CHAPTER T W O
An Introduction to
International Economics
Second Edition
Comparative Advantage
Dominick Salvatore
John Wiley & Sons, Inc.
1
The basic questions of
international trade
 What is the basis of trade?
Absolute Advantage
 Comparative Advantage

2
The basic questions of
international trade
 What is the basis of trade?
 What are the gains from trade?

The models of Absolute and Comparative
Advantage show that the gains from trade are
increased consumption gained through
specialization in production and trade.
3
The basic questions of
international trade
 What is the basis of trade?
 What are the gains from trade?
 What is the pattern of trade?

What determines the pattern of specialization
that drives international trade?
4
The Mercantilists
 What is wealth?

The Mercantilist answer was the stock of
precious metals possessed by a country.
5
The Mercantilists
 What is wealth?
 How can precious metals be obtained?

Extraction from naturally occurring stocks

This option is available to few countries
6
The Mercantilists
 What is wealth?
 How can precious metals be obtained?


Extraction from naturally occurring stocks
Earn precious metals through exports of goods
and services


Since payment for exports is made with precious
metals, exporting causes precious metals to flow into
a country
Similarly, since payment for imports is also made
with precious metals, importing causes precious
metals to flow out of country
7
The Mercantilists
 What is wealth?
 How can precious metals be obtained?
 The natural conclusion – exports must exceed
imports for a country to become wealthy!
8
The Mercantilists
 What is wealth?
 How can precious metals be obtained?
 The natural conclusion – exports must exceed
imports for a country to become wealthy!
 Can this condition hold for all countries?


No!
Therefore, the wealth of one country must come
at the expense of another country.
9
The Mercantilists
 What is wealth?
 How can precious metals be obtained?
 The natural conclusion – exports must exceed
imports for a country to become wealthy!
 Can this condition hold for all countries?
 Mercantilist policy

Strict government control over economic
activity to ensure a positive trade balance
10
Are precious metals
“wealth”?
 To the Mercantilists, yes.
 Modern measures of wealth are based on a
country’s ability to produce the goods and
services that improve quality of life.


Hence, the Mercantilist conclusion is based on a
definition of wealth that differs significantly
from modern notions of wealth.
This distinction leads to very different
conclusions about how to become a wealthy
nation.
11
Absolute advantage
 Built on the ideas of Adam Smith

The Library of Economic Liberty Biography
of Adam Smith
 Absolute advantage exists between nations
when they differ in their ability to produce
goods.

More specifically, absolute advantage exists
when one country is good at producing one
item, while another country is good at
producing another item.
12
An example of absolute advantage
 Countries
 Scotland
 Mexico
 Goods
 Coffee beans
 Wool
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Mexico
13
An example of absolute
advantage
Units produced per hour
 How does
specialization and
trade advantage
Scotland?


By reducing coffee
bean production,
resources are freed for
producing more wool
Each hour of
production change
costs 1 unit of coffee
beans but gains 4
units of wool
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Mexico
14
An example of absolute
advantage
Gains per hour of
production moved
 How does
specialization and trade
advantage Scotland?


Scotland can send 3
units of wool to Mexico
and receive 7 units of
coffee beans back
Thus, by specializing
in production Scotland
gains 1 unit of wool
and 6 units of coffee
per hour of production
moved
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Mexico
15
An example of absolute
advantage
Units produced per hour
 Does specialization and
trade also advantage
Mexico?


By reducing wool
production, resources
are freed for producing
more coffee beans
Each hour of
production change
costs 2 units of wool
but gains 10 units of
coffee beans
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Mexico
16
An example of absolute
advantage
Gains per hour of
production moved
 Does specialization
and trade also
advantage Mexico?


Mexico can send 7
units of coffee beans
to Scotland and
receive 3 units of wool
back
Thus, by specializing
in production Mexico
gains 1 unit of wool
and 3 units of coffee
beans per hour of
production moved
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Mexico
17
Policy recommendations from
absolute advantage
 Specialization and trade advantage both
countries
 Therefore, the best policy is to allow
producers and consumers in both countries
unfettered access to goods from both
countries to maximize the number of
advantageous trades that can occur.
 In other words, laissez-faire.

The policy of minimum government
interference with economic activity.
18
A fatal flaw?
 Absolute advantage requires one country to
be better at production of one product and
another country to be better at production of
another good for specialization and trade to
be mutually advantageous.
 What if one country is better at everything?

