Harvard Business School
9-796-183
Rev. November. 25, 1996
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The Economic Gains from Trade:
Comparative Advantage
Introduction
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How nations trade and whether they benefit from it are two of the oldest and most important
questions in political economy. In the 170 years since David Ricardo formally developed the
theory, comparative advantage has become one of the principles most widely accepted among
professional economists. Despite this wide acceptance in the professional community, the basics of
international trade are still poorly understood by many policy makers and casual commentators.
This note introduces the theory of comparative advantage. It is divided into four sections. The
first presents a short history of the concepts behind comparative advantage. The second develops a
simple model with several examples to demonstrate the gains that result from trade between
nations. The third briefly covers several extensions of the simple model. Finally, three
traditional objections to free trade are reviewed. Another note, The Economic Gains from Trade:
Strategic Theories, introduces and analyzes strategic approaches to trade.
While the sections below elaborate the theory in a structured manner, the following example
provides a good introduction.
CO
A famous and wealthy impresario of stage and screen in the 1940s, Billy Rose was
also a world-class typist and stenographer with many awards to his credit. He
would thus have encountered enormous difficulty in hiring a secretary who could
work nearly as well as he himself could. Still, he hired secretaries because even
though he was the world’s best at the job, he could still earn much more in an hour
spent manipulating his stage and screen empire than he could in typing.1
PY
This is the essence of comparative advantage. Compared to his secretary, Billy Rose had an
absolute advantage in both typing and managing an entertainment business—that is, he was more
efficient in both activities. He used a secretary because he had a comparative advantage in the
entertainment business. The gains from specialization and trade are determined by comparative
advantage, not absolute advantages.
1 quoted from W. B. Brown and J.S. Hogendorn, International Economics: Theory and Content, (Reading, MA:
Addison Wesley, 1994), p. 28.
Professors Robert E. Kennedy and Nancy F. Koehn prepared this note as the basis for class discussion.
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The Economic Gains from Trade: Comparative Advantage
Comparative Advantage: A Short History
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Beginning with Adam Smith, economists have emphasized specialization and exchange as
factors essential to increasing productivity and living standards. In his economic masterpiece, An
Inquiry into the Nature and Causes of the Wealth of Nations, Smith developed three ideas that
have shaped economic justifications for free trade ever since. Specifically, Smith argued that
specialization increases productivity, that exchange allows the benefits of specialization to be
realized, and that the gains from specialization and exchange apply to both individuals and to
nations. Smith argued that specialization must be combined with a process of exchange in order to
realize potential gains:
NO
It is the maxim of every prudent master of a family, never to attempt to make at
home what it will cost him more to make than to buy. The taylor does not attempt
to make his own shoes, but buys them from the shoemaker. . . . All of them find it
for their interest to employ their whole industry in a way at which they have
some advantage over their neighbors, and to purchase with a part of its produce. . .
whatever else they have occasion for.2
Conceived as an attack on mercantilism, a contemporary economic theory that emphasized
export promotion, import substitution, and the accumulation of national gold reserves, The Wealth
of Nations extends Smith’s analysis of trade between individuals to that between nations:
What is prudence in the conduct of every private family, can scarce be folly in that
of a great kingdom. If a foreign country can supply us with a commodity cheaper
than we ourselves can make it, better buy it from them with some part of the
produce of our own industry employed in a way in which we have some advantage.3
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A Simple Model
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Smith's work set the stage for David Ricardo’s more formal exposition four decades later.
Ricardo’s model, developed in Principles of Political Economy and Taxation, published in 1817,
came to be known as the theory of comparative advantage. Since Ricardo wrote, this theory has
been significantly expanded and refined, but it remains the foundation upon which modern trade
theory is built. Ricardo’s analysis made several simplifying assumptions. 4 He limited the
analysis to two countries and two commodities; he ignored factor (input) markets; and he accepted
differences in productivity as fixed. Despite these simplifications, Ricardo’s model provides the
best starting point for understanding the traditional arguments about the gains from international
trade.
PY
Consider a world in which there are only two countries—Germany and France—and two
products—beer and cheese. The resources in each country are finite, implying that each can produce
only a limited amount of goods. Increasing production of one good means reducing production of the
other. Each country can produce either good, but Germany is more efficient brewing beer than France
and France is more efficient at making cheese than Germany. The various production possibilities
(and tradeoffs) for each country can be summarized in graphical form (see Figure A). If Germany
dedicated all of its energy to making beer, it could produce up to 100 (million) barrels. If it focused
2Adam Smith, An Inquiry into the Nature and Cause of the Wealth of Nations, Fifth Edition, New York: Modern
Library, 1937, p. 424.
