CHAPTER 3 Why Everybody Trades: Comparative Advantage

Adam Smith: Theory of Absolute Advantage  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.  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 had absolute advantage in both products.

Adam Smith’s Example Absolute Advantage

Ricardo ’ s Theory of Trade Ricardo 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. Comparative advantage:  A country will export products that it can produce at a low opportunity cost (in terms of other goods that could be produced within the country).  A country will import products that it would otherwise produce at a high opportunity cost. Basis for trade: Relative differences in labor (resource) productivity.

Ricardo’s Example: Comparative Advantage

Ricardo’s Example: No-Trade Relative Prices

Figure 3.1 – The Gains from Trade, Shown for Ricardo’s Constant-Cost Case

Absolute Advantage Does Matter for Wage Rates