Chapter-1 Mec Extra

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Explain the theory of Absolute Advantage and comparative advantage in

international trade?

ANS: Absolute Advantage

The Scottish economist Adam Smith developed the trade theory of absoluteadvantage in 1776. A country that has an absolute advantage produces greater outputof a good or service than other countries using the same amount of resources. Smithstated that tariffs and quotas should not restrict international trade; it should be allowedto flow according to market forces. Contrary to mercantilism Smith argued that acountry should concentrate on production of goods in which it holds an absoluteadvantage. No country would then need to produce all the goods it consumed. Thetheory of absolute advantage destroys the mercantilistic idea that international trade isa zero-sum game. According to the absolute advantage theory, international trade is apositive-sum game, because there are gains for both countries to an exchange. Unlikemercantilism this theory measures the nation's wealth by the living standards of itspeople and not by gold and silver.

There is a potential problem with absolute advantage. If there is one country that doesnot have an absolute advantage in the production of any product, will there still bebenefit to trade, and will trade even occur? The answer may be found in the extensionof absolute advantage, the theory of comparative advantage.

Comparative Advantage

The most basic concept in the whole of international trade theory is the principle of comparative advantage,

first introduced by David Ricardo in 1817. It remains a major influence on much international trade policy and

is therefore important in understanding the modern global economy. The principle of comparative advantage

states that a country should specialise in producing and exporting those products in which is has a

comparative, or relative cost, advantage compared with other countries and should import those goods in

which it has a comparative disadvantage. Out of such specialisation, it is argued, will accrue greater benefit

for all.

In this theory there are several assumptions that limit the real-world application. The assumption that

countries are driven only by the maximisation of production and consumption, and not by issues out of

concern for workers or consumers is a mistake.

During the seventeenth and eighteenth centuries the dominant economic philosophywas mercantilism, which advocated severe restrictions on import and aggressive effortsto increase export. The resulting export surplus was supposed to enrich the nationthrough the inflow of precious metals. Adam Smith (1776), who is regarded as the father

of modern economics, countered mercantilist ideas by developing the concept ofabsolute advantage. He argued that it was impossible for all nations to become richsimultaneously by following mercantilist prescriptions because the export of one nationis another nationsimport. However, all nations would gain simultaneously if they practiced free trade andspecialized in accordance with their absolute advantage. Table I, illustrating Smithsconcept of absolute advantage, shows quantities of wheat and cloth produced by onehours work in two countries, the United States and the United Kingdom.


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Division of labor and specialization occupy a central place in Smiths writing. Table I

indicates what the international division of labor should be, as the United States has an

absolute advantage in wheat and the U.K. has an absolute advantage in cloth. Smithsabsolute advantage is determined by a simple comparison of labor productivities across

countries. Smiths theory of absolute advantage predicts that the United States will produce

only wheat (W) and the U.K. will produce only cloth (C). Both nations would gain if theyhave unrestricted trade in wheat and cloth. If they trade 6W for 6C, then the gain of theUnited States is 1/2 hours work, which is required

Absolute advantage TABLE-1U.S. U.K.

Wheat (bushel/hour) 6 1Cloth (yards/hour) 4 5

to produce the extra 2C that it is getting through trade with the U.K. Because theU.K. stops wheat production, the 6W it gets from the United States will save sixhours of labor time with which 30C can be produced. After exchanging 6C out of30C, the U.K. is left with 24C, which is equivalent to almost five hours labor time.Nations can produce more quantities of goods in which they have absoluteadvantage with the labor time they save through international trade.

