The document discusses the theories of absolute advantage, comparative advantage, and gains from trade. It explains that according to absolute advantage, nations should trade when one has an advantage in producing one good over another. Comparative advantage expands this to say that even if a nation is worse at producing both goods, it should still specialize in the good where its disadvantage is smallest. This allows both nations to increase total production and consumption through specialization and trade. Diagrams of production possibility frontiers are used to illustrate how gains from trade arise from specialization enabled by comparative advantage.

1. Chapter 2: The Law of Comparative Advantage
Basic questions that this chapter will answer is:
1. What is the basis for trade and what are the gains from trade?
2. What is the pattern of trade??
Assumption of the theory:
 We will consider a two nation world with only two commodities being traded.

2. In the 17th century a group of men (merchants, bankers, government
officials, and philosophers) wrote essays on international trade that
advocated an economic philosophy known as Mercantilism.
In their view, a country becomes rich if it exports more than it imports.
The surplus in trade balance will result in an inflow of precious metals;
gold and silver.
The accumulation of precious metals means a richer and more powerful
nation.
Countries have to do their best to increase exports and restrict imports.
The Mercantilists’ View on Trade

3. Since all countries cannot have surplus at the same time and because the
stock of metals is fixed in the short run, a country gains from trade only at
the expense of others.
Wealth of nations was measured by the stock of metals they possess.
In contrast, today we measure wealth of a nation by its stock of human,
man-made, and natural resources available for producing goods and
services.
Mercantilists advocated strict government control of economic activity
because gain from trade comes at the expense of other nations (i.e. zero-
sum-game).

4. Trade Based on Absolute Advantage: Adam Smith (Wealth of Nations: 1776)
A. Absolute Advantage:
 According to Adam Smith, trade between two nations is based on
absolute advantage. He advocated that both the nations should gain
from trade.
 When one nation is more efficient than (has an absolute advantage
over) another in the production of one commodity but is less efficient
than (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 nations
for the commodity of its absolute disadvantage

5. By this process, resources are efficiently utilized and the output of both
commodities will rise.
The growth in output measures the gains from specialization in production
available to be divided between the two nations through trade.
In contrast to the mercantilists, Smith believed that all nations would gain from
free trade and strongly advocated a policy of laissez-faire:
As little government interference with the economic system as possible.
Free trade would lead to efficient use of resources and would maximize world
welfare.
Only few exceptions were allowed to this policy.

6. B. Illustration of Absolute Advantage
 Example:
 The table shows that one hour of labor time produces 6 bushels of
wheat in the US versus only 1 in the UK, while one hour of labor
time produces 5 yards of cloth in the UK versus 4 in the US.
 Thus, the US has an absolute advantage in producing wheat, while
the UK has an absolute advantage in producing cloth.
 With trade, the US specializes in producing wheat, while the UK
specializes in producing cloth.
U.S U.K
wheat 6 1
cloth 4 5

7. If the US exchanges 6 bushels of wheat (6W) for six yards of UK cloth
(6C), it gains 2C or saves ½ hour of labor time (since it can only
exchange 6W for 4C domestically).
Similarly, the 6W the UK receives from the US is equivalent to or would
require 6 hours of labor time to produce in the UK.
These same 6 hours can produce 30C in the UK.
The exchange of 6C for 6W with the US, the UK gains 24C, or saves 5
man-hours.
Absolute advantage however explains only a part of world trade such
as trade between developed and developing countries.

8. Trade Based on Comparative Advantage: David Ricardo
A. The Law of Comparative Advantage (LCA)
 According to LCA, even if one nation has an absolute disadvantage
with respect to the other nation in the production of both
commodities, there is still a basis for mutually beneficial trade.
 This 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 its absolute disadvantage in greater (this is
the commodity of its comparative disadvantage).

9. Example:
The UK has an absolute disadvantage in the production of both
commodities with respect to the US
However, since the UK is half as productive in cloth but 6 times less
productive in wheat, it has a comparative advantage in cloth.
 The US has an absolute advantage in the production of both commodities
with respect to UK.
Since the US absolute advantage is greater in wheat (6:1) than in cloth
(4:2), it has a comparative advantage in wheat.
U.S U.K
Wheat 6 1
Cloth 4 2

10. Comparative Advantage with Money
A nation can export goods even if it has a comparative disadvantage in producing both
the goods only when the wages it pays to labors are so low that eventually price of at
least one commodity is lower than the nation which has a C.A.
Example:
Wage in U.S = $6/hour wage in U.K = £1/hour
Pw=$1 Pw=£1 = $2 (ER £1 = $2)
Pc=$1.50 Pc = £ 0.5 = $ 1
According to the above example, UK has a CA in producing cloth and hence itv exports
cloth to US importing wheat from them.
What would be the pattern of trade if $1 = £1 ???