3Ibid., p. 424.
4While Ricardo’s major lessons are still accepted, one of his premises has been dropped. Ricardo’s model assumed
that labor was the single factor used in production. This assumption is not essential to his findings and is not
included here.
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The Economic Gains from Trade: Comparative Advantage
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solely on cheese production, it could produce up to 50 (million) pounds of cheese. Because productive
resources are limited, increased production of one good translates directly into reduced manufacture
of the other. Germany can produce any combination along—or to the left of—the line in the left
panel of Figure A. This is referred to as Germany’s production possibility frontier. The French
have a different frontier, represented by the flatter line in the right panel. They can produce up to
100 (million) pounds of cheese or 50 (million) barrels of beer.
Note that the opportunity costs of production are different in the two countries. At any level
of production, Germany must forgo 20 barrels of beer in order to produce 10 pounds of cheese. The
price or opportunity cost of one pound of cheese is thus two barrels of beer (1/2 pound per barrel). In
France, the opportunity cost of producing 10 barrels is 20 pounds—or two pounds per barrel.
NO
Now consider how each country fares under autarky, meaning no trade.5 Without trade, a
country must consume the mix of goods it produces. This means that the lines also represent each
country’s consumption possibilities frontier. Given the resource endowments of each nation, it can
choose to produce and consume at any point on or inside its production possibilities line. Some
combination of goods along these lines will represent its preferred consumption bundle.6
We know from the production tradeoffs that beer is cheap and cheese is expensive in
Germany. In France, cheese is cheap and beer is expensive. To use Ricardo’s terms, Germany has a
comparative advantage in making beer; France has a comparative advantage in producing cheese.
In the absence of very strong preferences for either good, we would expect France’s consumption to be
weighted toward cheese and Germany’s toward beer, the goods that are relatively cheap in each
nation.
Figure AxxxProduction Possibilities under Autarky
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100
Germany's Consumption
France's Consumption
Beer
Production
80
B
60
40
60
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Beer
Production
80
100
40
20
A
20
40
60
Cheese Production
80
20
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20
40
60
80
100
Cheese Production
Assume that under autarky France would choose to produce and consume at point A, 60 pounds
of cheese and 20 barrels of beer—written as (60, 20)—and Germany would produce and consume at
point B, 20 pounds of cheese and 60 barrels of beer (20, 60).
5Autarky is the policy of national self-sufficiency and nonreliance on imports, exports, or foreign economic aid.
This should not be confused with autarchy, which describes autocratic or dictatorial rule.
6We will not address how these preferred consumption points are chosen. Students of economics will recall that
conceptually we could construct community indifference curves for each country and search for the point of
tangency with the production possibilities frontier.
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The Economic Gains from Trade: Comparative Advantage
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Introducing tradexxxNow consider what happens if we allow the countries to trade with each
other. With trade, each country now faces a different tradeoff. Germany will want to trade for
cheese if it can obtain the cheese for less than two barrels per pound. France will trade cheese for
beer if it can obtain more than 1/2 barrel per pound. As long as the ratio of exchange is greater than
1/2 and less than two barrels of beer per pound of cheese, both countries will gain from trade. For
simplicity assume both nations agree to trade and the exchange ratio is one barrel per pound.
NO
What happens when Germany and France specialize their production and trade beer for
cheese? Each country is better off. To see why, consider each county’s consumption possibilities
with trade. For the moment, assume that each country specializes entirely in the product it
produces most efficiently. This means that France will produce only cheese and Germany only beer,
yielding total production of 100 barrels of beer and 100 pounds of cheese. World production of each
good has increased (from 80 to 100) and the consumption tradeoff faced by each country is now
determined by the international price ratio (here assumed 1:1 7 ). Figure B shows that the
consumption possibilities with trade are superior to those with no trade. Every point on each
country’s new consumption possibilities frontier is above or to the right of its production
possibilities line, meaning it can consume more goods with trade than it could produce on its own.
One pair of attainable consumption bundles would be (63, 37) for France and (37, 63) for Germany.
These are charted as points A’ and B’.
Figure BxxxProduction Possibilities with Trade
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80
Germany's Consumption
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Beer
Production
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um
B
pt
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Po
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ib
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40
n
ilit
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Po
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Pro
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Pos
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ilitie
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A
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itie
40
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sib
oss
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um
60
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ctio
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Beer
Production
France 's Consumption
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B'
60
100
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Cheese Production
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80
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Cheese Production
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The key insight is that each country is unambiguously better off in terms of the goods it can
consume. In Figure B, France has moved from point A to A’ and Germany has moved from B to B’;
neither point was attainable without trade.8
It is important to note that the gains from trade come from exploiting each nation’s
comparative advantage. The gains from trade do not depend on one’s trading partner being “fair.”
