Comparative Advantage and Trade

Chapter 3

• 2 countries; A and B

Comparative advantage (technology differences)

David Ricardo; International trade based on differences in technology

Assumptions

• No transport costs

• 2 goods; X and Y

• 1 factor of production; labor L

• Constant returns to scale; CRS

• Labor mobility between sectors, not between countries

• Perfect competition

unit labor requirement = units of labor required to produce one

unit of a final good . By assumption this is independent of the

number of laborers active in a sector (CRS), but may differ between the two countries.

We can make a table to summarize the state of technology

USA EU

Cloth

Wine

1 6

4 2

Note that US is more efficient (higher productivity) than the EU in the production of both goods.

The US has absolute cost advantage in both sectors.

Why would the US trade with the EU?

Comparative advantage (technology differences)

Labor productivity; production per hour

USA EU

Cloth

Wine

8 12

8 8

Suppose the US has a total of 4 hours of labor and the EU has a total of 12 hours of labor.

Comparative advantage (technology differences)

Production of cloth and wineAutarky World Production

20

16

USA EU

Cloth

Wine

024

0 24

Suppose the US has a total of 4 hours of labor and the EU has a total of 12 hours of labor.

Comparative advantage (technology differences)

Production of cloth and wineSpecialization/comparative advantage World Production

24

24

How can we be sure that specialization takes place according to comparative advantage?

• Price of commodity =

Wage rate (per hour) / Labor productivity (per hour)

PUS,cloth < PEU,cloth or 1/6 x WUS < 1/1 x WEU (3.2)

PEU,wine < PUS,wine or 1/2 x WEU < 1/4 x WUS (3.3)

Combining the two inequalities we get(1/6) < (WEU/WUS) < 1/2

The wage rate in the US can be 2 to 6 times higher than in the EU for production to take place in accordance to comparative advantage

What happens if wages are not in this range?

Wages and productivity (Box 3.1)

Differences between country and firm competitiveness1. Firms can go out of business.2. Losing market share to a competitor is bad for a firm but

may be good for a country.3. The process of specialization according to comparative

advantage may sound unfair to individual firms.4. Firm relocation to low wage countries may result in

unemployment and/or low wages in the home country.

Comparative advantage versus competitiveness

Also known as the Heckscher-Ohlin-Samuelson model or the factor abundance model.

Explains international trade by the differences in factor endowments between countries.

Heckscher-Ohlin (H-O) theorem: A country will export the good that intensively uses its relatively abundant factor of production and import the good that intensively uses its relatively scarce factor of production.

Empirical tests of the H-O model (Box 3.3) Factor price equalization The fragmentation of production activities

Heckscher-Ohlin Model