international trade theory chapter 2: the law of comparative advantage

International Trade TheoryInternational Trade Theory

Chapter 2: The Law of Comparative AdvantageChapter 2: The Law of Comparative Advantage

OUTLINEOUTLINE

2.1 Introduction

2.2 The Mercantilists’ Views on Trade

2.3 Trade Based on Absolute Advantage: Adam Smith 2.4 Trade Based on Comparative Advantage: David Ricardo

2.5 Comparative Advantage and Opportunity Costs

2.6 The Basis for the Gains from Trade Under Constant Costs 2.7 Empirical Tests of the Ricardian Model

2.1 Introduction2.1 Introduction

Two Basic questions of international trade theory.

This chapter examines the development of trade theory from the mercantilists to Adam Smith, David Ricardo and Gottfried Haberler, and seeks to answer the basic questions.

(1) What is the basis for trade and what are the gains from trade?

(2) What is the pattern of trade?

Export Pattern of Türkiye -1-Export Pattern of Türkiye -1-

Export Pattern of Türkiye -2-Export Pattern of Türkiye -2-

Sectoral Distribution of Trade Sectoral Distribution of Trade (Exports)(Exports)

Sectoral Distribution of Trade Sectoral Distribution of Trade (Imports)(Imports)

Geographical Destination of ExportsGeographical Destination of Exports

Geographical Destination of ImportsGeographical Destination of Imports

Sectoral Composition of TR-EU Trade Sectoral Composition of TR-EU Trade (Exports)(Exports)

2.2 2.2 The MercantilistsThe Mercantilists’’ Views on Trade Views on Trade

The more gold and silver and a nation had, the richer and more powerful it was.

Thus the way for a nation to become rich is to export more than it imported.

The resulting export surplus would then be settled by an inflow of bullion or precious metals such as gold and silver.

Thus the mercantilists advocated restrictions on imports and incentives for exports.

2.2 2.2 The MercantilistsThe Mercantilists’’ Views on Trade Views on Trade

A nation can gain in international trade only at the expense of other nations.

i.e., “Trade is a zero-sum game.”

Criticism: (1) The measure of the wealth of a nation? (2) Rulers vs. common people

Case Study 2-2 Mercantilism is Alive and Well in the Twenty-First Century

2.3 2.3 Trade Based on Absolute Advantage: Trade Based on Absolute Advantage: Adam SmithAdam Smith

Adam Smith, The Wealth of Nations, 1776.

2.3A. Absolute Advantage

When one nation is more efficient than (or has an absolute advantage over) another in the production of one commodity but is less efficient than (or has an absolute disadvantage with respect to) the other nation in producing a second commodity,


then both nations can gain by each specializing in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage.

Examples: (1) Nations (2) Individuals:

Thus, Adam Smith believed that all nations would gain from free trade and strongly advocated a policy of laissez-faire and free trade.


2.3B. Illustration

The U.S. is more efficient than (or has an absolute advantage over) the U.K. in the production of Wheat but is less efficient than (or has an absolute disadvantage with respect to) the U.K. in producing Cloth.

U.S. U.K. Wheat(bushels/hour) 6 1

Cloth(yards/hour) 4 5

Table 2.1. The number of units produced by each hour of labor time


With trade, the U.S. would specialize in the production of wheat and exchange part of it for British cloth.

The opposite is true for the U.K.

If the U.S. exchanges 6W for 6C, the U.S. gains 2C or saves 1/2 hour of labor time. Similarly the U.K. also gains. (Explain!)

Note: Absolute advantage can explain only a very small part of world trade. Examples:

2.4 2.4 Trade Based on Comparative Advantage: Trade Based on Comparative Advantage: David Ricardo David Ricardo

David Ricardo, Principles of Political Economy and Taxation, 1817.

2.4A. The Law of Comparative Advantage

If one nation has an absolute disadvantage with respect to the other nation in the production of both commodities, the first nation should specialize in the production of and export the commodity in which its absolute disadvantage is small (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage).


Illustration:

- The U.S. is more efficient than (or has an absolute advantage over) the U.K. in the production of both commodities.

U.S. U.K. Wheat(bushels/hour) 6 1

Cloth(yards/hour) 4 2

Table 2.2. The number of units produced by each hour of labor time

- The U.K. is less efficient than (or has an absolute disadvantage over) the U.S. in the production of both commodities.


- But the U.K. has a comparative advantage in cloth, and the U.S. has a comparative advantage in wheat. (Explain!)

- With trade, the U.S. would specialize in the production of wheat and exchange part of it for British cloth.

- The opposite is true for the U.K.

- If the U.S. exchanges 6W for 6C, the U.S. gains 2C or saves 1/2 hour of labor time. Similarly the U.K. also gains. (Explain!)


2.4B. The Gains from Trade

- The relative prices before trade:

U.S.: (Pw/Pc)us = 4/6 U.K.: (Pw/Pc)uk = 2/1

- If the U.S. exchanges 6W for 6C, the U.S. gains 2C or saves 1/2 hour of labor time. Similarly the U.K. also gains. (Explain!)

