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Trade and the law of Comparative Advantage
International trade now accounts for nearly 25% of world GDP. The liberalization of trade in
goods and services, and the rapid increase in foreign direct investment across national
boundaries have been and will continue to be hugely important for the development of the
global economy.
The virtues of international trade and exchange
Economists are normally positive about the economic consequences of trade. Granted there
are those who highlight the inequities of the global trading system and in particular, the
marginalization of developing countries who have struggled to build and maintain a
competitive advantage in key markets. But taken as a whole, the consensus among
economists is that there are significant gains in economic welfare and efficiency arising from
the continued expansion of trade and investment between nations.
The concept of comparative advantage
First introduced by David Ricardo in 1817, comparative advantage exists when a country has
a ‘margin of superiority’ in the production of a good or service i.e. where the marginal cost of
production is lower.
Countries will usually specialize in and then export products which use intensively the factor
inputs which they are most abundantly endowed. If each country specializes in those goods
and services where they have an advantage, then total output can be increased leading to an
improvement in allocative efficiency and economic welfare. Put another way, trade allows
each country to specialize in the production of those products that it can produce most
efficiently (i.e. those where it has a comparative advantage).
This is true even if one nation has an absolute advantage over another country. So for
example the Canadian economy which is rich in low cost land is able to exploit this by
specializing in agricultural production. The dynamic Asian economies including China have
focused their resources in exporting low-cost manufactured goods which take advantage of
much lower unit labour costs.
In highly developed countries, the comparative advantage is shifting towards specializing in
producing and exporting high-value and high-technology manufactured goods and highknowledge services.
Comparative advantage for the UK
Using trade data drawn from the UK balance of payments with other countries, the UK’s
comparative advantage now lies in the following areas: oil, chemicals & pharmaceuticals,
aerospace and medical technology, insurance, financial services, computer services &
software, other business services, and entertainment. The UK has lost much if not all of its
comparative advantage in textiles, steel, coal and many other areas of traditional
manufacturing industry where it runs structural trade deficits.
Example of comparative advantage
Consider two countries producing two products – digital cameras and vacuum cleaners. With
the same factor resources evenly allocated by each country to the production of both goods,
the production possibilities are as shown in the table below.
Pre-specialization
UK
USA
Total
Digital Cameras
600
2400
3000
Vacuum Cleaners
600
1000
1600
To identify which country should specialize in a particular product we need to analyze the
internal opportunity costs for each country. For example, were the UK to shift more resources
into higher output of vacuum cleaners, the opportunity cost of each vacuum cleaner is _____
digital television. For the United States the same decision has an opportunity cost of _____
digital cameras. Therefore, the _____ has a comparative advantage in vacuum cleaners.
If the UK chose to reallocate resources to digital cameras the opportunity cost of one extra
camera is still one vacuum cleaner. But for the United States the opportunity cost is only
_______ of a vacuum cleaner. Thus the _____ has a comparative advantage in producing
digital cameras because its opportunity cost is lowest.
Complete the chart calculating output after specialization
Post-specialization
UK
USA
Total
Digital Cameras
Vacuum Cleaners
As a result of specialization according to the principle of comparative advantage, output of
both products has increased - representing a gain in economic welfare.
For mutually beneficial trade to take place, the two nations have to agree an acceptable rate of
exchange of one product for another.
There are gains from trade between the two countries. If the two countries trade at a rate of
exchange of 2 digital cameras for one vacuum cleaner, the post-trade position will be as
follows:
The UK exports ______ vacuum cleaners to the USA and receives ______ digital cameras
The USA exports _______digital cameras and imports ______vacuum cleaners
Complete the chart calculating post trade output / consumption
Digital Cameras
Vacuum Cleaners
UK
USA
Total
Compared with the pre-specialization output levels, consumers in both countries now have an
_____________ supply of both goods to choose from.
What Determines Comparative Advantage?