11. Comparative Advantage and Opportunity Costs
A. Comparative Advantage and the Labor Theory of Value (LTV)
 According the LTV, the value or price of a commodity depends
exclusively on the amount of labor going into its production.
 This implies that:
1) either labor is the only factor of production or it is used in the
same fixed proportion in the production of all commodities.
2) labor is homogeneous (i.e. of only one type).
 Since neither of the assumptions is true, we can’t base the
explanation of comparative advantage on the LTV.

12. B. The Opportunity Cost Theory (OCT)
 According to the OCT, the cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources to
produce one additional unit of the first commodity.
 Thus, the nation with the lower opportunity cost in the production of a
commodity has a comp-adv. in that commodity.
 U.S will not trade if it gets 4 or less units of cloth for 6 bushels of wheat.
 If the US has to give up 2/3 of a unit of cloth to release enough resources
to produce an additional unit of wheat, then the opp. cost of wheat is 2/3
of a unit of cloth (i.e. 1W=2/3 C)

13. If 1W=2C in the UK, then the opp. cost of wheat is lower in the US, and the
US has a comparative (cost) advantage over the UK in wheat.
In a two-nation, two-commodity world, the UK would have a comp-adv. In
cloth.
According to the LCA, the US should specialize in producing wheat and
export some of it in exchange for British cloth.
C. The Production Possibility Frontier (PPF) under Constant Costs:
 The PPF: a curve showing the alternative combinations of the two
commodities that a nation can produce by fully utilizing its resources with
the best technology available to it.

14. WHEAT (USA) CLOTH (USA) WHEAT (UK) CLOTH (UK)
180 0 60 0
150 20 50 20
120 40 40 40
90 60 30 60
60 80 20 80
30 100 10 100
0 120 0 120
Production Possibility Frontier under Constant Costs

15. The PPFs of the United States and the United Kingdom.

16. The US has to give up 30W to produce an additional 20C (30W=20C), the
opp. cost of W is 1W=2/3C.
 The UK has to give up 10W to produce an additional 20C (10W=20C), the
opp. cost of W is 1W=2C.
Constant opportunity costs arise when:
1. Resources are perfect substitutes or used in fixed proportions in the
production of both commodities.
2. All units of the same factor are homogeneous.
 While opp. costs are constant in each nation, they differ among
nations, providing the basis for trade.
 The opp. cost is measured by the slope of the PPF, also known as the
marginal rate of transformation.

17. D. Opportunity Costs and Relative Commodity Prices:
 Figure 2-1 shows that the (absolute) slope of the US transformation
curve is 120/180=2/3= opp. cost of wheat in the US and remains
constant.
 The (absolute) slope of the UK transformation curve is 120/60=2= opp.
cost of wheat in the UK and remains constant.
 Assuming prices equal costs and the nation produces both commodities,
the opp. cost of wheat is equal to wheat price relative to cloth price (Pw
/Pc).
 In the US, Pw /Pc=2/3, and inversely Pc /Pw= 3/2=1.5.
 In the UK, Pw /Pc=2, and inversely Pc /Pw= ½=1/2.

18. The lower Pw /Pc in the US reflects its comp-adv. in wheat.
The lower Pc /Pw in the UK reflects its comp-adv. in cloth.
Conclusion: the difference in relative commodity prices between the two
nations is a reflection of their com-adv. and provides the basis for mutually
beneficial trade.

19. A. Illustration of the Gains from Trade:
 With no trade, the US may produce a combination of (90W-60C) on its PPF
 The UK may produce a combination of (40W-40C) on its PPF (point A/ in
figure 2-2).
 With trade, the US would specialize in producing wheat and produce at
point B (180W-0C).
 The UK would specialize in producing cloth and produce at point B / (0W-
120C).
 If they trade 70W for 70C, US consumes 110W-70C (point E), the UK
consumes 70W-50C (point E /).
The Basis for and the gains from Trade under Constant Costs

20. The Gains from Trade.

21. The US gains 20W and 10C from trade (E compared to A), UK gains 30W and 10C (E
/ compared to A /).
The increase in consumption resulted from the specialization of the two nations.
Without trade, total production of wheat is 130 (90+40), but with trade it is 180 (all
in the US).
Without trade, total production of cloth is 100 (60+40), but with trade it is 120 (all
in the UK).
Gains from trade come from the increase in production (50W and 20C) shared by
both nations.
Without trade no nation would specialize in production because both need to
consume some of the other commodity.

22. Pw/Pc
wheat
Dw (US+UK)
Sw (US+UK)
2/3
1
2
180
240
Equilibrium Relative Commodity Price

23. Important terms learnt in this chapter:
1. Absolute Advantage
2. Comparative Advantage.
3. Labor Theory of Value.
4. Opportunity Cost Theory.
5. Pattern of Trade.
6. PPF.
7. Relative Commodity Price.
8. Small Country Case.