Though Smith successfully established the case for free trade, he did not developthe concept of comparative advantage. Because absolute advantage is determinedby a simple comparison of labor productivities, it is possible for a nation to haveabsolute advantage in nothing. In Table I, if the labor productivity in clothproduction in the United States happened to be 8 instead of 4, then the UnitedStates would have absolute advantage in both goods and the U.K. would haveabsolute advantage in neither.Adam Smith, however, was much more concerned with the role of foreign trade ineconomic development and his model was essentially a dynamic one with variablefactor supplies, as pointed out by Hla Myint (1977).David Ricardo (1817) was concerned with the static resource allocation problemwhen he defined the concept ofcomparative advantage, which is determined not by

absolute values of labor productivity but by labor productivity ratios. Ricardo wouldhave interpreted the numbers in Table I by pointing out that, whereas U.S. labor inwheat production is 1.5 (= 6/4) times as productive as it is in cloth production, theU.K.s labor productivity in wheat is only one fifth of its labor productivity in cloth.

Therefore, the United States has comparative advantage in wheat and by invertingthese ratios one can show that the U.K. has comparative advantage in cloth. Thispattern of comparative advantage will not be affected if the United Sates hasabsolute advantage in both wheat and cloth, which will be the case if we raise U.S.labor productivity in cloth from 4 to 8. This is because 3/4 will still be greater than1/5.

The rationale of labor productivity ratios comes from Ricardos labor theory of value.Ricardo treated labor as the only source of value, as all other factors of production(such as capital) are also produced by labor. Thus the price of a good (P) is simply

equal to the wage rate (w) times the labor (L) used in production, divided by output(Q), as profit is zero in competitive markets: P = (w L)/Q.Because the average productivity of labor is a = Q / L, P = w / a. If the labor marketis competitive, the wage rate paid in all industries will be the same. Therefore, theratio between the price of wheat (Pw) and the price of cloth (Pc) will be equal to theratio between average productivity of labor in cloth (ac) and average productivity oflabor in wheat (aw): [Pw / Pc] = [ac / aw]. This creates a direct link betweencomparative advantage and relative commodity prices in a competitive economy. Ifthe United States has comparative advantage in wheat production, wheat will be


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relatively cheaper in the United States than in the U.K., which provides the basis fortrade.Ricardos theory of comparative advantage creates hope for technologically backwardcountries by implying that they can be a part of world trading system even though theirlabor productivity in every good may be lower than that in the developed countries. Inthe Ricardian model, trade is a win-win situation, as workers in all trading countries are

able to consume more of all goods. Ricardo was blissfully unaware of the complicationsthat would be created if his model included another factor such as capital, and if theproducers had responded to changes in factor price ratio in favor of the cheaper factor.It was Wolfgang Stolper and Paul A. Samuelson (1941) who later discussed the effect ofinternational trade on income distribution. The comparative advantage model has manyunrealistic assumptions, which ignore the fact that the real world consists of manycountries producing many goods using many factors of production.Each market is assumed to be perfectly competitive, when in reality there are manyindustries in which firms have market power. Labor productivity is assumed to be fixedand full employment is guaranteed. The model assumes that technology differences arethe only differences that exist between the countries. Finally, in a dynamic context,comparative advantage changes, as trade in goods and capital alters the tradingcountries factor endowments.

Explain the CONCEPT of opportunity cost used by Ricardo in international

trade?

ANS: Ricardian Model

Wine Cloth

Portugal 80 hrs/bbl 90 hrs/yd

England 120 hrs/bbl 100 hrs/yd

Table 1 from page 31

Note that Portugal has the absolute advantage in production of both wine and cloth. Hours

per wine and per unit cloth lower than in England. From Smithian point of view - no trade

between two countries.

Ricardian basis for trade - comparative advantage or relative costs

Calculate opportunity costs of production

Opportunity cost of producing a yard of cloth

Absolute costs for England 100 hrs. per yard clothRelative cost of cloth - the amount of wine given

up -

is (100hrs./yd) /(120 hrs/bbl) = 10/12 bbl/yd or 5/6 bbl/yd

Absolute costs for Portugal 90 hrs. per unit cloth

Relative cost of cloth - the amount of wine given

up -

is (90 hrs./yd) / (80 hrs/bbl) = 9/8 bbl/yd or 1 1/8 bbl/yd


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Opportunity costs of producing a barrel of wine (inverse of above)

England 6/5 yd/ bbl

Portugal 8/9 yd/bbl

Compare opportunity costs

Define comparative advantage - specialize in production ofgood for which the country has the lower opportunity cost.

