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Part I
2.0 Introduction
International Trade Theory

Chap.2 the Law of Comparative Advantage • 2.0a Main issues in trade theory
Chap.3 Neoclassical Trade Theory
Chap.4 Modern Trade Theory • 2.0b Framework of international trade
Chap.5 Economic Growth and International theory
Trade

2.0 Introduction 2.0a Main issues in Trade Theory

Why do people trade?

2.0a Main issues in Trade Theory =What is the basis for trade?
• gains from trade : when countries sell goods and
• Why do people trade? services to one another, this is almost always to their
mutual benefit
• What is the pattern of trade?
• how are gains from trade generated?
• Effects of trade
how large are the gains?
• Trade in goods and factor movement how are they divided among the trading
nations
David Ricardo’s Model
Heckscher-Olin Model
Economies-of-scale Model

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2.0a Main issues in Trade Theory 2.0a Main issues in Trade Theory

What is the pattern of trade? Effects of trade

• David Ricardo :international differences ---- effects on the distribution of income :
in labor productivity
owners of resources
• Heckscher-Olin Model : supplies of
national resources between broad groups----
workers and the owners of capital
• Others: economies of scale and
imperfect competition

2.0a Main issues in Trade Theory 2.0 Introduction

2.0b Framework of International

Trade in goods and factor Movement
Trade Theory
• tangible goods :
a trade of labor for goods and services from 17 th century, the Mercantilists ’
view on trade before Classical trade
• international migration and theory, till Modern Trade Theory as
international borrowing : Vernon’s theory based on Product cycle
a trade of current goods for the
promise of future goods