- The U.S. would be indifferent to trade if it received 4C from the U.K. in exchange for 6W. The U.S. wouldn’t trade if it received less than 4C for 6W.


- The U.K. would be indifferent to trade if it received 1W from the U.K. in exchange for 2C. The U.K. wouldn’t trade if it received less than 1W for 2C.

- i.e., Both nations would gain from trade as long as the international relative price (terms of trade) is

4C < 6W < 12C

(Pw/Pc)US < (Pw/Pc) < (Pw/Pc)UK 4/6 < (Pw/Pc) < 2/1- If, for example, they trade 6W for 6C [(i.e., (Pw/Pc) =

1)], then both would gain. (Explain!)

- Examples:


- When the absolute disadvantage that one nation has with respect to another nation is the same in both commodities.

- Explain!

2.4C. Exception to the Law of Comparative Advantage

2.4D. Comparative Advantage with Money (Skip)

2.5 Comparative Advantage and Opportunity 2.5 Comparative Advantage and Opportunity Costs Costs

Assumptions of the Ricardian Model

While assumptions (1) through (6) can easily be relaxed, assumption (7) is not valid.

1) Only two nations and two goods2) Free trade3) Perfect mobility of labor within each nation but

immobility between the two nations4) Constant costs of production5) No transportation costs6) No technical change7) The labor theory of value


2.5A. Comparative Advantage and the Labor Theory of Value

Implications

- Labor theory of value: the value or price of a good depends exclusively on the amount of labor going into the production of the good.

1) Either labor is the only factor of production or labor is used in the same fixed proportion in the production of all goods.

2) Labor is homogeneous (i.e., of only one type).


Neither of these implications is true, and hence we cannot base the explanation of comparative advantage on the labor theory of value.

Use the opportunity cost theory to explain the comparative advantage.

2.5B. The Opportunity Cost Theory

- G. Herberler, The Theory of International Trade, 1936.

- The opportunity cost theory: the cost of a good is the amount of a second good that must be given up to release just enough resources to produce one additional unit of the first good.

- Examples:


2.5C. The Production Possibility Frontier under Constant Costs

- The production possibility frontier (or transformation curve) is a curve that shows the alternative combinations of the two goods that a nation can produce by fully utilizing all of its resources with the best technology available to it.


Table 2.4. Production Possibility Schedules for Wheat and Cloth in the U.S. and the U.K.

U.S. U.K.

Wheat Cloth Wheat Cloth

180150120 90 60 30 0

0 20 40 60 80100120

605040302010 0

0 20 40 60 80100120


Figure 2.1. the Production Possibility Frontiers of the U.S. and the U.K.


Downward slope: If a nation wants to produce more of a good, it must give up some of the other good.

Straight line: Opportunity costs are constant. That is, for each additional 1W to be produced, the U.S. must give up (2/3)C and the U.K must give up 2C, no matter from which point on its production possibility frontier the nation starts.


2.5D. Opportunity Costs and Relative Commodity Prices

- The opportunity cost is given by the (absolute) slope of the production possibility frontier.

- This is also called as the marginal rate of transformation.

- Explain:

(Pw/Pc)US = 4/6 = 2/3

(Pw/Pc)UK = 2/1 = 2

- Note that under constant costs, Pw/Pc is determined exclusively by production considerations in each nation.

2.6 The Basis for and the Gains from Trade 2.6 The Basis for and the Gains from Trade Under Constant Costs Under Constant Costs

2.6A. Illustration of the Gains from Trade

Figure 2.2. The Gains from Trade

- Complete specialization

2.6 The Basis for and the Gains from Trade 2.6 The Basis for and the Gains from Trade Under Constant Costs Under Constant Costs

2.6B. Relative Commodity Prices with Trade (Pw/Pc)US < (Pw/Pc) < (Pw/Pc)UK

4/6 < (Pw/Pc) < 2/1

Figure 2.2. The Gains from Trade

2.7 Empirical Tests of the Ricardian Model 2.7 Empirical Tests of the Ricardian Model

G. D. A. MacDougall (1951, 1952)

- Labor productivity and export data for 25 industries in the U.S. and the U.K for the year 1937.

Since wages were twice as high in the U.S. as in the U.K., costs of production would be lower in those industries where American labor was more than twice as productive as British labor.

These would be the industries in which the U.S. had a comparative advantage with respect to the U.K. and in which it would undersell the U.K in third markets.

Hypothesis


Figure 2.4. Relative Labor Productivities and Comparative Advantage – U.S. and U.K.

Chemical

Food

Office MachineryTextilesFuel

Basic Iron

WoodElectric Machinery

Paper

MetalTransport Machinery

Non- metal

General Machinery

Precision Machinery.

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1.2

1.4

1.6

1.8

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2.2

2.4

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2.8

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J PN Exports/ KOR Exports

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2.7 Empirical Tests of the Ricardian Model2.7 Empirical Tests of the Ricardian Model Figure 2.4. Relative Labor Productivities and Comparative

Advantage – Japan and Korea


Case Study 2-4 Relative Unit Labor Costs and Relative Exports - U.S. and Japan

international trade theory chapter 2: the law of comparative advantage

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