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Chapter 3
Why Everybody Trades:
Comparative
Advantage and Factor
Proportions
Mercantilism

Mercantilists' view on Trade: The
more gold and silver a nation had,
the richer and more powerful it was.
Thus, the government had to do all
in its power to stimulate the
nation's exports and discourage and
restrict imports (particularly the
import of luxury consumption
goods).
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Absolute Advantage

When one nation is more efficient (AA
over) than another in the production of
one good but is less efficient than
(absolute disadvantage with respect to)
the other nation in producing other goods,
then both nations can gain by each
specializing in the production of the good
of its AA and exchanging part of its
output with the other nation for the good
of its absolute disadvantage (AD).
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Absolute advantage
U.S.A
Rest of the
world
aLW
2hours/bu
2.5hours/bu
aLC
4hours/yd
1.0hours/yd
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Absolute advantage
U.S.A
Rest of the
world
Price of
wheat
0.5yd/bu
2.5yd/bu
Price of cloth
2bu/yd
0.4bu/yd
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Comparative advantage

A country will export the goods and
services that it can produce at a low
opportunity cost and import the
goods and services that it would
otherwise produce at a high
opportunity cost.
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Comparative advantage

The opportunity cost of producing
more of a product in a country is
the amount of production of the
other product that is given up. The
opportunity cost exists because
production resources must be
shifted from the other product to
this product.
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Comparative advantage
U.S.A
Rest of the
world
aLW
2hs/bu
1.5hs/bu
aLC
4hs/yd
1hs/yd
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Comparative advantage
U.S.A
Rest of the
world
Price of wheat
(aLW/ aLC)
0.5yd/bu
1.5yd/bu
Price of cloth
(aLC/ aLW)
2.0bu/yd
0.67bu/yd
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Comparative advantage
Ricardo focused on labor
productivity (or resource
productivity more generally) for
different products in different
countries.
Basis for trade: Relative differences
in labor (resource) productivity.
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Comparative Advantage:
The Ricardian Model
 Assumptions
:
(1) One factor
(2) Differences in labor productivity across
countries
(3) Two goods
(4) Two countries
(5) Constant returns to scale
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Ricardo’s constant costs and the
production-possibility curve
Production possibility curve
(PPC) shows all combinations of
amounts of different products that
an economy can produce with full
employment of its resources and
maximum feasible productivity of
these resources.
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Figure 3.1
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Community Indifference Curves
A curve that shows how the economic
well-being of a whole group
depends on the whole group’s
consumption of products.
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Figure 3.3
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Figure 3.4
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Production and consumption together

Trade triangle shows export and
import quantities for each country.
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The gains from trade


Trade allows each country to
consume at a point that lies beyond
its own ability to produce.
Trade allows each country to
achieve a higher community
indifference curve.
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The gains from trade


Terms of trade shows a country’s
export prices relative to its import
prices.
For each country, the gains from
trade depend on the country’s
international terms of trade.
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Trade affects production and
consumption


The opening has two types of implications
for production: First, within each country
output expands for the product in which
the country has a comparative advantage.
Second, the shift from no trade to free
trade results in more efficient world
production as each country expands
output of the product in which it is initially
the lower-cost producer.
In each country, opening to trade also
alters the quantities consumed of each
product.
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What determines the trade pattern



Production conditions differ---the relative
shapes of the production-possibility
curves differ between the countries.
Consumption conditions differ---the
relative shapes and positions of the
community indifference curves differ
between the countries.
Some combination of these two
differences.
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The skewness of one country’s PPC
could arise for two reasons:


Production technologies or resource
productivities may differ between
countries.
Differences in resource availability
and resource use
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Heckscher-Ohlin Theory of Trade
A country will export products that
use relatively intensively those
production factors found relatively
abundantly in the country, and
import products that use relatively
intensively those production factors
that are relatively scarce in the
country.
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Heckscher-Ohlin Theory of Trade


A country is relatively laborabundant if it has a higher ratio of
labor to other factors than does the
rest of the world.
A product is relatively laborintensive if labor costs are a
greater share of its value than they
are of the value of other products.
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Questions

Using standard Ricardian
assumptions analyzes questions
Labor hours per
bottle of wine
A
15
Labor hours per
kilogram of
cheese
10
B
10
4
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Questions
A has 30 million hours of labor in
total per year. B has 20 million
hours of labor per year.
1)Which country has an absolute
advantage in wine? In cheese?
2)Which country has a comparative
advantage in wine? In cheese?
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Questions
3)Graph each country’s productionpossibility curve. Using community
indifference curves, show the notrade equilibrium for each country
(assuming that with no trade, A
consumes 1.5 million kilos of cheese
and B consumes 3 million kilos of
cheese).
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Questions
4)When trade is opened, which
country exports which good? If the
equilibrium international price ratio
is ½ bottle of wine per kilo of
cheese, what happens to production
in each country?
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Questions
5)In this free-trade equilibrium, 2 million
kilos of cheese and 1 million bottles of
wine are traded. What is the consumption
point in each country with free trade?
Show this graphically using community
indifference curves.
6)Does each country gain from trade?
Explain, referring to your graphs as is
appropriate.
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Questions

“According to Ricardo’s analysis, a country
exports any good whose production
requires fewer labor hours per unit than
the labor hours per unit needed to
produce the good in the foreign country.
That is, the country exports any good in
which its labor productivity is higher than
the labor productivity for this good in the
foreign country.” Do you agree or disagree?
Why?
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Comparative Advantage and
Economic Growth

China's President Hu Jintao recently
reported the strongest economic growth
in three years, noting that his country's
economy (or GDP) was 10.2 percent
larger in the first quarter of 2006 than it
was in the first quarter of 2005. This
strong surge in economic activity--the
strongest in three years--has many
analysts wondering whether the Chinese
government will take any action to
prevent their economy from overheating.
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
The Chinese government tried to control similar
rapid growth in 2002 by urging bankers to clean up
bad loans and ensure that new loans are based on
creditworthiness requirements. But many
economists say that China's actions to stem the
economic tide will not be nearly as noticeable this
year. China is experiencing low inflation; domestic
consumption is growing stronger, and economic
growth is not as concentrated in large factory and
public works projects as it has been in recent years.
Add to these factors China's clear comparative
advantage in its virtually inexhaustible labor
resource and the strong growth rate could last for
many years.
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
Economists speak of comparative advantage when
a country--such as China--has a lower relative or
comparative resource cost than do other countries.
In this case, the comparative advantage over the
U.S. and European countries consists of China's
ability to produce labor-intensive goods like
textiles, which can be produced cheaply in China
where labor is abundant and inexpensive. One
Chinese economist, Lu Zheng, says this
comparative advantage in labor could last two
decades and play an important part in promoting
Chinese economic growth.
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
Many countries, including the U.S., would
like to see China apply some economic
restraints, but such intervention does not
look likely in the near future. "I don't
expect them to take any drastic action;
they are comfortable with higher growth,"
said Frank Gong, the chief economist for
greater China at J.P. Morgan Chase. "They
will keep growth like this for a while."
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
How does comparative advantage
promote economic growth?
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