Chapter 3
Why Everybody Trades: Comparative Advantage
Overview
This chapter extends the analysis of international trade to consider trade in a multiple-product
economy. An economy composed of two products is useful to bring out insights about
international trade. This general equilibrium approach explicitly shows the effects of resource
reallocations between industries. The chapter culminates in showing the importance of
comparative advantage for understanding why countries trade.
The story begins with Adam Smith and absolute advantage. (A box on mercantilism summarizes
the view that Smith opposed and shows how mercantilist thinking continues today.) The analysis
focuses on the productivity of labor (output per hour) in producing each of two products (wheat
and cloth) in two countries (the United States and the rest of the world). Smith examined the case
of absolute advantage, in which labor productivity in producing one product is higher in one
country and labor productivity in producing the other product is higher in the other country. With
no trade each country must produce both products to meet national demands. The discussion of
the Smith case focuses on the increase in global production efficiency achieved by shifting
production in each country toward the product in which it has the higher labor productivity.
National demands can be met by international trade—apparently excess supplies can be exported
and apparently excess demands can be met by imports. The increase in total world production is
the evidence of gains from international trade.
Smith’s approach does not indicate what would happen if the same country has absolute
advantage in both products. Ricardo took up this case and demonstrated the principle of
comparative advantage—a country will export products that it can produce at low opportunity
cost and import products that it would otherwise produce at high opportunity cost. The Ricardian
example is developed in more detail. The ratio of resource costs (labor hour input-output
coefficients, the inverse of labor productivities) indicates the opportunity costs or relative prices
of the products in each country with no trade. The difference in prices with no trade sets up the
opportunity for arbitrage, with each good being exported from the initially low-price country and
imported by the initially high-price country. The shift to a free trade equilibrium results in an
equilibrium international price. Without information on demand, we cannot say exactly what this
price will be, but we do know that it is in the range bordered by the two no-trade price ratios.
The chapter uses the Ricardian example to introduce a key analytical device—the production
possibility curve, which shows all combinations of outputs of different goods that an economy
can produce with full employment of resources and maximum productivity. The resource costs of
producing each product in the country and the total amount of labor hours available in the
country are used to graph the country’s production possibility curve, a straight line whose slope
equals the (negative of the) extra (or marginal) cost of additional cloth. The straight line indicates
that the marginal or opportunity cost of each good in each country is constant, following
Ricardo’s assumptions. The slope of this line also indicates the relative price of cloth (the good
on the x-axis) with no trade.
If free trade results in an equilibrium international price ratio that is strictly between the two
no-trade price ratios (because both countries are “large countries”), then each country specializes
completely in producing only the good in which it has the comparative advantage. Each trades at
the equilibrium international price ratio (along a trade line or price line) to reach its consumption
point. Both countries gain from trade. Each is able to consume more of both goods than it
consumed with no trade.
Tips
This chapter begins the full sweep of the development of thinking about comparative advantage
as an explanation of the pattern of trade, starting with absolute advantage, and continuing with
comparative advantage according to Ricardo. Most instructors will want to emphasize the
continuity of thinking by tying this chapter closely to Chapter 4, which presents Heckscher and
Ohlin’s insight that comparative advantage can be based on differences in factor proportions and
factor endowments. We have divided the discussion of comparative advantage into these two
chapters (3 and 4), because students (especially students who find this conceptual material
challenging to master) are likely to appreciate that the reading comes in more manageable sizes.
This chapter has the first of a series of boxes that “Focus on Labor.” Issues of wages and work
conditions are prominent in criticisms of globalization. These boxes should be of major interest
to many students, as they take up these issues. The box in this chapter examines the link between
(real) wages and productivity. It argues that wages in developing countries are low because labor
productivity is low. This is not caused by international trade or foreign exploitation—wages will
be low with or without trade. The key to raising wages and living standards is raising
productivity, perhaps through education, better health, and better government policies toward
labor markets. Problem 9 at the end of the chapter focuses on the calculation of real wages in a
Ricardian example.