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2.0b Framework of International Trade Theory
Chap.2
The law of comparative advantage
• 2.1 The mercantilists’ view on trade
• 2.2 Trade based on absolute advantage: Adam Smith
• 2.3 Trade based on comparative advantage: David
Ricardo
• 2.4 Comparative advantage and opportunity cost
• 2.5 the basis for and the gains from trade under
constant costs
• 2.6 Empirical tests of the Ricardian Model
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2.0b Framework of International Trade Theory
2.1 The Mercantilists’ View on Trade
• 2.1a Economic thought in international trade
before Adam Smith
• 2.1b The main ideas of Mercantilism on
international trade
• 2.1c Trade Policies advocated by Mercantilists
• 2.1d Mercantilism: Older than Smith but still
alive today
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2.1 The mercantilists’ view on trade
2 .1aEconomic thought in international trade before
Adam Smith
• Writings on international trade preceded Adam Smith
in such countries as England, Spain, France, Portugal,
and the Netherlands as they developed into modern
national states.
• During the fifteenth and eighteenth 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.
• Two stages:
the earlier stage of mercantilism (from
the end of 15 th century to the mid of 16 th century)
the later stage of mercantilism (from
the second part of 16 th century to the end of 17 th
century).
2.1b The main ideas of Mercantilism on international trade
the main idea of mercantilism:
The mercantilists took money and wealth as
equal, believing that the increasing of nation ’s
wealth was the same as the increasing of
nation’s money.
Therefore mercantilists maintained that the
way for a nation to become rich and powerful
was to export more than it imported.
1. Money (at that time measured by the stock of
precious metals, that was gold silver)was the
main form if not the only form of wealth
2. The main source of wealth was from trade,
and only from foreign trade.
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2.1 The mercantilists’ view on trade
2.1b The main ideas of Mercantilism on
international trade
Thomas Munn (1571-1641)
England’s Treasure by Foreign Trade
l         Case Study 2-1 Munn ’s Mercantilistic View on Trade
Although a kingdom may be enriched by gifts received, or by purchase taken from some other Nations,
The ordinary
yet these are things uncertain and of small consideration when they happen.
means therefore to encrease our wealth and treasure is by
Foreign Trade, wherein we must ever observe this rule; to sell more
to strangers yearly than we consume of theirs in value. For…that
part of our stock [exports] which is not returned to us in ware
[imports] must necessarily be brought home in treasure
[bullion]…
We may … diminish our importations, if we would soberly refrain from excessive
consumption of foreign wares in our diet and raiment [dress] …In our exportations we
must not only regard our superfluities, but also we must consider out neighbours necessities, that so … we
may… gain so much of the manufacture as we can, and also endeavourer to sell them dear, so far forth as
the high price cause not a less vent in the quantity [of our exports]. But the superfluity of our commodities
which strangers use, and may also have the same form other Nations, or may abate their vent by the use of
some such like wares from other places, and with little inconvenience; we must in this case strive to sell as
cheap as possible we can, rather than to lose the utterance [the sale] of such wares …
• Source: Thomas Munn, England’s Treasure by Foreign Trade ( Reprinted, Oxford: Basil Blackwell, 1928).
• The words in brackets have been added to clarify the meaning.
•  
•  
•
2.1b The main ideas of Mercantilism on international trade
3. In order to get money from trade a country
should keep balance of trade.
That is, to keep foreign trade with export surplus .
Thomas Munn : The ordinary means therefore to
encrease our wealth and treasure is by Foreign Trade,
wherein we must ever observe this rule; to sell more to
strangers yearly than we consume of their in value.
4. The government should interfere national
economy actively, to protect the nation ’s industry
and commerce and promote the development of
foreign trade.
economic nationalism; protectionism
stimulating the nation ’s exports; discourage and restrict
Import (particularly luxury goods) compulsive means
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2.1c Trade Policies advocated by Mercantilists
1.From restricting trade to promoting trade
mercantilists in the earlier stage : constraint money
(gold and silver) inside the country
mercantilists in the later stage : put money into the
profitable foreign trade
Thomas Munn : Money generated trade, and Trade increased money.
2. Awarding export while restricting import
Import: strongly opposing imports of luxury goods, restricting imports of
ordinary manufactures by imposing high tariffs; while imports of raw
materials treated by low tariffs or free of duty.
Export: exports of commodities given special treatment as exempting from
duty or offering subsidies.
3. Government interfering
The government had monopoly power on foreign trade. Some of the big
trading corporations were authorized monopoly power by the government.
The government directly interfered foreign trade by controlling the
channels of trading .
2.1d Mercantilism: Older than Smith but still
alive today
• The fatal weakness of the mercantilism was that they
searched the source of wealth in circulation (for them
was foreign trade),but not production.
Asian crisis in 1997, the fable of IT disappearing
the “bubble economy ” in Japan
• Mercantilists advocated strict government control of
all economic activity and preached economic
nationalism because they believed that a nation could
gain in trade only at the expense of other nations .
trade : a zero-sum game win-win game
• The ideas of classical economists are regarded as
reactions to the mercantilists ’ views on trade and on
the role of government.
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2.1c Trade Policies advocated by Mercantilists
4. Supporting foreign trade by domestic industries.
Supporting the development of infant industries from fierce
competition of foreign industries by the means of tariffs .
Enhancing the competition of domestic industries by the
measurements of exempting from duty, subsidy and
Privileged rights
 5.  Promoting foreign trade by strengthening system
and organization
Trading system : nation----monopoly corporations----
ordinary merchants----sectors supporting trade.
2.1d Mercantilism: Older than Smith but still alive today
l         Case Study 2-2 Mercantilism is Alive and Well in the Twentieth Century
Although most nations claim to be in favor of free trade, most of them continue to impose
many restrictions on international trade . For example, in 1956 the United States and
other industrial nations began to restrict exports of cotton textiles from Japan .
These restrictions were then extended to developing countries in 1962 . This was
followed in 1974 by the Multifiber Arrangemnet (MFA), which limited the
growth of all textile and clothing imports into the United States by 6
percent per year. Subsequent renewals and extensions of the MFA further limited textile
and clothing imports into the United States and other industrial countries and extended it to
also cover synthetic fibers. By 1995, the United States had bilateral textile
export restraints arrangements with 46 countries and the industry was
getting more protection than any other major U.S. industry . Still, under
pressure from imports and automation, employment in the industry declined from 1.3 million
in 1980 to less than 800,000 at the turn of the century.
The multilateral trade agreement, known as the Uruguay Round, which took effect in 1995 will
replace quantitative restrictions on textile imports by equivalent tariffs (taxes) on imports and
is to lower those tariffs by 25 percent by 2005. Thus, most restrictions on textile exports
remain. As in most cases, trade restrictions are demanded to protect
domestic jobs from foreign competition---- a classic mercantilist request .
Mercantilism, though declining, is still alive and well in the twentieth century.
Source: D. Savatore, “Trade Protection and Welfare in the United States, ” in D. Savlatore, ed., Protectionism and World Welfare (New York: Cambridge University Press, 1993), pp. 311 —
335; and “Squeezing the Textile Workers, ” The New York Times, February 21, 1996, p. D1.
• resurgence of neo-mercantilism
• In fact, aside from England during the period 1815-1914, no
Western nation has ever been completely free of mercantilist
idea.
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The Father of Economics:

