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N THE LAW OF COMPARATIVE ADVANTAGE

Even if one nation is less efficient than (has absolute disadvantage with respect to) the other nation in production of both commodities, there is still a basis for mutually beneficial trade. That is even if a country is absolutely more productive at producing everything and the other country is absolutely less productive, both countries can gain from trade.

COMPARATIVE ADVANTAGE AND OPPORTUNITY COSTS

The original idea of comparative advantage was based on the labor theory of value: the value or price of a commodity depends exclusively on the amount of labor used to produce it.

Comparative advantage is the ability of a nation to produce commodity more efficiently than it does any other good.

The opportunity cost of a commodity is the amount of the second commodity that must be given up to release just enough resources to produce one additional unit of the first commodity.

The opportunity costs exist because production resources could be shifted from one product to the other. For example, a country has a comparative advantage in cotton production if its opportunity cost, in terms of wheat, is lower than the other country.

Example#1: Wheat and cloth are produced in both countries, the U.S and the U.K. with labor productivity given in the table.

As we can see ____________________ (the UK, the US) has an absolute advantage in production of ________________________ (wheat, cloth, both wheat and cloth). Is there still an incentive to trade?

Please, calculate and compare the opportunity costs in production of both commodities for the U.S and the U.K. Indicate in what commodity each country has a comparative advantage. Reffering to David Ricardo theory of comparative advantage, indicate please, who will export wheat and who will export cloth?

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Example#2: 2 countries – England and Portugal; 2 products – wine and cloth. It can be seen that Portugal can produce both wheat and wine more cheaply than England (ie it has an absolute advantage in both commodities). What David Ricardo saw was that it could still be mutually beneficial for both countries to specialise and trade.

Table 1.

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In Table 1, a unit of wine in England costs the same amount to produce as ____ units of wheat (ie the opportunity cost of a unit of wine is ____ units of wheat). In Portugal, a unit of wine costs ____ units of wheat to produce (ie the opportunity cost of a unit of wine is ____ units of wheat in Portugal). _____________ is relatively better at producing wine than wheat: so ____________ is said to have a COMPARATIVE ADVANTAGE in the production of wine. ___________ is relatively better at producing wheat than wine: so __________ is said to have a comparative advantage in the production of wheat.

Show in Table 2 how trade might be advantageous. Costs of production are as set out in Table 1. England is assumed to have 270 man hours available for production. Before trade takes place it spends 120 resourses for production of wheat and 150 resourses for production of wine. Portugal has fewer labour resources with 180 man hours of labour available for production: 90 resourses for production of wheat and 90 resourses for production of wine.

Table 2.

If both countries now specialise, __________ (country) produces only __________ (commodity) and _________ (country) produces only __________ (commodity), total production is ____ units of wheat and ______ units of wine. Specialisation has enabled the world economy to increase production by ____ unit of wheat and ____ unit of wine.