1. Why Everybody Trades: Comparative Advantage
Chapter 3
Why Everybody Trades: Comparative Advantage

2. Adam Smith’s Theory of Absolute Advantage
In his Wealth of Nations, Adam Smith promoted free trade by comparing nations to households. Every household finds it worthwhile to produce only some of the products it consumes, and to buy other products using the proceeds from what the household can sell to others. The same should apply to nations.
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3. Principle of Absolute Advantage
A country is expected to export those goods in which it has an absolute cost advantage and import goods in which it has an absolute cost disadvantage
Labor hours to make: US
Rest of the World (ROW)
1 unit of cloth
4.0
1.0
1 unit of wheat
2.0
2.5
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4. Absolute Advantage
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5. David Ricardo’s Theory of Comparative Advantage
Mutually beneficial trade can occur even when one nation (say, ROW) is absolutely better at producing all goods 
Although ROW is absolutely better, the key is relative prices (or costs) and not absolute prices (or costs) of products.
In other words, it is the opportunity cost of producing each product in each country that will determine the basis for trade among nations.
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6. Ricardo’s Theory of Trade
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.
Ricardo focused on labor productivity (or resource productivity more generally) for different products in different countries.
Basis for trade: Relative differences in labor (resource) productivity.
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7. Comparative Advantage
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8. Relative Price
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9. The Ricardian Model
Hence, U.S. has a comparative advantage in production of wheat, and a comparative disadvantage in production of cloth.
The rest of the world has a comparative advantage in production of cloth, and a comparative disadvantage in production of wheat.
With free trade the U.S. will export wheat and import cloth.
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10. Ricardo’s Constant Costs and The Production-Possibilities Curve
Production-possibility curve (ppc) shows all combinations of amounts of different products that an economy can produce with full employment of its resources and maximum feasible productivity of these resources.
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11. Ricardo’s Constant Costs and the Effects of Trade
With no trade, each nation’s choices for the consumption of wheat and cloth is limited to a point along its production possibilities curve.
With free trade between the two countries, each country specializes (at point S1) in producing its comparative-advantage product.
With free trade consumers in each country can consume at any point along the new trade line (for example, at point C) and enjoy a higher standard of living.
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12. The Gains from Trade
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13. Question: Does it make sense for a country to pursue a policy of self-sufficiency in, for example, food, or energy? Why or why not?
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14. Some Implications of the Theory of Comparative Advantage
According to the Ricardian model, relative price differences arise from productivity differences that are in turn due to exogenous differences in technology among nations.
Although comparative advantage determines the pattern of trade among nations, absolute advantage is important in determining the income in each country.
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15. Does absolute advantage matter?
If free trade is so good, why do so many people fear it? Activists and protesters have recently been complaining loudly that trade has bad effects on • Workers in developing countries. • Workers in the industrialized countries. • The natural environment. Analysis of absolute advantage and comparative advantage focuses on a resource called labor, so let’s focus on trade and workers.
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16. Does absolute advantage matter?
A big part of the answer to these questions is that absolute advantage does matter . But it matters not for determining the trade pattern but rather for determining national wage levels and national living standards .
Workers can receive high wages and enjoy high living standards if they are highly productive. Workers with low productivity are paid low wages.
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17. Average Labor Productivity and Average Wage in Manufacturing, 2006
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