Adam Smith (1723-1790)
2.2 Trade Based on Absolute • Adam Smith was born on June 5 th,1723 ,
Advantage: Adam Smith •
Scotland
           One of the founders of Classical
Economics
Countries engage in international trade for two • The first economist setting up the
theory of international division of
basic reasons gain from trade labor and international trade
1.countries trade because they are different • Masterwork: Inquiry into the Nature
and Causes of the Wealth of the
from each other Nations (abbr.: Wealth of Nation ),
published in 1776
2. countries trade to achieve economies of scale •          Symbol of Political Economics
in production being an independent subject
•      Investigating the origin of wealth
In the real world, patterns of international trade and the conditions for its increasing
reflect the interaction of both these motives.                     I n t h i s b o o k , A d a m S m i t h
attacked mercantilists’ views of protective
trade policy, advocated the idea of
laissez faire (on international trade that
is free trade )

The Father of Economics:

Adam Smith (1723-1790) 2.2 Trade Based on Absolute Advantage:

• invisible hand:operation of market forces Adam Smith

• markets would guide economic activity and

act like an invisible hand allocating
resources.
• Prices would be the main means to do this.
• the 'invisible hand' would organize markets
and ensure that they arrived at the optimum
outcome
• self-interest ;
best outcome for all concerned

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2.2a Model of Absolute Advantage by
Adam Smith
• Basic Assumptions for the Model of Absolute
Advantage
• Basis for trade: Absolute Advantage in
Commodity Production
• Determination of the Absolute Advantage:
differences in technology
• Measurements of Absolute Advantage:
Productivity or Cost of Production
• Pattern of production and trade
• Gains from trade
• Trade Policy
2.2a Model of Absolute Advantage by
Adam Smith
technology labor productivity
• unit labor requirement, the number of hours
of labor required to produce a unit of product
(aLW and aLC)
If country A requires 1 unit of labor in
producing one pound of cheese, that is aLC
=1.
If country B requires 1.5 units of labor in
producing one pound of cheese, that is a *LC
=1.5.
aLC < a*LC means the technology in producing
cheese in country A is more advanced than in
country B.
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2.2a Model of Absolute Advantage by
Adam Smith
Basic Assumptions for the Model of Absolute Advantage
• Two Countries: e.g. U.S. and U.K.
• Two outputs: e.g. Wheat (Q W) and Cloth (Q C)
• One input: Labor (L)
• Different technologies: different productivity of
labor
• Labor supply is fixed. No international labor
movement, but free to move within the country
• Full employment, perfect competition, and constant
return to scale
• No transportation cost
• Balanced trade
2.2a Model of Absolute Advantage by
Adam Smith
Basis for trade: Absolute Advantage in
commodity Production
• Absolute advantage: When one country
can produce a unit of a good with less
resource than the other country, we say
that the first country has an absolute
advantage over the second one in
producing that good.
• purchasing cost was less than the
production cost; exchange
• get benefit from trade
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2.2a Model of Absolute Advantage by
Adam Smith
Determination of the Absolute Advantage:
differences in technology
• differences in technology caused by labor
productivity and occupational division of labor .
2.2a Model of Absolute Advantage by Adam Smith
Determination of the Absolute Advantage:
differences in technology
If a nation had higher productivity on a commodity
than another nation, then we could say it had
absolute advantage on this commodity over the
second one.
• The reason for a nation to import a commodity
was that the nation had a disadvantage on the
technology of producing this commodity.
• The reason for the second nation to export a
commodity was that the nation had more
advanced technology of producing this commodity,
or had absolute advantage.
lower per-unit cost
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2.2a Model of Absolute Advantage by Adam Smith
Determination of the Absolute Advantage:
differences in technology
• reasons for the effect of division of labor on
increasing productivity
1.the labor would be more skillful by specialization.
the example of pin-making; product line;
“professional”
2. division of labor could save the time of transferring
from one kind of work to another.
3. focusing on one kind of job would stimulate
innovation, such as inventing new machines and new
techniques that would shorten working time and be
laborsaving.
2.2a Model of Absolute Advantage by Adam Smith
Measurements of Absolute Advantage:
Productivity or Cost of Production
• higher productivity =absolute advantage
lower productivity =absolute disadvantage
• cost of production:the unit of labor
requirement in each unit of output
aL=L/Q
If aL < a*L, the nation with cost of production of
aL has an absolute advantage over the nation
with a*L
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2.2a Model of Absolute Advantage by Adam Smith 2.2a Model of Absolute Advantage by Adam Smith

