Foundations of
Modern Trade Theory:
Comparative Advantage
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1
Chapter Outline
• Historical Development of Modern Trade
Theory
• Absolute and Comparative Advantage
• Trading Under Constant Cost Conditions
• Dynamic Gains from Trade
• Trading Under Increasing Cost Conditions
• Comparative Advantage across many products
and many countries
• Outsourcing
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2
Historical Development of Modern Trade Theory
• The Mercantilists, 1500–1800
• Promoted a favorable trade balance by
encouraging exports and discouraging imports
• Rise in domestic output and employment
• Government regulation of trade
• Tariffs, quotas, other commercial policies
• Static view of the world economy
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3
Historical Development of Modern Trade Theory
• Criticisms of Mercantilism
• David Hume’s price-specie-flow doctrine
• A favorable trade balance is possible only in the
short run
• Adam Smith, The Wealth of Nations (1776)
• World’s wealth is not a fixed quantity
• International trade increases general level of
productivity within a country as well as increase
world output
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4
Historical Development of Modern Trade Theory
• Why Nations Trade? : Absolute Advantage
• Assumptions
• Production costs differ among nations due to
different productivities of factor inputs
• Labor – homogenous
• Absolute cost advantage
• Countries that use less labor to produce one
unit of output
• Labor theory of value – assumes that within a
nation, labor is the only factor of production
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5
Historical Development of Modern Trade Theory
• Principle of absolute advantage
• Consider a two-nation, two-product world
• First nation - absolute cost advantage in one good
• Second nation - absolute cost advantage in the
other good
• Each nation produces a good which is absolutely
more efficient than its trading partner
• With Trade and Specialization
• Countries export goods – if absolute cost advantage
• Countries import goods – if absolute cost disadvantage
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6
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7
Historical Development of Modern Trade Theory
• Comparative advantage (David Ricardo) 1772-1823
• Emphasizes relative cost differences based on
opportunity costs
• Trade is possible even if a nation has an absolute
cost disadvantage in the production of both goods
• The more efficient nation
• Specializes and export s goods in which it is relatively more
efficient or where its absolute advantage is greatest
• The less efficient nation
• Specializes and exports the good in which it is relatively less
inefficient or where its absolute disadvantage is least
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8
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9
Historical Development of Modern Trade Theory
• Principle of comparative advantage, simplified
model - assumptions:
1. World consists of two nations and two goods
2.Each nation uses only one input - labor
Fixed, homogeneous, fully employed and is mobile
within a country only
3. Technology and costs of production are constant
4. Perfect Competition prevails in all markets
5. Free trade with no transportation/trade barriers
6. Firms make output decisions to maximize profits
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10
Historical Development of Modern Trade Theory
• Principle of comparative advantage, simplified
model - assumptions:
7. No Money Illusion
Consumers and Producers take into account the
behavior of all prices
8. Trade is balanced
Exports must pay for imports
Rules out flows of money between nations
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11
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12
TRADE
CONFLICTS
David Ricardo, 1772–1823
• Leading British economist of the early 1800s
• Theories of classical economics
• Economic freedom through free trade and
competition
• Successful businessman, financier, speculator
• Stockbroker, loan broker
• 1819 – 1823, British parliament
• Advocated the repeal of the Corn Laws (trade
barriers)
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13
TRADE
CONFLICTS
David Ricardo, 1772–1823
• Interest in economics
• Adam Smith’s The Wealth of Nations
• Newspaper articles on economic questions
• 1817, The Principles of Political Economy and
Taxation
• Laid out the theory of comparative advantage
• Advocate of free trade
• Opponent of protectionism
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14
Production Possibilities Schedules
• Production possibilities schedule
• Various alternative combinations of two goods
a nation can produce when all factors of
production are used to the maximum efficiency
• Maximum output possibilities of a nation given
the resource constraints, level of technology.
