TOPIC 1: ABSOLUTE AND COMPARATIVE ADVANTAGE

Many economists would express their views on international trade in a more positive
way. The evidence that international trade benefits economies, in general, is quite
compelling. Trade has accompanied economic growth in the United States and around
the world. There is no modern example of a country that has isolated itself from global
trade and thrived. To comprehend the advantages of trade, or why we trade in the first
place, we must first comprehend the concepts of comparative and absolute advantage.

In this chapter, we examine the development of trade theory from the seventeenth
century through the first part of the twentieth century. This historical approach is useful
not because we are interested in the history of economic thought as such, but because
it is a convenient way of introducing the concepts and theories of international trade
from the simple to the more complex and realistic.

We begin with a brief discussion of the economic doctrines known as mercantilism that
prevailed during the seventeenth and eighteenth centuries. We then go on to discuss
the theory of absolute advantage, developed by Adam Smith. It remained, however, for
David Ricardo, writing some 40 years after Smith, to truly explain the pattern of and the
gains from trade with his law of comparative advantage. The law of comparative
advantage is one of the most important laws of economics, with applicability to nations
as well as to individuals and useful for exposing many serious fallacies in apparently
logical reasoning. One difficulty remained. Ricardo had based his explanation of the law
of comparative advantage on the labor theory of value, which was subsequently
rejected. In the first part of the twentieth century, Gottfried Haberler came to Ricardo’s
“rescue” by explaining the law of comparative advantage in terms of the opportunity cost
theory, as reflected in production possibility frontiers, or transformation curves. For
simplicity, our discussion will initially refer to only two nations and two commodities.

By the end of this section, you will be able to:

- Define absolute advantage, comparative advantage and opportunity costs

- Explain the gains of trade created when a country specializes
The Mercantilists’ Views on Trade

Economics as an organized science can be said to have originated with the publication
in 1776 of The Wealth of Nations by Adam Smith. However, writings on international
trade preceded this date in such countries as England and Spain as they developed into
modern national states. Specifically, during the 17th and 18th centuries a group of men
(merchants, bankers, government officials, and even philosophers) wrote essays and
pamphlets on international trade that advocated an economic philosophy known as
mercantilism. Briefly, the mercantilists maintained that the way for a nation to become
rich and powerful was to export more than it imported. The resulting export surplus
would then be settled by an inflow of bullion, or precious metals, primarily gold and
silver. 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).
However, since all nations could not simultaneously have an export surplus and the
amount of gold and silver was fixed at any particular point in time, one nation could gain
only at the expense of other nations. The mercantilists thus preached economic
nationalism, believing as they did that national interests were basically in conflict.

Here is an overview before we begin defining absolute and comparative advantage.

Absolute vs. Comparative Advantage: An Overview

Absolute advantage and comparative advantage are two important concepts in

economics and international trade. They largely influence how and why nations and
businesses devote resources to the production of particular goods and services.
Absolute advantage describes a scenario in which one entity can manufacture a
product at a higher quality and a faster rate for a greater profit than another competing
business or country can accomplish. Comparative advantage, on the other hand, takes
into consideration the opportunity costs involved when choosing to manufacture
multiple types of goods with limited resources.

Absolute Advantage: Adam Smith

Smith started with the simple truth that for two nations to trade with each other
voluntarily, both nations must gain. If one nation gained nothing or lost, it would simply
refuse to trade. But how does this mutually beneficial trade take place, and from where
do these gains from trade come?

Absolute Advantage
 Absolute advantage refers to the uncontested superiority of a country or
business to produce a particular good better.

A country has an absolute advantage in producing a good over another country

if it uses fewer resources to produce that good. Economists use the term absolute
advantage to explain how an entity can manufacture a better product at a faster rate
and with greater profit than one produced by a competing country or business.

According to Adam Smith, trade between two nations is based on absolute advantage.
When one nation is more efficient than (or has an absolute advantage over) another in
the production of one commodity but is less efficient than (or has an absolute
disadvantage with respect to) the other nation in producing a second commodity, then
both nations can gain by each specializing in the production of the commodity of its
absolute advantage and exchanging part of its output with the other nation for the
commodity of its absolute disadvantage. By this process, resources are utilized in the
most efficient way and the output of both commodities will rise. This increase in the
output of both commodities measures the gains from specialization in production
available to be divided between the two nations through trade.

For example, because of climatic conditions, Canada is efficient in growing wheat

but inefficient in growing bananas. On the other hand, Nicaragua is efficient in growing
bananas but inefficient in growing wheat. Thus, Canada has an absolute advantage
over Nicaragua in the cultivation of wheat but an absolute disadvantage in the
cultivation of bananas. The opposite is true for Nicaragua.