Measurements of Absolute Advantage: Measurements of Absolute Advantage:

Productivity or Cost of Production Productivity or Cost of Production

Table 2-1 Possible Output (L =L *=100) Table 2-2 Productivity (P=Q/L)

  Rice (ton) Wheat (ton)   Rice  Wheat 

China 100 50 China 1.0 0.5
U.S. 80 100 U.S. 0.8 1.0

2.2a Model of Absolute Advantage by

2.2a Model of Absolute Advantage by Adam Smith
Adam Smith
Measurements of Absolute Advantage:
Productivity or Cost of Production Pattern of production and trade:
when one nation is more efficient than (or has an
absolute advantage over) another in the production
Table 2-3 Production Cost (a L=L/Q ) of one commodity but is less efficient than (or has
an absolute disadvantage with respect to) the other
  Rice  Wheat  nation in producing a second commodity, then both
nations can gain by each specializing in the
production of the commodity of its absolute
China 1.00 2.00 advantage and exchange part of its output with the
other nation for the commodity of its absolute
disadvantage.
U.S. 1.25 1.00 • U.S. specializes in and exports wheat;
• China specializes in and exports rice;

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2.2a Model of Absolute Advantage by 2.2a Model of Absolute Advantage by

Adam Smith Adam Smith

Gains from trade: Trade Policy:

• resources are utilized in the most efficient
way; the output of both commodities will rise;
total output and the welfare of all nations are
maximized.
• 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.
• Smith believed that all nations would gain
from free trade and strongly advocated a
policy of laissez-faire
• a policy of laissez-faire:
as little government interference with the
economic system as possible

Table 2-4  Absolute Advantage  

2.2b Illustration of Absolute Advantage    U.S.                 U.K.

Wheat (bushels/man-hour)                    
     6                       1
Table 2-4  Absolute Advantage
Cloth (yards/man-hour)      4                       5
 

   U.S.                 U.K. • Absolute advantage : (P=Q/L a L=L/Q)

Wheat (bushels/man-hour)        
     
Cloth (yards/man-hour)      
• Production condition
(Pu.s) w=6 > (Pu.k) w= 1; (au.s) w=1/6 < (au.k) w=1
           
6                       1
The U.S is more efficient than, or has an absolute
4                       5
advantage over, the United Kingdom on the production
of wheat.
(Pu.s) c=4 < (Pu.k) c=5 ; (a u.s) c=1/4 > (au.k) c=1/5
The United Kingdom is more efficient than, or has an
absolute advantage over, the United States on the
production of cloth.

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Table 2-4  Absolute Advantage   Table 2-4  Absolute Advantage  

   U.S.                 U.K.    U.S.                 U.K.
Wheat (bushels/man-hour)                    
     6                       1 Wheat (bushels/man-hour)                   
     6                       1
Cloth (yards/man-hour)      4                       5
Cloth (yards/man-hour)      4                       5
• Pattern of trade: • Gains from trade :
With trade, the United States would specialize If 6W=6C, the United States gains 2C or saves
in the production of wheat and exchange part of it 1/2 man-hour.
(Domestically the United States can only exchange 6W for 4C)
for British Cloth.
the United Kingdom gains 24C or save
The United Kingdom would specialize in the
almost 5 man-hours.
production of cloth and exchange part of it for
(The 6W that the United Kingdom receives from the United
American wheat. States would require six man-hours of labor time to produce in
the United Kingdom. Six man-hours can produce 30C in the
United Kingdom ; by trading, the U.k. just needs 6C )