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15
Production Possibilities Schedules
• Marginal rate of transformation (MRT)
• The amount of a good a nation must sacrifice
to obtain an additional unit of another good
• Rate of sacrifice = opportunity cost of a product
• Absolute value of the slope of production
possibilities schedule
• For Figure 2.1
Wheat
MRT 
Autos
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16
Trading Under Constant Opportunity Costs
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17
Trading Under Constant-Cost Conditions
• Constant opportunity costs
• Straight line production possibilities schedules
• Factors of production are assumed to be
perfect substitutes for each other of the same
quality
• Autarky
• Absence of trade
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18
Trading Under Constant-Cost Conditions
• Basis for Trade
• Principle of comparative advantage
• Direction of Trade
• Each country specializes and exports a good in
which it has the lowest opportunity cost
• Production Gains from Specialization
• Production gains for both countries
• Arise from the reallocation of existing resources
• Static gains from specialization
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20
Trading Under Constant-Cost Conditions
• Consumption Gains from Trade
• Trade = consumption gains for both countries
• Consumption points
• Outside domestic production possibilities schedules
• Consume more of both goods
• Terms of trade
• Rate at which a country’s export product is
traded for the other country’s export product
• Define the relative prices of the two products
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21
Trading Under Constant-Cost Conditions
• Domestic rate of transformation
• Domestic terms of trade
• Slope of the production possibilities schedule
• Relative prices that two commodities can be
exchanged at home
• Terms of trade for exports
• More favorable than domestic terms of trade
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22
Trading Under Constant-Cost Conditions
• Trading possibilities line
• International terms of trade for both countries
• Trade triangle for a country
• Exports – along the horizontal axis
• Imports – along the vertical axis
• Terms of trade – the slope
• Complete specialization
• Produce only one product
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23
Trading Under Constant-Cost Conditions
• Domestic cost ratio
• Negatively sloped production possibilities
schedule
• Transform into a positively sloped cost-ratio line
• Outer limits for the equilibrium terms of trade
• Becomes no-trade boundary
• Region of mutually beneficial trade
• Bounded by the cost ratios of the two countries
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24
Equilibrium Terms-of-Trade Limits
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25
Trading Under Constant-Cost Conditions
• Equilibrium Terms of Trade, John Stuart Mill
(1806–1873)
• Add the intensity of the trading partners’
demands
• Determine the actual terms of trade
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26
Trading Under Constant-Cost Conditions
• Theory of reciprocal demand
• Within the outer limits of the terms of trade
• Actual terms of trade are determined by the
relative strength of each country’s demand for the
other country’s product
• Production costs determine the outer limits of
the terms of trade
• Reciprocal demand determines what the actual
terms of trade will be within those limits
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27
Trading Under Constant-Cost Conditions
• Theory of reciprocal demand
• Best applies when both nations are of equal
economic size
• The demand of each nation - noticeable effect on
market price
• If two nations are of unequal economic size
• The relative demand strength of the smaller nation
will be dwarfed by that of the larger nation
• Domestic exchange ratio of the larger nation will prevail
• The small nation can export as much of the commodity
as it desires
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Trading Under Constant-Cost Conditions
• The importance of being unimportant
• For two nations engaged in international trade
• Same size, similar taste patterns
• Gains from trade – shared equally between them
• One nation is significantly larger than the other
• Larger nation - fewer gains from trade
• Smaller nation - most of the gains from trade
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29
TRADE
CONFLICTS
Babe Ruth and the principle of
comparative advantage
• George Herman Ruth (1895–1948)
• 1914 – 1920, Boston Red Sox, 158 games
• Left-handed pitcher
• Pitching record: 89 wins and 46 losses
• 23 victories in 1916
• 24 victories in 1917
• Babe Ruth
• Absolute advantage in pitching
• Comparative advantage in hitting
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30
TRADE
CONFLICTS
Babe Ruth and the principle of
comparative advantage
• 1920 – 1934, New York Yankees, Babe Ruth
• Ended his pitching career - 2.28 earned run
average
• Switched to only hitting
• Dominated professional baseball
• Teamed with Lou Gehrig
• Greatest one-two hitting punch in baseball
• 1927 Yankees - the best in baseball history
• Record of 60 home runs
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31
TRADE
CONFLICTS
Babe Ruth and the principle of
comparative advantage
• 1920 – 1934, New York Yankees, Babe Ruth
• 1923, Yankee Stadium – nicknamed “The House
That Ruth Built”
• Baseball Hall of Fame, 1936
• Win four World Series
• Most renewed franchise
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32
Trading Under Constant-Cost Conditions
• Terms-of-Trade Estimates
• Commodity terms of trade
• Barter terms of trade
• Measure of the international exchange ratio
• Measures the relation between the prices a nation
gets for its exports and the prices it pays for its
imports
Export Price Index
Terms of trade =
100
Import Price Index
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33
Trading Under Constant-Cost Conditions
• Improvement in a nation’s terms of trade
• Rise in its export prices
• Relative to its import prices
• A smaller quantity of export goods sold abroad
• Required to obtain a given quantity of imports
• Deterioration in a nation’s terms of trade
• Rise in its import prices
• Relative to its export prices
• Purchase of a given quantity of imports
• Sacrifice of a greater quantity of exports
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34
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35
Dynamic Gains From Trade
• Dynamic gains from international trade
•
•
•
•
•
•
•
More efficient use of an economy’s resources
Higher output and income
More saving, More investment
Higher rate of economic growth