Under these circumstances, both nations would benefit if each specialized in the
production of the commodity of its absolute advantage and then traded with the other
nation. Canada would specialize in the production of wheat (i.e., produce more than
needed domestically) and exchange some of it for (surplus) bananas grown in
Nicaragua. As a result, both more wheat and more bananas would be grown and
consumed, and both Canada and Nicaragua would gain. In this respect, a nation
behaves no differently from an individual who does not attempt to produce all the
commodities she or he needs. Rather, the individual produces only that commodity that
he or she can produce most efficiently and then exchanges part of the output for the
other commodities she or he needs or wants. This way, total output and the welfare of
all individuals are maximized.

We will now look at a numerical example of absolute advantage that will serve to
establish a frame of reference for presenting the more challenging theory of
comparative advantage in the next section.

California Mexico
Wine (bottle/day) 10 2

Tequila (bottle/day) 4 8

California makes a lot of wine, and grapes grow easily in the Napa Valley region.
This table shows that one day of a man's labor produces 10 bottles of wine in California,
but due to the difficulty of growing grapes in a desert, the man will only be able to
produce 2 bottles of wine in Mexico. On the other hand, because agave plants, which
are a derivative of tequila, are very easy to grow, a man in Mexico can spend one day
producing 8 bottles of tequila, whereas a similar worker in California can only produce 4
bottles of tequila. Thus, in the production of wine, California is more efficient than, or
has an absolute advantage over, Mexico, whereas in the production of tequila, Mexico
is more efficient than, or has an absolute advantage over, California. With trade,
California would specialize in wine production and exchange part of it for tequila. The
opposite is true for Mexico.

If California exchanges 10 bottles of wine for 10 bottles of tequila, the California

gains 6 bottles of tequila or save one and a half days or 36 hours of labor time since
California can only exchange 10 bottles of wine for 4 bottles of tequila domestically.
Similarly, the 10 bottles of wine that the Mexico receives from California is equivalent to
or would require 5 days of labor time to produce in Mexico. These same 5 days can
produce 40 bottles of tequila in Mexico (5 days X 8 bottles of tequila per day). By being
able to exchange 10 bottles of tequila for 10 bottles of wine with California the Mexico
gains 30 bottles of tequila, or save almost 4 labor days.

The fact that Mexico gains much more than California is not important at this time.
What is important is that both nations can gain from specialization in production and
trade.

Pg.82 interntl econ

Comparative Advantage: David Ricardo

In 1817, David Ricardo, a businessman, economist, and member of the British

Parliament, wrote a treatise called On the Principles of Political Economy and Taxation.
In this treatise, Ricardo argued that specialization and free trade benefit all trading
partners, even those that may be relatively inefficient.

Comparative Advantage

Comparative advantage refers to the ability to produce goods and services at a lower
opportunity cost compared to the competition.
 Comparative advantage takes a more holistic view of production. In this case, the
perspective lies in the fact that a country or business has the resources to produce a
variety of goods and services rather than focus on just one product.

The opportunity cost of a given option is equal to the forfeited benefits that could
have been achieved by choosing an available alternative in comparison. In general,
when the profit from two products is identified, analysts would calculate the opportunity
cost of choosing one option over the other.

According to the law of comparative advantage, even if one nation is less efficient than
(has an absolute disadvantage concerning) the other nation in the production of both
commodities, there is still a basis for mutually beneficial trade. The first nation should
specialize in the production and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its comparative advantage) and import
the commodity in which the absolute disadvantage is greater (this is the commodity of
its comparative disadvantage).

For example, let's assume that China has enough resources to produce either
smartphones or computers such that China can produce either 10 computers or 10
smartphones. Computers generate a higher profit. The opportunity cost is the difference
in value lost from producing a smartphone rather than a computer. If China earns $100
for a computer and $50 for a smartphone then the opportunity cost is $50. If China has
to choose between producing computers over smartphones it will probably select
computers because the chance of profit is higher.

Here is a numerical example of comparative advantage:

Comparative Advantage U.S. U.K.

Wheat (bushels/hour) 6 1

Cloth (yards/hour) 4 2

The statement of the law can be clarified by looking at this table. The United
Kingdom has an absolute disadvantage in the production of both wheat and cloth with
respect to the United States. However, since U.K. labor is half as productive in cloth but
six times less productive in wheat with respect to the United States, United Kingdom
has a comparative advantage in cloth. On the other hand, the United States has an
absolute advantage in both wheat and cloth with respect to the United Kingdom, but
since its absolute advantage is greater in wheat (6:1) than in cloth (4:2), the United
States has a comparative advantage in wheat.