Even if Germany imposed tariffs on French cheese, France would benefit from trade, so long as the
7 The international price could be anywhere between 0.5 and 2 barrels per pound. We assume 1:1 here for
simplicity. The actual price is determined by a variety of factors, including industry structure, relative market
size, and bargaining power.
8 This example has been constructed so that consumption of both goods rises, although it is possible that
consumption of one may fall as the relative prices of the goods change.
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The Economic Gains from Trade: Comparative Advantage
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tariffs were smaller than the difference in relative prices.9 Tariffs reduce the gains from trade, but
as long as trade is voluntary, they would not leave France worse off than autarky.
A Model with Absolute Advantage in Both Goods
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The theory tells us that there will be gains from trade even if one country is absolutely more
productive in all products. The example illustrated in Figures A and B showed two countries of
approximately equal size (roughly 60 million people) and average productivity (150 million units
of total output, or 2.5 units per person). Consider what would happen if France’s productivity in
both products suddenly increased by a factor of three. France would have an absolute advantage in
producing both cheese and beer. It could manufacture either 150 barrels of beer (2.5 barrels per
person) or 300 pounds of cheese (five pounds per person). Note that the tradeoff between cheese and
beer production is still 2 to 1. Given that France has an absolute productivity advantage in both
products over Germany, does it still make sense to trade with Germany?
Figure CxxxProduction Possibilities When One Nation Has an Absolute Advantage in Both Goods
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Beer
Production
180
120
A'
France's
Consumption
A
60
B
B'
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Germany's
Consumption
60
120
180
240
300
Cheese Production
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Unequivocally YES!!!—because the opportunity costs of producing beer and cheese in the two
countries still differ. Germany still has a comparative advantage (a lower opportunity cost) in
producing beer.10 France can still raise its total consumption by shifting production from beer to
cheese and trading for beer, just as in the earlier example.
Adding to the Model
PY
Ricardo’s original model was a simple one, but it contains the key insights still endorsed
today by an overwhelming majority of economists.11 Trade in the real world is much more complex,
9A tariff can be thought of as equivalent to confiscating some percentage of the cheese and throwing it into the sea.
The government raises some revenue with the tariff, but the loss to consumers is greater than the gain to the
government. As long as the tariff does not exceed the difference in the opportunity costs of production, trade will
still occur and both parties will benefit. While a tariff is a price restriction, a quota is a quantity restriction.
Trade with either type of restriction leaves a country better off than no trade, but not as well off as with free
trade. Removing such restrictions would make both countries richer.
10Germany’s opportunity cost of a barrel of beer is 1/2 pound of cheese; France’s opportunity cost of beer is 2
pounds per barrel or four times that of Germany.
11A 1992 survey in the American Economic Review revealed that 93.5 percent of the economists surveyed agreed
with the statement that “tariffs and import quotas usually reduce general economic welfare.” This was the issue
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The Economic Gains from Trade: Comparative Advantage
but bringing this complexity into the model does not change the conclusions regarding the benefits of
trade. Three additions to Ricardo’s model are worth noting.
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The first addition is to add more products and/or additional countries. Ricardo’s model
easily expands to include more tradeable goods.12 When we add tradeable goods or additional
countries, each nation should specialize in producing those goods for which it is a comparatively
low-cost producer and import those goods for which it has comparatively high costs—after all
relevant costs, such as transportation costs, have been considered.
NO
A second addition is to bring factor markets into the analysis. To this point, we have taken
differences in productivity across countries as given. We have not examined why nations should
specialize in particular products. The factor proportions model, developed by Eli Heckscher and
Bertil Ohlin, highlights the role that factor endowments—such as land, labor, and capital—have
on the pattern of trade. The factor proportions model suggests that a country will export products
that use its abundant factors intensively and will import products that use its scarce factors
intensively. For example, Germany has accumulated large amounts of capital while Vietnam has
abundant labor but little capital. We would expect Germany to export capital-intensive products to
countries like Vietnam while Vietnam exports labor-intensive products to countries like Germany.
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A third addition is to define factor inputs even more broadly. Recent work expands the
definition of factor inputs beyond land, labor, and capital to include intangible factors such as
industry-specific skills and competencies. An early effort along these lines was the product life
cycle theory of trade.13 More recently, Paul Krugman, Bruce Scott, Michael Porter, and others have
investigated how nations create and sustain other factor advantages.14 Because it highlights how
factors can be developed, this research has led to a more dynamic view of comparative
advantage—one which allows that government policies can affect the accumulation of valuable
factor inputs. These policies are discussed in a companion note The Economic Gains from Trade:
Strategic Theories.