2.2b Illustration of Absolute Advantage 2.2c Limitation of the Smith Model

• Table 2-1 Possible Output (L =L *=100)
Attention   Rice (ton) Wheat (ton)
• The fact that the United Kingdom gains China 100 50
much more (24C) than the United U.S. 80 100
States (2C) is not important at this time.
• Table 2-5 Possible Output (L =L *=100)

• What is important is that both nations   Rice (ton) Wheat (ton)

can gain from specialization in China 100 50
production and trade. U.S. 150 100
The U.S. has an absolute advantage on both of 
the two commodities.  

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2.2c Limitation of the Smith Model

• Absolute advantage, however, can explain
only a very small part of world trade today,
such as some of the trade between developed
and developing countries .
2.3 Trade Based on Comparative
• Most of world trade, especially trade among Advantage: David Ricardo
developed countries, could not be explained by
absolute advantage David Ricardo,
the law of comparative advantage
• Absolute advantage will be seen to be only a
special case of the more general theory of
comparative advantage.

One of the Greatest Economists: 2.3a Model of Comparative Advantage by

David Ricardo (1772-1823)
David Ricardo was born
in1772, London:
At the age of 25, he had
been a financier wallowing in
money;
  At the age of 27, Ricardo
devoted to researching
economic issues
   Contributing a lot to the
development of Classical
Economics and International
Trade Theory.
    In 1817, his masterwork:
Principles of Political economy
and Taxation was published.
David Ricardo
Basic Assumptions for the Model of Comparative
Advantage
• Two Countries: e.g. U.S. and U.K.
• Two outputs: e.g. Wheat (Q W) and Cloth (Q C)
• One input: Labor (L)
• Different technologies: different productivity of
labor
• Labor supply is fixed. No international labor
movement, but free to move within the country
• Full employment, perfect competition, and constant
return to scale
• No transportation cost
• Balanced trade

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2.3a Model of Comparative Advantage by

2.3a Model of Comparative Advantage by David Ricardo
David Ricardo • Possible Output (L =L *=100)
Comparative advantage:
  Rice (ton) Wheat (ton)
refers to the degree of advantage.
China 100 100
Country A can have an absolute U.S. 200 600
advantage over country B in commodities X Productivity (P=Q/L)
and Y. But if the degree of advantage is
greater in X, we say that it has a
  Rice  Wheat 
comparative advantage in X, and China 1.0 1.0
comparative disadvantage in Y. U.S. 2.0 6.0
The U.S. has a comparative advantage in wheat,
and a comparative disadvantage in rice.
China has a comparative advantage in rice, and a
comparative disadvantage in wheat.

2.3a Model of Comparative Advantage by 2.3b Illustration of Comparative

David Ricardo Advantage
According to the law of comparative advantage, Table 2-6 Comparative Advantage
even if one nation is less efficient than (has an
   U.S.                 U.K.
absolute disadvantage with respect to) the other
nation in the production of both commodities, Wheat (bushels/man-hour)                    
     6                       1
there is still a basis for mutually beneficial trade. Cloth (yards/man-hour)      4                       2
• The nation should specialize in the production of
and export the commodity in which its absolute Table 2-4 Absolute Advantage
disadvantage is smaller (this is the commodity of
its comparative advantage) and import the
commodity in which its absolute disadvantage is    U.S.                 U.K.
greater (this is the commodity of its comparative Wheat (bushels/man-hour)                    
     6                       1
disadvantage). Cloth (yards/man-hour)      4                       5

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2.3b Illustration of Comparative 2.3b Illustration of Comparative

Advantage Advantage
• Production Condition
• Comparative advantage:
The United States has absolute advantage over the • Pattern of trade:
United Kingdom in the production of both goods. The United States specializes in the
The degree of American Advantage over the production of wheat and exports some of it in
exchange for British cloth.
United Kingdom is not the same in both industries.
The United Kingdom specializes in the
In the model of two countries, two outputs, the production of cloth and exports some of it in
analysis can be expressed by asserting that the United exchange for American wheat.
States has a comparative advantage in wheat while
the United Kingdom has a comparative advantage in
cloth.

