Blueprint:

Theoretical Explanations for Trade

1. Definition: Absolute Advantage
2. Definition: Comparative Advantage
3. Example
4. Determining wage rates and exchange rates
5. Definition: Competitive Advantage
6. Additional Comments

A. Definition: Absolute Advantage

• A nation has an absolute advantage with respect to a product if that nation can produce the product more efficiently than a competitor.
• Here is an example of absolute advantage in the following 2 country, 2 good world.

• In this case England can produce a unit of textiles more efficiently than Portugal, so it has an absolute advantage in the production of textiles. Portugal can produce a unit of wine more efficiently than England, so it has an absolute advantage in wine production.
• Adam Smith, in his book Wealth of Nations, made the insight that England should specialize in the production of textiles and export textiles to Portugal and Portugal will specialize in the production of wine and export wine to England.

• A country has a comparative advantage in the production of a good if the opportunity cost of producing the good is lower in that country than other countries.
• Def’n of Opportunity Cost: The opportunity cost of any action is the value of the next most valuable action forgone.

• The English economist David Ricardo first advanced the theory of comparative advantage in the early 19th century.
• A country can have a comparative advantage even when it does not have an absolute advantage.

• In our example England has an absolute advantage over Portugal in the production of both textiles and wine.
• To see which country has the comparative advantage in textiles we consider how many units of wine it "costs" to produce a unit of textiles. In England it costs 0.5 units of wine to produce a unit of textiles (since forgoing production of one unit of wine enables the production of an additional 2 units of textiles). In Portugal it costs one unit of wine to produce a unit of textiles. England's opportunity cost (of textiles in terms of wine) is lower, so it enjoys a comparative advantage in the production of textiles.
• Now consider how many units of textiles it "costs" to produce a unit of wine. In England it costs 2 units of textiles to produce a unit of wine (the opportunity cost of wine in terms of textiles for England is 2). In Portugal it costs one unit of textiles to produce a unit of wine. Therefore Portugal's opportunity cost (of wine in terms of textiles) is lower, so it enjoys a comparative advantage in the production of wine. This advantage exists despite the fact that England has an absolute advantage over Portugal in the production of wine.
• Since England is relatively more efficient at producing textiles and Portugal is relatively more efficient (less bad) at producing wine, England should specialize in the production of textiles and Portugal in the production of wine.
• To see the gains from trade, assume that the total number of units of available labour is 100 in each country. Suppose also that without trade, England could produce and consume 30 units of textiles and 10 units of wine. (30 units of textiles X 2 units of labour/unit of textile PLUS 10 units of wine X 4 units of labour/unit of wine EQUALS 100 units of labour.) Suppose also that without trade, Portugal could produce and consume 12 units of textiles and 8 units of wine. This is just one of many combinations of possible outputs, but we will assume this one and ignore any taste preferences.

• If we open the two countries up to trade, we know that the price for the same good will equalise in both countries (otherwise consumers would only buy from the cheaper country). Prices are determined by the countries’ relative input coefficients.
• For instance, before trade the price of textiles in terms of wine in England was 0.5 and in Portugal it was 1. Clearly there is an opportunity here for trade. England would be willing to trade textiles provided it can get at least 0.5 units of wine per unit of textile. Portugal would be willing to buy textiles provided it does not need to pay more than one unit of wine for a unit of textiles. Any trading price between 0.5 and 1.0 (of textiles in terms of wine) will be attractive to both countries.

• Suppose the trading price (textiles in terms of wine) is 0.8 and suppose that both countries completely specialise. If they do so, England will produce 50 units of textiles and Portugal will produce 20 units of wine. Portugal could keep 9 units of wine for itself and trade the other 11 units to England for (11/0.8=) 13.75 units of textiles. So Portugal would be able to consume 9 units of wine and 13.75 units of textiles. This is an improvement over the 8 units of wine and 12 units of textiles that Portugal would have consumed without trade. Again, this is just one of many combinations of possible export/import scenarios. There will always be a gain from trade, though, as long as what is retained in the exporting country is more than was consumed in autarky (no trade).
• Looking at the total production, we can see that with the same amount of labour as before, there is more textiles and wine produced? What's going on? What happened is that both countries only produced the thing that they were relatively more efficient at. More bang for their buck.
• After the trade, England would consume (50-13.75=) 36.25 units of textiles and 11 units of wine. This is an improvement over the 30 units of textiles and 10 units of wine that England would have consumed without trade.
• Both countries gained although England gained more because it is wealthier (it had the absolute advantage, remember).

