International Trade

The Law of Comparative Advantage

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 • Comparative Advantage and Opportunity
Costs
-Opportunity cost Theory (Modern Theory of Trade).
*This theory provides a more generalized theory of comparative
advantage based on production possibilities or transformation
schedule.
*PP Schedule shows various alternative combinations of two good that
a nation can produce when all resources (Land, labor, capital,
entrepreneurship) are fully employed and used with efficient manner.
**The modern theory of trade explained the comparative advantage
based on production possibility schedule :
***Constant opportunity cost.
*** Increasing opportunity cost.
 Comparative Advantage and
Opportunity Costs
• The original idea of comparative advantage was based on
the labor theory of value:
• The value or price of a commodity depends exclusively on the
amount of labor used to produce it.
• Can use the opportunity cost theory to explain comparative
advantage:
. The opportunity cost of producing one unit of a certain good is
the number of units that must be given up from the other good.

Opportunity Cost (O.C) of (X) = =

*According to the law of comparative advantage with opportunity costs:-
• The 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 costs can be illustrated with Production Possibility Frontier.
• Production Possibilities Frontier
• A curve that shows alternative combinations of the two commodities a nation can
produce by fully using all resources with best available technology.
• Constant opportunity costs arise when:
• Resources are either perfect substitutes for each other or used in fixed proportion
in production of both commodities, and All units of the same factor are
homogeneous. for that Production Possibilities Frontier will be a straight line with a
constant slope.
The Production Possibility Frontiers of the
United States and the United Kingdom.
• All Points on or along the PPF are Attainable: it can be
produced and Efficient(no idle resources).
• Points inside or below the PPF are possible but inefficient,
since the nation has idle resources and (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
• The slope of the PPF must be downward (negative
slope) that indicates the opportunity costs.
*PPF of the two nations are straight lines, which
reflect the constant opportunity cost.
**The opportunity costs are constant in each nation,
but differ between nations, providing the basis for trade.
In the absence of trade (autarky
policy):
• 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 .
• This is determined by the point of tangency between
the indifference curves map of the nation and its PPF,
such that: production = consumption.
 • Case Study
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
 • Draw the PPF for both nations (assuming that wheat on the
horizontal axis) & in case of the absence of trade, U.S produces
and consumes 90W & 60C, while U.K produces and consumes
40W & 40C, also determine these points on PPF of each nation.

In U.S, point (A) represent actual production and consumption point before
trade, while In U.K, point (A’) represent actual production and consumption
point before trade.
• According to comparative advantage principle, which product
should each country specialize in & export “the pattern of trade”,
also determine the production point after specialization of each
nation.
***Calculate the slope “opportunity cost” or “pre-trade
(internal) relative price” or “MRT” or “Internal rate of trade”
of wheat & cloth in each nation.

** Opportunity cost of wheat in U.S =

**Opportunity cost of wheat in U.K =

**Opportunity cost of Cloth in U.S =

**Opportunity cost of Cloth in U.K =

***U.S has a lower opportunity cost in producing Wheat, then U.S has a
comparative advantage in Wheat, U.K has a lower opportunity cost in
producing Cloth, then U.K has a comparative advantage in Cloth.

**In case of constant opportunity cost, each nation will completely

specialize in their comparative advantage.

-U.S should specialize in & export Wheat & import Cloth, for that we
will move to point (B) at which it produces 180 Wheat & no Cloth.
-U.K should specialize in & export Cloth & import Wheat, for that we
will move to point (B’) at which it produces 120 Cloth & no Wheat.
• Calculate the total production gain in each good as a result of
specialization.
*Total production gains = production after specialization - production before specialization
• Total production gain in wheat: 180 – (90 + 40) = 50 Wheat

• Total production gain in cloth: 120 – (60 + 40) = 20 Cloth

**Assuming that 70 yards of cloth are traded for 70 bushels of
wheat, what are the consumption gains in U.S & U.K?
Total consumption gains = consumption after specialization - consumption before
specialization

*In U.S, Consumption gains: “We consume at point (E)”

• Wheat (110 - 90) = 20 bushels of wheat

Cloth (70 - 60) = 10 yards of cloth

*In U.K, Consumption gains: “We consume at point (E’)”