Higher productivity
Economies of large-scale production
Increased competition
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36
Changing Comparative Advantage
• Patterns of comparative advantage change
over time
• Productivity increases
• Production possibilities schedule changes
• More output can be produced - with the same
amount of resources
• Producers - need to hone their skills to
compete in more profitable areas
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38
Trading Under Increasing-Cost Conditions
• Increasing opportunity costs
• Concave production possibilities schedule
• Bowed outward from the diagram’s origin
• Inputs are imperfect substitutes for each other
• MRT rises
• Absolute slope of the production possibilities
schedule
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39
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40
Trading Under Increasing-Cost Conditions
• Increasing-Cost Trading Case
• One country specializes in producing one good
• The other country specializes in producing the
other good
• Specialization continues in both nations until
• Relative cost of one good is identical in both
nations
• One country’s exports of one good are precisely
equal to the other country’s imports of the good
• Same domestic rates of transformation
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42
Trading Under Increasing-Cost Conditions
• Production gains
• More of each good is being produced
• Consumption gains
• Both countries consume more of at least one
good
• The trade triangle
• Exports, imports, and terms of trade
• Same for both countries
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Trading Under Increasing-Cost Conditions
• Partial Specialization
• Each country specialize only partially
• In the production of the good in which it has a
comparative advantage
• Increasing costs - mechanism that forces costs
in two trading nations to converge
• Basis for further specialization ceases to exist
• Both nations will produce some of each good
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45
Trading Under Increasing-Cost Conditions
• Partial Specialization
• Not all goods and services are traded
internationally
• Differing tastes for products
• Most products are differentiated
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46
The Impact of Trade on Jobs
• Extent to which an economy is open
• Influences the mix of jobs within an economy
• Can cause dislocation in certain areas or
industries
• Little effect on the overall level of employment
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Comparative Advantage Extended to Many
Products and Countries
• More Than Two Products
• Comparative advantage
• Rank the goods by the degree of comparative cost
• Each country exports the product(s)
• Has the greatest comparative advantage
• Each country imports the product(s)
• Has greatest comparative disadvantage
• Cutoff point between exports and imports
• Relative strength of international demand
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Comparative Advantage Extended to Many
Products and Countries
• More Than Two Countries
• Multilateral trading relations
• Bilateral balance should not pertain to any two
trading partners
• Trade surplus
• With trading partners that buy a lot of the things
that it supplies at low cost
• Trade deficit
• With trading partners that are low-cost suppliers of
goods that it imports intensely
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Exit Barriers
• Open trading system
• Channeling resources from uses of low
productivity to those of high productivity
• Competition
• High cost plants exit
• Low cost plants operate in the long run
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Exit Barriers
• Restructuring of inefficient companies
• Long time
• Cling to capacity
• Existence of exit barriers
• Various cost conditions -make lengthy exit a
rational response by companies
• Hinder the market adjustments
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Empirical Evidence on Comparative Advantage
• The Ricardian model
• Nations export goods - their labor productivity
is relatively high
• Testing the Ricardian model
• G.D.A. MacDougall, 1951
• Export patterns of 25 separate industries; United
States and United Kingdom, 1937
• 20 industries fit the predicted pattern
• Balassa and Stern
• Also supported Ricardo’s conclusions
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Empirical Evidence on Comparative Advantage
• Testing the Ricardian model
• Stephen Golub
• Relative unit labor costs and trade for United States
• United Kingdom, Japan, Germany, Canada, Australia
• Relative unit labor cost helps to explain trade
patterns for these nations
• Limitations of the Ricardian model
• Labor is not the only factor input
• Production and distribution costs
• Differences in product quality
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Does Comparative Advantage Apply in the Face
of Job Outsourcing?
• Comparative advantage
• Weakened if resources can move to wherever
they are most productive
• Relatively few nations with abundant cheap labor
• No longer shared gains
• Some nations win and others lose
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Does Comparative Advantage Apply in the Face
of Job Outsourcing?
• Advantages of Outsourcing
•
•
•
•
Reduced costs and increased competitiveness
New exports
Repatriated earnings
Job losses tend to be temporary
• The creation of new industries and new products
• More lucrative jobs for Americans
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Does Comparative Advantage Apply in the Face
of Job Outsourcing?
• Outsourcing and the U.S. Automobile Industry
• Early 1900s, Ford Motor Company – Model T:
700 parts
• Gains of large-scale mass production
• Gains of a high degree of specialization within a
single plant
• More sophisticated cars and competition
• Ford – outsource production
• Keep strategically important tasks & production in-house
• Noncore tasks purchased from external suppliers
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Does Comparative Advantage Apply in the Face
of Job Outsourcing?
• Outsourcing and the U.S. Automobile Industry
• Increasing numbers of parts and services –
noncore
• Today - about 70% of a typical Ford vehicle
• Parts, components, and services purchased from
external suppliers
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GLOBALIZATION
Outsourcing of Boeing 787 Dreamliner
triggers machinist’s strike
• 2007, Boeing 787 Dreamliner, $150 million
• 3 Japanese firms, 35% of the design and
manufacturing work
• Boeing - final assembly in three days
• Italy, China, and Australia
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