading Possibilities Lines.
• Suppose now that the United States decides to export, say, 60
autos to Canada
• Starting at post-specialization production point B in the figure,
the United States will slide along its trading possibilities line until
point C is reached. At point C, 60 autos will have been exchanged
for 60 bushels of wheat, at the terms-of-trade ratio of 1:1.
• Point C then represents the U.S. post-trade consumption point.
Compared with consumption point A, point C results in a
consumption gain for the United States of 20 autos and 20
bushels of wheat.
• The triangle BCD that shows the U.S. exports (along
• the horizontal axis), imports (along the vertical axis), and terms
of trade (the slope) is referred to as the trade triangle.
 Distributing Gains from Trade
o comparative advantage => only outer limits for the
terms of trade
o based on domestic
cost ratios
o form no-trade
boundaries and region
of mutually beneficial
trade
oFor gainful international
trade to exist, a nation
must achieve a post-trade
consumption location at
least equivalent to its
point along its domestic
production possibilities
schedule
• According to Ricardo, the domestic cost ratios set the outer limits for the
equilibrium terms of trade.
• If the United States is to export autos, it should not accept any terms of
trade less than a ratio of 0.5:1, indicated by its domestic cost-ratio line.
Otherwise, the U.S. post-trade consumption point would lie inside its
production possibilities schedule. the United States would clearly be
better off without trade than with trade. The U.S. domestic cost-ratio line
therefore becomes its no-trade boundary.
• Similarly, Canada would require a minimum of 1 auto for every 2 bushels
of wheat exported, as indicated by its domestic cost-ratio line; any terms of
trade less than this rate would be unacceptable to Canada.

• Thus, its domestic cost-ratio line defines the no-trade boundary line for
Canada.
Equilibrium Terms of Trade
John Stuart Mill – Theory of Reciprocal Demand
o terms of trade determined by the relative
strength of each nation’s demand for the other
nation’s product
o nations of roughly equal size => gains from
trade distributed roughly equally
o one nation larger => smaller nation attains
most of the gains from trade because trade
occurs closer to the larger nation’s existing price
ratio – “importance of being unimportant”
 Illustration
• Referring to Figure 2.2, if Canadians are more eager for U.S.
autos than Americans are for Canadian wheat, the terms of
trade would end up close to the Canadian cost ratio of 2:1.
Thus, the terms of trade would improve for the United States.

• However, if Americans are more eager for Canadian wheat

than Canadians are for U.S. autos, the terms of trade would
fall close to the U.S. cost ratio of 0.5:1, and the terms of trade
would improve for Canadians.
 Terms of Trade Estimates
o terms of trade = export price index × 100
import price index
o prices of
exports rise in
relation to
imports shows
improvement
o 2006 terms of
trade data using
2000 as the
base year
• Table 2.5 gives the commodity terms of trade for selected countries.
With 2000 as the base year (equal to 100), the table shows that by
2008 the U.S. index of export prices rose to 167, an increase of 67
percent.
• During the same period, the index of U.S. import prices rose by 47
percent, to a level of 147.
• Using the terms-of-trade formula, we find that the U.S. terms of trade
improved by 14 percent [(167/147) × 100 =114] over the period
2000–2008.
• This means that to purchase a given quantity of imports, the United
States had to sacrifice 14 percent fewer exports; conversely, for a
given number of exports, the United States could obtain 14 percent
more imports.
Dynamic Gains from Trade
1) increased income leads to increased savings
which leads to increased investment
2) greater options in supply chain
3) increased output level can lead to benefits
from economies of scale
4) improved competition can lead to lower prices
for consumers and a greater variety of
products offered to consumers
 Changes in Comparative Advantage
o Thus far our analysis has assumed comparative
advantage did not change.
o However, if productivity changed at different rates,
comparative advantage could shift from one nation
to another.
• Because of these productivity gains, the production possibilities schedule of each country
rotates outward and becomes flatter.
• More output can now be produced in
• each country with the same amount of resources. Referring to the new production
• possibilities schedules, the MRT of automobiles into computers equals 0.67 for the United
States and 0.5 for Japan. The comparative cost of a computer in Japan has thus fallen
below that in the United States. For the United States, the consequence of
• lagging productivity growth is that it loses its comparative advantage in computer
• production. But even after Japan achieves comparative advantage in computers, the
• United States still has a comparative advantage in autos; the change in manufacturing
• productivity thus results in a change in the direction of trade. The lesson of this
• example is that producers who fall behind in research and development, technology,
• and equipment tend to find their competitiveness dwindling.
 Increasing Opportunity Costs
o result of diminishing marginal productivity
o cost of producing one
good increases as more
of that good is produced
o production possibilities
schedule has concave
shape
o MRT will increase as
we move around the
curve towards the
intercepts
• In Figure 2.4, with movement along the production possibilities schedule
from A to B, the opportunity cost of producing autos becomes larger and
larger in terms of wheat sacrificed.
• Increasing costs mean that the MRT of wheat into autos rises as more
autos are produced. Remember that the MRT is measured by the absolute
slope of the production possibilities schedule at a given point.
• With movement from production point A to production point B, the
respective tangent lines become steeper— their slopes increase in
absolute value.
• The MRT of wheat into autos rises, indicating that each additional auto
produced requires the sacrifice of increasing amounts of wheat.
Trade with Increasing Opportunity
Costs
o specialize until relative costs are equal
o line tt becomes terms of trade for both the U.S. and Canada
 Gains – Increasing Cost Case

If the U.S. specializes and trades 7 autos for 7 bushels

of wheat, consumption would increase in each country.
Impact of Trade on U.S. Jobs

o little to no impact on overall employment

o will impact mix of jobs and specific industries
Many Products
1) Various products have different comparative
costs resulting in different degrees of
comparative advantage.

2) Each nation will produce and export the

goods for which it has the greatest
comparative advantage subject to supply and
demand constraints.
Many Countries
1) multilateral trade
2) implies bilateral trade balance is unlikely
result
Outsourcing – Pros & Cons
Pros
1) reduced costs and increased competitiveness
for domestic companies
2) increased exports to countries in which new
jobs are created
3) higher level of repatriated earnings
reinvested into domestic economy
Cons
1) reduced employment in specific industries
2) lower wages, particularly for unskilled workers