• Wheat (70 - 40) = 30 bushels of wheat

Cloth (50 - 40) = 10 yards of cloth

NOTE
*Any terms of trade between USA and UK more than the internal rate of
trade in UK will achieve gains to British people.
*Any terms of trade between USA and UK more than the internal rate of
trade in USA will achieve gains to American people.
*Any international terms of trade in between internal rate of trade in both
countries, achieve benefit for both.
**** The range of mutually beneficial trade for 1 bushel of wheat should lie between the 2
domestic relative prices (opportunity cost)

****Increases output resulting from specialization and trade

represents nations’ gains from trade, allowing nations to consume
outside production possibilities frontier
• NOTE
*Specialization after international trade under constant
opportunity cost will be complete ,means all resources
will devote to produce one product that has
comparative advantage( there is no any constraint on
the resource transformation)
*The gains from international terms of trade for both
countries will generate as a result of each nation will
completely specialize (why) in its high productivity
product (low comparative cost) and exports it to the
second country
• NOTE
• Each country will import a product that it hasn’t
comparative advantage ( highly comparative
cost) .
• Through the specialization and division of work
that based on the comparative advantage
principle , each nation could achieve gains from
international trade.
 The increasing of opportunity cost
• The increasing of opportunity cost is more realistic in
application, it includes main realistic assumptions such as:
-
*The available amount of each factor of production
not homogenous as assumed in the constant
opportunity cost.
*The increasing of production of one product could
achieve with highly cost of production as result of
diminishing productivity of production factor and
decreasing returns to scale.
• If USA wants to increase its production of autos
by one unit should sacrifice by more units of
wheat and vice versa in Canada.
• The producers in each country to increase its
production from certain product will start to use
more efficient resources (less cost) at the
beginning ,with increasing of the production,
they will use less efficient resources with highly
cost as a result of diminishing productivity law of
production and decreasing returns to scale..
• Based on increasing opportunity cost, (2.4 & 2.5) the PP
curve will be concave to the origin (why?????).
• It means that the increasing of production of certain product
in any country “that has comparative advantage of producing
it” is combined with highly opportunity cost “more sacrifice
of units of the product that the country has no comparative
advantage” for each extra unit produced from the product
that has comparative advantage.
• As a result of increasing opportunity cost, the specialization
will not be complete .. Explain HOW ?? Based on figure (2.4
& 2.5) explain the situation before and after international
trade
• Refer to the following graph and answer the following question:
1-From the graph, in the absence of trade, Canada would produce and consume:
A) 8 televisions and 16 refrigerators B) 12 televisions and 16 refrigerators
C) 8 televisions and 12 refrigerators D) 12 televisions and 8 refrigerators
2- From the graph, Canada has a comparative advantage in ………
A) TVs B) Refrigerators
C) TVs and Refrigerators D) Neither TVs nor Refrigerators
3- From the graph, with specialization, Canada produces:
A) 16 TVs B) 12 TVs & 16 refrigerators
C) 8 TVs & 12 refrigerators D) 24 refrigerators
4- From the graph, with trade, Canada consumes:
A) 12 televisions and 8 refrigerators B) 12 televisions and 16 refrigerators
C) 8 televisions and 12 refrigerators D) 24 refrigerators
5- From the graph, Exports for Canada total:
A) 6 refrigerators B) 8 refrigerators C) 12 refrigerators D) 16 refrigerators
6- From the graph, Imports for Canada total:
A) 6 televisions B) 8 televisions C) 12 televisions D) 16 televisions
7- If with one hour of labor time nation A can produce either 3X or 3Y while nation B can
produce either 1X or 3Y (and labor is the only input):
A) Nation A has a comparative disadvantage in commodity X
B) Nation B has a comparative disadvantage in commodity Y
C) Nation A has a comparative advantage in commodity X
D) Nation A has a comparative advantage in neither commodity
8- With reference to the statement in Question 3:
A) Px/Py=1 in nation A B) Px/Py=3 in nation B
C) Py/Px=1/3 in nation B D) All of the above
9- With reference to the statement in Question 3, if 3X is exchanged for 3Y:
A) Nation A gains 2X B) Nation B gains 6Y
C) Nation A gains 3Y D) Nation B gains 3Y
10- If domestically 3X=3Y in nation A, while 1X=1Y domestically in nation B:
A) There will be no trade between the two nations
B) The relative price of X is the same in both nations
C) The relative price of Y is the same in both nations
D) All of the above