To summarize, the U.S. absolute advantage is greater in wheat, so its comparative

advantage lies in wheat. The United Kingdom’s absolute disadvantage is smaller in
cloth, so its comparative advantage lies in cloth. According to the law of comparative
advantage, both nations can gain if the United States specializes in the production of
wheat and exports some of it in exchange for British cloth. (At the same time, the United
Kingdom is specializing in the production and exporting of cloth.)

Note that in a two-nation, two-commodity world, once it is determined that one nation
has a comparative advantage in one commodity, then the other nation must necessarily
have a comparative advantage in the other commodity.
The Gains from Trade

However, we have not yet proved the law. To do so, we must be able to show that the United States and
the United Kingdom can both gain by each specializing in the production and exporting of the
commodity of its comparative advantage.

To start with, we know that the United States would be indifferent to trade if it received only 4C from
the United Kingdom in exchange for 6W, since the United States can produce exactly 4C domestically by
utilizing the resources released in giving up 6W (see Table 2.2). And the United States would certainly
not trade if it received less than 4C for 6W. Similarly, the United Kingdom would be indifferent to trade if
it had to give up 2C for each 1W it received from the United States, and it certainly would not trade if it
had to give up more than 2C for 1W.

To show that both nations can gain, suppose the United States could exchange 6W for 6C with the
United Kingdom. The United States would then gain 2C (or save 1/ 2 hour of labor time) since the United
States could only exchange 6W for 4C domestically. To see that the United Kingdom would also gain,
note that the 6W that the United Kingdom receives from the United States would require six hours to
produce in the United Kingdom. The United Kingdom could instead use these six hours to produce 12C
and give up only 6C for 6W from the United States. Thus, the United Kingdom would gain 6C or save
three hours of labor time. Once again, the fact that the United Kingdom gains more from trade than the
United States is not important at this point. What is important is that both nations can gain from trade
even if one of them (in this case the United Kingdom) is less efficient than the other in the production of
both commodities.

we see that both nations would gain by exchanging 6W for 6C. However, this is not the only rate of
exchange at which mutually beneficial trade can take place. Since the United States could exchange 6W
for 4C domestically (in the sense that both require 1 hour to produce), the United States would gain if it
could exchange 6W for more than 4C from the United Kingdom. On the other hand, in the United
Kingdom 6W = 12C (in the sense that both require 6 hours to produce). Anything less than 12C that the
United Kingdom must give up to obtain 6W from the United States represents a gain from trade for the
United Kingdom. To summarize, the United States gains to the extent that it can exchange 6W for more
than 4C from the United Kingdom. The United Kingdom gains to the extent that it can give up less than
12C for 6W from the United States. Thus, the range for mutually advantageous trade is

4C < 6W < 12C

The spread between 12C and 4C (i.e., 8C) represents the total gains from trade available to be shared by
the two nations by trading 6W. For example, we have seen that when 6W are exchanged for 6C, the
United States gains 2C and the United Kingdom 6C, making a total of 8C. The closer the rate of exchange
is to 4C = 6W (the domestic, or internal, rate in the United States—see Table 2.2), the smaller is the
share of the gain going to the United States and the larger is the share of the gain going to the United
Kingdom. On the other hand, the closer the rate of exchange is to 6W = 12C (the domestic, or internal,
rate in the United Kingdom), the greater is the gain of the United States relative to that of the United
Kingdom.

For example, if the United States exchanged 6W for 8C with the United Kingdom, both nations would
gain 4C, for a total gain of 8C. If the United States could exchange 6W for 10C, it would gain 6C and the
United Kingdom only 2C. (Of course, the gains from trade are proportionately greater when more than
6W are traded.) In Section 2.6b, we will see how this rate of exchange is actually determined in the real
world by demand as well as supply considerations. The rate of exchange will also determine how the
total gains from trade are actually shared by the trading nations. Up to this point, all we have wanted to
do is to prove that mutually beneficial trade can take place even if one nation is less efficient than the
other in the production of both commodities.

So far, the gains from specialization in production and trade have been measured in terms of cloth.
However, the gains from trade could also be measured exclusively in terms of wheat or, more
realistically, in terms of both wheat and cloth. This will be done in the graphical presentation of the law
of comparative advantage in Section 2.6a.

 Absolute advantage evaluates how efficiently a single product can be

produced for quality, quantity and profit.
 Comparative advantage helps an entity select between several products
to determine which has the greater return.