Comparative advantage is best viewed as a dynamic concept meaning that it can and does
change over time. Some businesses find they have enjoyed a comparative advantage within
their own market in one product for several years only to face increasing competition as rival
producers from other countries enter their markets and under cut them on price or take market
share through non-price competition. For a country, the following factors are often seen as
important in determining the relative costs of production:
The quantity and quality of factors of production available (e.g. the size and efficiency of the
available labour force and the productivity of the existing stock of capital inputs)
Investment in research & development (this is important in industries where patents give
some firms a significant market advantage) – there is quite strong evidence that an emerging
comparative advantage often comes from entrepreneurial trial and error – the never ending
process of engaging in research and innovation to find more efficient process and new
products
Fluctuations in the real exchange rate which then affect the relative prices of exports and
imports and cause changes in demand from domestic and overseas customers
Import controls such as tariffs, export subsidies and quotas can be used to create an artificial
comparative advantage for a country's domestic producers
The non-price competitiveness of producers (e.g. covering factors such as the standard of
product design and innovation, product reliability, quality of after-sales support)
Comparative advantage is often a self-reinforcing process.
Entrepreneurs in a country develop a new comparative advantage in a product (either because
they find ways of producing it more efficiently or they create a genuinely new product that
finds a growing demand in home and international markets). Rising demand and output
encourages the exploitation of economies of scale; higher profits can be reinvested in the
business to fund further product development, marketing and a wider distribution network.
Skilled labour is attracted into the industry and so on.
The wider benefits of international trade
Expanding trade by collectively reducing barriers is the most powerful tool that countries,
working together, can deploy to reduce poverty and raise living standards. A growing body of
evidence shows that countries that are more open to trade grow faster over the long run than
those that remain closed. And growth directly benefits the world's poor. A one percentage
point increase in growth on average reduces poverty by more than 1.5 per cent each year.
Increased trade also benefits consumers and efficient producers, through lower prices and
access to a wider variety of goods. This is because trade encourages greater specialization which dramatically lowers costs - and more intense competition, which is central to
innovation. In sharp contrast, trade barriers can impose high costs on society - and
particularly on those that can least afford them. For example, it has been estimated that
barriers to imports in the 1990s saved 226 jobs in the US luggage industry, but at a cost to
American consumers of nearly $1.3m per year for each job. And taxpayers in the European
Union spend over $500m annually to subsidize the production of peas and beans.
One way of expressing the gains from trade in goods and services between countries is to
distinguish between the static gains from trade (i.e. improvements in allocative and
productive efficiency) and the dynamic gains (the gains in welfare that occur over time from
improved product quality, increased choice and a faster pace of innovative behaviour)
Some of the broader gains from free trade are outlined below:
Welfare gains – allocative efficiency: Free trade can be shown under certain conditions to
lead to significant increases in welfare. Neo-liberal economists who support the liberalization
of trade between countries believe that trade is a ‘positive-sum game’ – in other words, all
counties engaged in open trade and exchange stand to gain.
Economies of scale - trade allows firms to exploit scale economies by operating in larger
markets. Economies of scale lead to lower average costs of production that can be passed onto
consumers.
Competition / market contestability – trade promotes increased competition particularly for
those domestic monopolies that would otherwise face little real competition.
Dynamic efficiency gains from innovation - trade also enhances consumer choice and
international competition between suppliers help to keep prices down. Trade in ideas
stimulates product and process innovations that generates better products for consumers and
enhances the overall standard of living.
Access to new technology: Trade, like investment, is also an important mechanism by which
countries can have access to new technologies. Although the importation of new technology
may have negative employment consequences for those workers who lose their jobs because
of capital-labour substitution, provided that an economy is flexible enough to be able to
reemploy these workers, there should be no net loss of jobs as a result.
To the contrary, new technology creates new jobs in support industries.
Rising living standards and a reduction in poverty - James Wolfeson has argued that trade can
be a powerful force in reducing poverty and raising living standards. A growing body of
evidence shows that countries that are more open to trade grow faster over the long run than
those that remain closed. And growth directly benefits the world's poor. A one percentage
point increase in growth on average reduces poverty by more than 1.5 per cent each year.
For next class I want you to summarize the following points regarding the law of comparative
advantage. This needs to be typed and no less than 300 words. I will collect this and grade it.
No work late will be accepted.
How does trading under the law of comparative advantage benefit countries?
What determines which products a country has comparative advantage in?
Once a country has achieved comparative advantage in a product, why forces seem to allow it
to maintain this comparative advantage?
What are some of the main arguments in favour of international trade?