D. Determining wage rates and exchange rates

• Relative wages are determined by the autarky (before trade) relative productivities.
• In this example, wages in England would be higher than wages in Portugal because England is more efficient at producing both products than Portugal. We have assumed that labour is the only factor of production and there are no profits, so prices equal costs. And we know that because of the comparative advantages in this model, Portugal specializes in wine and England specializes in textiles :

• The bounds for the relative wage rates is actually the ratio of the two countries’ productivities. Productivity in this one factor world is simply the inverse of the units of labour required for production. So, 5/4=(1/4)/(1/5), which is England’s productivity at wine over Portugal’s productivity at wine. Likewise, 5/2=(1/2)/(1/5), which is England’s productivity at textiles over Portugal’s productivity at textiles.
• Now, if just one country completely specialized and the other continued to produce both products, the wage would be determined by the relative productivities of the good in common. For example, if the scenario was that England produced both goods and Portugal produced only wine, then the English to Portuguese wage rate would be exactly (¼)/(1/5)=1.25. As long as both countries are only producing one good, we can only determine a range for the relative wage rates.
• If the wages are fixed, then the exchange rate will change to match what the relative wage should be. Say the English wage rate is fixed at 1.25 Pound per worker per day and the Portuguese wage rate is 1 Escudo per worker per day, then what is the likely range for the Pound/Escudo exchange rate?

• Usually the term competitive advantage is used with respect to an individual firm. It’s harder to define when talking about countries.
• From the point of view of an individual firm, having a competitive advantage means being able to produce a product of given quality at a lower cost than its foreign rivals. Let’s say hypothetically that one company owned 2 firms operating in both England and Portugal. The firm was trying to decide which plant to make which products in, then…
• In this example, if the Portuguese wage > 4/5 * English wage then the Portuguese plant would have no competitive advantage and nothing would be produced there. Ie: the wage in Portugual would be so high that it wouldn’t be worth it to produce anything in Portugal. This is the situation where the relative wages are < 5/4.
• If the Portuguese wage < 2/5 * English wage then the English plant would have no competitive advantage and would be shut down because the wages in Portugal are relatively so low. This is the situation where the relative wages are > 5/2.

1. Important and concerning assumptions that were made:

1. Only one factor of production -- labour.
2. No transportation costs.
3. Resources can be redeployed costlessly to different sectors of the economy (no discussion of training or retraining).
4. Fixed labour supply.

2. Changes in production due to trade opportunities improve the total welfare of each country. But they do not necessarily make each individual in a country better off. For example, English wine growers and Portuguese textile producers might be worse off as a result of the trade opportunities.
3. Can't always determine the exact trading price.

II. Factor Abundance Theory

• Countries are not only different in their productivities, but they also differ in their endowments of factors of production.
• What is a factor of production?

• The Heckscher-Ohlin trade theory of factor endowments says that a country has an comparative advantage in the production of those goods that use its abundant factors intensely. Comparative advantage arises from differences in national factor endowments.
• Intensive use just means it accounts for a high share of the cost of producing that good.
• If we have just two factors: land (L) and capital (K), then country 1 is defined to be relatively abundant in factor K if K₁/L₁> K₂/L₂.
• In the real world, there are many factors and countries so we must rely on a different rule. If your share of the world’s endowment of some factor exceeds your share of the world’s income then that factor is relatively abundant at home. ie: if K₁/(K₁+ K₂+…) > Y₁/(Y₁+Y₂+…).
• So, why does Canada export so much newsprint? Because newsprint makes intensive use of two factors "forest land" and "capital" that are relatively abundant in Canada.
• The big producers of paper and allied products (pulp and paper, newprint, paperboard) are:

• The FTP theory predicts that the countries that are relatively well endowed in forest resources will be net exporters of the products that use the factor intensively.

• We can see that Canada and Finland are relatively well endowed in forest resources and they are, indeed, net exporters of paper and allied products.

• Empirical support for this theory is actually relatively weak. The most famous empirical study of this theory found that, despite the U.S. being relatively abundant in capital, U.S. exports are less capital intensive than U.S. imports. This finding is known as the Leontief paradox.