2.3b Illustration of Comparative 2.3c Exception to the Law of

Advantage Comparative Advantage
Table 2-7 Exception to the Law of
• Gains from trade:
Comparative Advantage
If 6W=6C, the United States gains 2C
or saves 1/2 man-hour; the United
Kingdom gains 6C or saves almost 3
   U.S.                 U.K.
man-hours. Wheat (bushels/man-hour)                    
     6                       3
Cloth (yards/man-hour)      4                       2
Both nations can gain from specialization
in production and trade.

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2.3c Exception to the Law of
Comparative Advantage
• The degree of American Advantage
over the United Kingdom is the same in
both industries.
• The United Kingdom (and the United
States) would then have a comparative
advantage in neither commodity, and
no mutually beneficial trade could take
place.
2.4 Comparative Advantage and
Opportunity Cost
2.4a Comparative Advantage and the
Labor theory of Value
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2.3c Exception to the Law of
Comparative Advantage
• Modifying the statement of the law of
comparative advantage :
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, unless
the absolute disadvantage (that one nation has
with respect to the other nation) is in the same
proportion for the two commodities.
2.4a Comparative Advantage and the
Labor theory of Value
Basic assumptions of the Ricardian Model:
• 1)        Two Countries
• 2)        Two outputs
• 3)        Different technologies: different productivity of
• labor; no technical change
• 4)        Labor supply is fixed. No international labor
• movement, but free to move within the country
• 5)        Full employment, perfect competition, and
• constant returns to scale
• 6)        No transportation cost
• 7)        Balanced trade
• 8)        One input: Labor (L)
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2.4a Comparative Advantage and the

Labor theory of Value
• Ricardian School: 19 century “conquered the
whole England”
• The main theorem in the labor theory of value is, 2.4b The Opportunity Cost
the value or price of a commodity depends Theory
exclusively on the amount of labor going into the
production of the commodity:
1. Labor is the only factor of production;
  2.  Labor is homogeneous (only one type).
• The theory of comparative advantage needs not
be based on the labor theory of value but can be
explained on the basis of the opportunity cost
theory

Case Study 2-3 Rose and Computer----

2.4b The Opportunity Cost Theory
Case Study 2-3 Rose and Computer----
Opportunity Cost
On Valentine ’s Day, 1996, Republican presidential candidate Patrick
Buchanan stopped at a nursery to buy a dozen roses for his wife. He took
the occasion to make a speech denouncing the growing imports of flowers
into the United States, which he claimed were putting American flower
growers out of business. And it is indeed true that a growing
share of the market for winter roses in the United States is
being supplied by imports flown in from South America. But is
that a bad thing?
Consider first how hard it is to supply American sweethearts with fresh
rose s in F e bruary. The flowers must be grown in heated
greenhouse, at great expense in terms of energy, capital
investment, and other scarce resource. Those resources could
there is a
have been used to produce other goods. Inevitably,
trade-off. In order to produce winter roses, the U.S.
economy must produce less of other things, such as
computers.
Opportunity Cost (CONT ’D)
Suppose, for example, that the United States currently grows 10 million
roses for sale on Valentine ’s Day, and that the resources used to grow
those roses could have produced 100,000 computers instead. Then the
opportunity cost of those 10 million roses is 100,000
computers. Conversely, if the computers were produced instead, the
opportunity cost of those 100,000 computers would be 10 mullion roses.
Those 10 million Valentine ’s Day roses could instead have been grown in
South America. It seems extremely likely that the opportunity cost of
those roses in terms of computers would be less than it would be in the
United States. For one thing, it is a lot easier to grow February roses in
the Southern Hemisphere, where it is summer in February rather than
winter. Furthermore, South American workers are less efficient than their
U.S. counterparts at making sophisticated goods such as computers,
which means that a given amount of resources used in computer
production yields fewer computers in South American than in the United
Stated. So the trade-off in South America might be something
like 10 million winter roses for only 30,000 computers.