The theory of comparative advantage
provides this answer.
19
Comparative advantage
 Built on the ideas of David Ricardo

The New School History of Economic Thought
Biography of David Ricardo

WWW Link
 The law of comparative advantage says a nation
should specialize in and export the commodity
in which its absolute disadvantage is smaller
(this is the commodity of its comparative
advantage), and should import the other
commodity.

Implications of comparative advantage are best seen
through example.
20
An example of
comparative advantage
 Countries
 Scotland
 Mexico
Units produced per hour
10
 Goods
 Coffee beans
 Wool
 The difference lies in the
relative productivity of
the countries

In this case, Mexico is
more productive at
generating both goods.
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Mexico
21
An example of
comparative advantage
 How does
specialization and
trade advantage
Mexico?


By reducing wool
production, resources
are freed for producing
more coffee beans
Each hour of
production change
costs 5 units of wool
but gains 10 units of
coffee beans
Units produced per hour
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Mexico
22
An example of
comparative advantage
Gains per hour of
production moved
 How does
specialization and
trade advantage
Mexico?


Mexico can send 9
units of coffee beans to
Scotland and receive 7
units of wool back
Thus, by specializing
in production Mexico
gains 1 unit of coffee
beans and 2 units of
wool per hour of
production moved
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Mexico
23
An example of
comparative advantage
Units produced per hour
 Does specialization
and trade also
advantage Scotland?


It does. To see this
consider consider
Scotland trading two
hours of output.
Two hours of
production change
from coffee beans to
wool costs 2 units of
coffee beans but gains 8
units of wool
10
9
8
7
Coffee
beans
Wool
6
5
4
3
2
1
0
Scotland
Mexico
24
An example of
comparative advantage
Gains per hour of
production moved
 Does specialization
and trade also
advantage Scotland?


Scotland can send 7
units of wool to
Mexico, receiving 9
units of coffee beans
in return
Thus, by specializing
in production
Scotland gains 1 unit
of wool and 7 units of
coffee beans
10
9
8
7
6
5
4
3
2
1
0
Coffee
beans
Wool
Scotland
Mexico
25
Implications of comparative
advantage
 Laissez-faire still holds
 Gains need not be equal
 Hours of work traded need not be equal but
the advantage still exists
 Trade is based on the existence of relative –
not absolute – production advantages
26
Does money alter the story?
 No
 Suppose the costs of
production are as
given below


Mexico: 100
pesos/hour
Scotland: 4
pounds/hour
 Suppose the exchange
Peso price per unit of
output
40
35
30
25
20
Coffee
beans
15
rate between pesos and 10
5
pounds is 1£ = 10P
0
 This gives the unit
Scotland
Mexico
costs indicated in the
4£ ÷ 1 unit = 4£ per unit
chart
4£ x 10P/£ = 40P per unit
27
Does money alter the story?
 No
 Suppose the costs of
production are as
given below
Peso price per unit of
output
40
Mexico: 100
pesos/hour
 Scotland:
4 1£ per unit
4£
÷ 4 units =
pounds/hour
1£ x 10P/£ = 10P per unit
35
rate between pesos and
pounds is 1£ = 10P
 This gives the unit
costs indicated in the
chart
10

 Suppose the exchange
30
Coffee
beans
Wool
25
20
15
5
0
Scotland
Mexico
28
Does money alter the story?
 No
 Suppose the costs of
production are as
given below
Mexico: 100
pesos/hour
100P÷ Scotland:
10 units =4 10P per unit
pounds/hour
 Suppose the exchange

rate between pesos and
pounds is 1£ = 10P
 This gives the unit
costs indicated in the
chart
Peso price per unit of
output
40
35
30
Coffee
beans
Wool
25
20
15
10
5
0
Scotland
Mexico
29
Does money alter the story?
 No
 Suppose the costs of
production are as
given below
Mexico: 100
pesos/hour
100P÷ Scotland:
5 units = 420P per unit
pounds/hour
 Suppose the exchange

rate between pesos and
pounds is 1£ = 10P
 This gives the unit
costs indicated in the
chart
Peso price per unit of
output
40
35
30
Coffee
beans
Wool
25
20
15
10
5
0
Scotland
Mexico
30
Does money alter the story?
 At these prices goods
will naturally flow
from the cheaper
market (Scotland for
wool, Mexico for
coffee beans) to the
more expensive
market.
 Again, this
demonstrates the law
of comparative
advantage but through
prices not relative
outputs.
Peso price per unit of
output
40
35
30
Coffee
beans
Wool
25
20
15
10
5
0
Scotland
Mexico
31
Does the source of the productive
difference matter?
 No
 The original idea of comparative advantage
was based on the labor theory of value.