England specializes in production of cloth since its opportunity

cost 5/6 bbl/yd is less than Portugals opportunity cost of 9/8bbl/yd. Who has comparative advantage in production of

wine?

If a country has an absolute advantage in a good, will it also have a

comparative advantage? How about if country has a comparative advantage

will it have an absolute advantage?

Autarkic prices in this model are determined by domestic costs (labor theory of

value). Therefore, the price of a yard of cloth in England is 5/6 barrel of wine,

whereas in Portugal, a yard of cloth is priced at 9/8 barrel of wine.

Allow trade.

An English cloth merchant would earn more profit selling cloth

to the Portugese than domestically. He/she would earn 9/8 bbl

Conversely, a Portugese wine merchant does better selling wine to

the English earning 6/5 yd of cloth instead of 8/9 yd in Portugal.

Therefore the price of cloth will rise in England and the price of wine will rise in

Portugal. Eventually there will be one set of prices - the terms of trade - between 9/8

barrel and 5/6 barrel of wine per yard of cloth.

Impose resource constraints - total numbers of labor hours available.

Construct Production Possibilities Frontier

from page 34 Cloth Wine

Country A 1 hr/yd 3hr/bbl

Country B 2 hr/yd 4hr/bbl

(Do all the oppt. cost and comparative advantage concepts.)


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Oppt. cost of cloth in Country A Oppt. cost of cloth in Country B

(1 hr/yd) / ( 3 hr/bbl) = 1/3 bbl/yd (2hr/yd) / (4hr/bbl) = bbl/yd

Oppt. cost of wine in Country A

(3 hr/bbl) / ( 1 hr/yd) =3 yd/bbl

Oppt. cost of wine in Country B

(4hr/bbl) / (2hr/yd) = 2 yd/bbl


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suppose country A has a total of 9000 labor hours &

country B has a total of 16,000 labor hours - construct PPFs

SEE GRAPH 1 AT END OF DOCUMENT

MRT

Note that the slope of PPFs equals the oppt. costs of wine in terms of cloth for both

countries. Define the Marginal Rate of Transformation (MRT)

Terms of Trade - must fall between 3c/w and 2c/w - arbitrary choice of 2.5 c/w

Gains from trade - divide into

two gains from

exchange

do not change autarkic production, but allow trade

terms of trade line (slope 2.5 c/w) intersects PPFs at production

points define consumption possibilities frontier

gains from specialization

profit maximization

shift productionIncrease production of a good if marginal revenue greater than marginal cost

In this model relative price (2.5 c/w) equals marginal revenue and marginal rate

of transformation (2 c/w for country b) equals marginal cost

For country b since relative price 2.5 c/w > MRT 2 c/w it will produce more

and more wine until it becomes complete specialized in its production.

For country a we have the reverse. Here because MRT 3 c/w > relative price it

will produce less and less wine until it produces only cloth. This reasoning may

be difficult to follow. However, if we invert the analysis (put cloth on the vertical

axis) then we would have a parallel analysis to country b.

With the change in production, we now allow trade at the terms of trade, the

consumption possibilities frontier now emanates from the end points representing

complete specialization. Note that gains from trade are now greater than

previously.

SEE GRAPH 2 AT END OF DOCUMENT

9000Cloth

Cloth 8000


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6000

3000 3000

3 C/W

2 C/W

3000

Country B2500 4000

Country A Wine Wine

GRAPH 1


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9000Cloth

Cloth

8000

60002.5 C/W

2.5 C/W

3000 3000

3 C/W

2 C/W

30002500

4000

Country A Wine Country B Wine

GRAPH 2

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Chapter-1 Mec Extra