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Case Study 2-3 Rose and Computer----

Opportunity Cost (CONT ’D) 2.4b The Opportunity Cost Theory
This difference in opportunity costs offers the possibility of
a mutually beneficial rearrangement of world production. Let • Opportunity Cost:
the United States stop growing winter roses and devote the resources
this frees up to producing computers; meanwhile, let South America
The opportunity cost of a commodity is
grow those roses instead, shifting the necessary resources out of its the amount of a second commodity that
computer industry. The resulting changes in production would look like
Table 2-8. must be given up to release just
enough resources to produce one
Table 2-8 Hypothetical Changes in Production
additional unit of the first commodity.
Million Roses Thousand Computers
United States - 10 + 100
South America + 10 - 30
Total 0 + 70

2.4b The Opportunity Cost Theory 2.4b The Opportunity Cost Theory
Table 2-9 Opportunity Cost and Comparative Advantage The opportunity Cost theory and
   U.S.                 U.K. Comparative Advantage
• According to comparative advantage based on the
Wheat (bushels/man-hour)                    
     6                       1 opportunity cost theory, the nation with the lower
Cloth (yards/man-hour)      4                       2 opportunity cost in the production of a commodity
• The U.S. must give up 6 bushels of wheat to obtain 4 has a comparative advantage in that commodity,
yard of cloth,6W= 4C. and a comparative disadvantage in the second
The resource cost, or the opportunity cost, of commodity.
1 yard of cloth in the U.S. is 1.5 bushels of
wheat. Conversely, the cost of 1 bushel of • Cloth is cheaper (in terms of wheat) in the U.K.
Wheat is cheaper (in terms of textiles) in the U.S.
wheat is 2/3 yard of cloth. • The U.S. should specialize in producing wheat and
• The U.K: 1W=2C
export some of it in exchange for British cloth.
The the opportunity cost, of 1 yard of cloth in The U.K. should specialize in producing cloth and
the U.K. is 0.5 bushels of wheat; the cost of 1 export some of it in exchange for American wheat.
bushel of wheat is 2 yards of cloth.

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Table 2-10 Production Possibility Schedules for Wheat

2.4c The Production Possibility and Cloth in the U.S. and the U.K.
Frontier under Constant Costs United States United Kingdom
Wheat Cloth Wheat Cloth
180 0 60 0
The Production Possibility Frontier is a 150 20 50 20
curve that shows the alternative 120 40 40 40
combination of the two commodities 90 60 30 60
that a nation can produce by fully 60 80 20 80
30 100 10 100
utilizing all of its resources with the best 0 120 0 120
technology available to it. The opportunity cost of one unit of wheat in the U.S. is
1W=2/3C and remain constant.
The opportunity cost of one unit of wheat in the U.K. is
1W=2C and remains constant.

Figure 2-3 The Production Possibility The Characteristics of PPF

Frontiers of the U.S. and the U.K. Figure2.4 Production Possibility Frontier

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PPF with Increasing Cost

PPF with Constant Cost

2.4d Opportunity Costs and Relative

Commodity Prices
PPF with Decreasing Cost

• Relative price: is the price of one good in

terms of the other. (P w /Pc ).
• Basis for Trade
Lower relative price----export
Higher relative price----import

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2.4d Opportunity Costs and Relative

2.4d Opportunity Costs and Relative
Commodity Prices
Commodity Prices
The relationship between relative price and Relationship between prices and production:
opportunity cost: The economy will specialize in the
• If Pw /Pc> aw/ac, income in the wheat sector will
production of cloth if the relative price of
be higher ; the economy will specialize in the cloth exceeds its opportunity cost,
production of wheat. (P c /Pw> ac/aw );
• If Pw /Pc<aw/ac, that is P c /Pw> ac/aw, income in it will specialize in the production of wheat if
the cloth sector will be higher; the economy will the relative price of cloth is less than its
specialize in the production of cloth.
opportunity cost, (P c /Pw< ac/aw ).
• If Pw /Pc= aw/ac, income in the wheat and cloth
sector will be the same, both goods will be
produced.