The labor theory of value holds that costs and prices are
solely determined by the labor content of an item.
 The examples given above rely on opportunity
cost.

Opportunity cost holds that the cost of an item is the
amount of another item the must be given up to release
sufficient resources to produce one more unit of the first
item.
32
The production possibility frontier
 The production
possibility frontier
(PPF) identifies the
maximum combinations
of two products that a
nation can produce by
fully utilizing all factors
of production with the
best technology
available.
 Consider the production
possibilities schedule
for an example:
United States
Wheat
Cloth
180
0
150
20
120
40
90
60
60
80
30
100
0
120
33
The production possibility frontier
 The production
possibility frontier
(PPF) identifies the
maximum combinations
of two products that a
nation can produce by
fully utilizing all factors
of production with the
best technology
available.
 Consider the production
possibilities schedule
for an example:
United Kingdom
Wheat
Cloth
60
0
50
20
40
40
30
60
20
80
10
100
0
120
34
Constructing the PPF
United States
Cloth
140
120
Wheat
Cloth
100
180
0
80
150
20
60
120
40
40
90
60
20
60
80
30
100
0
120
0
0
50
100
Wheat
150
200
35
Constructing the PPF
United States
Cloth
140
120
Wheat
Cloth
100
180
0
80
150
20
60
120
40
40
90
60
60
80
30
100
0
120
20
0
0
50
100
Wheat
150
200
36
Constructing the PPF
United States
Cloth
140
120
Wheat
Cloth
100
180
0
80
150
20
60
120
40
40
90
60
20
60
80
30
100
0
120
0
0
50
100
Wheat
150
200
37
Regions of the PPF
140
Productive maximum
120
Underutilized resources
Cloth
100
80
Unattainable with existing
resources and technology
60
40
20
0
0
50
100
150
200
Wheat
38
Trade with the PPF model
 Suppose the US and
Cloth
140
120
100
80
60
40
20
0
0
20 40 60 80 100 120 140 160 180 200
Wheat
UK
Cloth
the UK have the PPFs
given to the right
US
140
120
100
80
60
40
20
0
0
20 40 60 80 100 120 140 160 180 200
Wheat
39
Trade with the PPF model
 Suppose the US and the
Cloth
140
120
100
80
60
40
20
0
(90W, 60C)
0
20 40 60 80 100 120 140 160 180 200
Wheat
UK
Cloth
UK have the PPFs given
to the right
 Further suppose that
each country produces
and consumes at the
marked spot in the
absence of
international trade
US
140
120
100
80
60
40
20
0
(40W, 40C)
0
20 40 60 80 100 120 140 160 180 200
Wheat
40
Trade with the PPF model
 Can specialization and
Cloth
140
120
100
80
60
40
20
0
(90W, 60C)
0
20 40 60 80 100 120 140 160 180 200
Wheat
UK
Cloth
trade lead to more
aggregate production
and consumption?
 If the US specialized in
wheat production and
the UK in cloth
production, aggregate
production would
increase from 130W to
180W and from 100C to
120C.
US
140
120
100
80
60
40
20
0
(40W, 40C)
0
20 40 60 80 100 120 140 160 180 200
Wheat
41
Trade with the PPF model
 This increased
Cloth
140
120
100
80
60
40
20
0
(110W, 70C)
Production
0
20 40 60 80 100 120 140 160 180 200
Wheat
Production
Cloth
production would
allow each country to
consume at a point
outside of its PPF as
indicated by the blue
lines in the graphs.
 The increased
consumption is the
gains from trade.
US
140
120
100
80
60
40
20
0
UK
(70W, 50C)
0
20 40 60 80 100 120 140 160 180 200
Wheat
42
Trade with the PPF model
140
120
100
80
60
40
20
0
(110W, 70C)
UK
Cloth
Cloth
US
140
120
100
80
60
40
20
0
Production
(70W, 50C)
0 20 40 60 80 100 120 140 160 180 200
0 20 40 60 80 100 120 140 160 180 200
Wheat
Wheat
43