Traditional Objections to Free Trade
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While free trade leads to aggregate economic gains, three objections are traditionally used to
oppose free trade. The first concerns the distribution of gains and losses; the second, infant
industries; and the third, national security.
Although nations benefit from free trade in the aggregate, these gains are often unevenly
distributed. For example, China may possess a comparative advantage in producing laborintensive textiles while the United States has an advantage in agricultural products. Trade would
make both countries better off in the aggregate, but American textile workers and Chinese farmers
PY
on which there was greatest agreement. [“Is There a Consensus Among Economists in the 1990s?” American
Economic Review V, 82 (May, 1992)].
12Some products may be theoretically tradable but have characteristics, such as low value-to-weight ratios, that
make trade infeasible.
13 The theory suggests that the pattern of trade in advanced products follows a regular pattern. Innovation, early
production and early consumption occur in high income countries, followed by exports, some overseas production,
and finally a shift toward production in low income countries (and imports back into the innovating country). See
Wells’ (ed.) The Product Life Cycle and International Trade (Cambridge: Harvard Business School, 1972).
14Porter’s The Competitive Advantage of Nations (New York: The Free Press, 1990) examines highly competitive
industries in 10 countries, many of which are located in geographic clusters. Industries examined include
American movie production and computer software, German chemicals and textiles, Swiss pharmaceuticals, and
Italian home appliances. Many of the industries benefit from factors, such as supporting industries or workers
with industry-specific skills, which appear to be created, rather than endowed by nature. Porter suggests that
factor advantages can be created, that they are often industry specific, and that they are best nurtured by vigorous
competitive forces.
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would bear losses as specialization and trade increased. Such distributional consequences have
important political implications. The gains from trade are often widely dispersed while the losses
are concentrated and borne by highly visible groups. The few who bear the adjustment costs
involved in free trade have much greater incentive to organize politically than do the many who
each receive a small individual benefit. This argument is particularly strong when made on behalf
of industries such as textiles that make intensive use of relatively low-skilled labor. While in
theory the beneficiaries of trade could compensate the losers, making everyone better off, this
rarely occurs.
A related point is that the theory implicitly assumes that at least one of two conditions
exists: that resources (workers, capital) are easily transferred across industries; or that resource
prices are allowed to adjust to changes in demand. If resources are not mobile and prices are sticky,
trade could cause resources to become idle and total output could decline.
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The second objection is referred to as the infant industry argument. In its traditional form, the
argument asserts that a new industry which has a potential comparative advantage may not get
started unless it is given temporary protection against foreign competition. This protection imposes
social costs but presumably leads to long term gains. To justify such a social investment, however, at
least three (somewhat stringent) conditions must hold: that private entrepreneurs would not be
willing to make this investment on their own (absorbing short-term losses to realize long-term
gains); that the government is better at identifying such opportunities than private firms; and that
the protection will truly be temporary.
Summary
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The third traditional objection is that some industries must be protected for national security
reasons. For example, even if Iraq could produce tanks and process uranium ore more efficiently than
the United States, the U.S. would be unlikely to relinquish these activities for those in which it
has a comparative advantage.
CO
It is important to remember at least two issues when discussing trade and comparative
advantage. First, the gains from trade depend on relative, not absolute, productivity levels. Even
a country that is absolutely less productive in every product benefits from trade. It will always be
relatively less bad at producing some product and can therefore raise its consumption possibilities
by specializing in this activity.
PY
Second, global economic growth has historically been associated with free trade, especially
since World War II. Trade barriers have been progressively lowered and international institutions
such as the General Agreement on Tariffs and Trade (GATT) have promoted trade and investment.
Growth in the volume of international trade has far outpaced national economic expansion. Real
GDP growth in six industrial democracies averaged 3.3 percent per year from 1950 through 1987
while the volume of foreign trade grew by 7.4 percent annually.15
On the other hand, individual countries have sometimes developed rapidly while protecting
their domestic markets. For example, early industrialization in both Britain and the United
States occurred behind high tariffs, and post-World War II Japan and Korea restricted access to
their local markets. Leading nations have historically been the greatest proponents of free trade,
while countries attempting to catch up view home-market protection as one tool they can use to gain
on the leaders.
15Angus Maddison, Dynamic Forces of Capitalist Development: A Long Run Comparative View (Oxford: Oxford
University Press, 1991), pp. 6-7, 148.
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