2.4d Opportunity Costs and Relative 2.4d Opportunity Costs and Relative
Commodity Prices Commodity Prices
• United States : • (Pw /Pc) u.s=2/3 < (Pw /Pc) u.k=2
The U.S. has comparative advantage in wheat.
(aw/ac) u.s. = 2/3 = (P w /Pc) u.s
• (Pc /Pw) u.k = 0.5< (Pc /Pw) u.s = 1.5
(Pc /Pw) u.s = 1.5
The U.K has comparative advantage in cloth.
• The difference in relative commodity prices
• United Kingdom: between the two nations (given by the
(aw/ac) u.k. = 2 = (P w /Pc) u.k difference in the slope of their opportunity
cost) is a reflection of their comparative
(Pc /Pw) u.k = 0.5 advantage and provides the basis for
mutually beneficial trade.

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2.5 The Basis for and the Gains from Trade Under
Constant Costs
Figure 2.6 The Gains from Trade 2.5a The Gains from Trade

• The United States gains 20W and 10C

from trade (from CIC u.s to CIC u.s’);
• The United Kingdom gains 30W and
10C from trade (from CIC u.k to CIC u.k’);
• The output of wheat increases from
130W to 180W; the output of cloth
increases from 100C to 120C;

2.5b Relative Commodity Prices with Trade

Figure 2-7 Equilibrium-Relative Commodity Prices with
2.5a The Gains from Trade Demand and Supply
Wheat Cloth
• Where do gains come from?
The increased consumption of both wheat
and cloth in both nations was made
possible by the increase output that
resulted as each nation specialized in
the production of the commodity of its
comparative advantage.

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Table 2-9 Opportunity Cost and Comparative Advantage Figure 2-8 Region of Mutually Beneficial Trade

   U.S.                 U.K.
Wheat (bushels/man-hour)                    
     6                       1
Cloth (yards/man-hour)      4                       2
maximum of 1.5 bushels of
wheat for the United States
1 yard of cloth =
minimum of 0.5 bushel of
wheat for the United Kingdom

2.6 Empirical Tests of the Ricardian Model

2.6 Empirical Tests of the Ricardian Model
The basic prediction of the Ricardian
model----that countries should tend to
export those good in which their
productivity is relatively high----has been
strongly confirmed by a number of
studies over the years.
Empirical Tests 1
• The pioneering study was conducted by
MacDougall in 1951 and 1952, using labor
productivity and export data for 25 industries in the
U.S. and the U.K. for the year 1937.
• The positive relationship between labor productivity
and exports for the United States and the U.K. was
confirmed by subsequent studies by Balassa using
1950 data and Stern using 1950 and 1959.
• Additional and more recent confirmation of the
Ricadian trade model is provided by Golub in a 1995
study.

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Empirical Test 2
Case Study 2-4 Examples from U.S. Trade(CONT ’D)
Case Study 2-4 Examples from U.S. Trade Table 2-11 Indices of Unit Labor Cost in Iron and Steel and All
In the 1970s and the early 1980s, much public Manufacturing For 1980(1964= 100) in Five Countries
attention was focused on the decline in U.S exports---- Hourly Output per Unit Labor
and the increase in imports----of autos and steel. In part, Compensation Hour Cost
this was widely attributed to wrong managerial decisions:
delays in the introduction of new technology in the case Country Iron and All Iron All Iron All
Steel Mfg. and Mfg. and Mfg.
of steel and the “wrong” product mix and inferior quality
Steel Steel
in the case of automobiles. However, much of the
U.S. 382 316 119 141 321 224
deterioration can be analyzed in terms of production
costs. To do that, it is necessary to rank all industries Japan 725 807 352 394 206 205
within each country by order of their production cost: Germany 448 461 227 217 197 212
from the lowest to the highest cost industries. This is U.K. 827 898 119 167 689 538
equivalent to ranking them by comparative advantage. France 754 632 221 233 341 271

Table 2-12 Ratio of Unit Labor Cost Within Three

Countries, 1980-1981
Since the 1980s
Industry Ratio U.S. Japan Germ- • General Motors (GM), requires 3.64
any
workers per day to assemble a vehicle,
Iron and Steel/All Manufactures 1.57 0.93 1.02
down from 4.88 in 1989.
Motor Vehicles/All Manufactures 1.42 1.07 1.18
High Technology/All Manufactures 0.9 0.95 1.08 • Nissan, Japan’s most efficient
automaker, requires only 2.09 man-days.

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