Principles of Economics: Comparative Advantage
Historically, trade typically first occurred between communities rather than within
communities where leaders of the family or the community usually determined the allocation of
goods and services. Trade first occurs between Polynesian islands, rather than within islands, and
between native Americans tribes, rather than within tribes, for example. This is also true for the
rise of the European market economy after the 11 century CE where periodic large fairs (such
as at Champagne) for long distance trade dominated commercial activity and after the 14 th
century when Atlantic shipping dominated European commercial development. In fact, the first
capitalists were merchants who moved commodities from one place to another but did not
initially change the existing individual and small-scale production of European farmers and
This development of European merchants generated the theory of Mercantilism, the first
integrated economic system, from the 16 to the 18 centuries. Mercantilism is most easily
understood as the articulation of the merchant viewpoint, viewing profit as a consequence of
exchange (circulation) by ‘buying cheap and selling dear’, rather than due to anything in
production. There is no such thing as profit for a country as a whole, as a consequence, since
someone’s gain in another’s loss. Mercantilists considered gold and silver as the only form of
wealth in keeping with a merchant’s recognition that gold and silver was the capital necessary
for buying and selling commodities. Most concluded that the only way for a country to increase
wealth or profit was through exporting more goods to other countries than they imported from
1 This position, which Adam Smith attributed to Mercantilism, is actually a simplistic form called
Bullionism. Mercantilist, for the most part, accepted any storable commodities as wealth, provided they could
be easily exchanged for other goods. Ships and sailors were physical capital and labour, respectively but
Mercantilist tended to ignore this in their focus of pure exchange.
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those countries. They therefore favoured intervention in the market process through policies of
tariffs (taxes to limit imports), bounties (subsidies) to simulate exports, and monopolies (such as
the Hudson’s Bay Company) to control the inflow and outflow of trade.
Adam Smith specifically attacked the Mercantilist notions of wealth, government controlled
trade, and monopolies in his Wealth of Nations (1776), thereby initiating the modern analysis of
trade. He began by defining wealth as a nation’s output relative to its population rather than as
the sum of precious metals . He argued that competition and self-interest would drive free
markets (laissez-faire) to optimal allocation of resources without government intervention. He
famously argued that countries would mutually benefit if they specialized in commodities
requiring the least local resources and traded for other commodities produced cheaper by foreign
countries. In particular, he showed that Britain should export wool to France and import wine
from France rather than pursue the Mercantilist policy of producing wool for export and wine for
domestic use to avoid importing from France. If it took two people to produce a unit of wool and
one person to produce a unit of wine in France due to warm and dry weather and one person to
produce a unit of wool and two people to produce a unit of wine in Britain due to cool and wet
weather, he showed that mercantilism would mean that each country would produce only 1 wool
and 1 wine with 3 workers. Trade, however, would allow Britain to produce 3 wool and France
to produce 3 wine with 3 workers each for a net world gain of 1 wine and 1 wool. Economists
call this the Principle of Absolute Advantage and it is the first step in international trade theory.
2 As opposed to the modern definition of GDP (output) as the sum of consumption, government spending,
investment and exports less imports, Smith defines GDP as C + I + G plus import minus exports because he
focused on the goods available for consumption through trade and not simply on output. From the beginning
of his book, he recognized that international trade would increase consumption possibilities by trading exports
for relative more imports in terms of home resources used.
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Smith campaigned for free trade more fundamentally in the first few chapters of his book.
He argued that the division of labour, or specialization, was the direct effect of trade through the
expansion of the market. Since specialization through expanding markets increased the output of
society by increasing productivity, trade increased total output relative to the population. This is
a very powerful argument but Marx pointed out that the division of labour might mean that some
people would have menial low-paying positions while others had skilful high-paying positions
that captured the extra output for themselves.
Definition: A country can produce cheaper in terms of resources than another country
Adam Smith showed that countries benefit if they trade commodities for which they have an
absolute advantage (e.g., Britain should trade wool to France and France should trade wine to
→ increases in consumption per capita, i.e., the wealth per capita
This is a criticism of the Mercantilist perspective that countries should minimize imports
and maximize exports to accumulate wealth defined as gold and silver
→ A country can produce cheaper in terms of opportunity cost than another country
David Ricardo showed that trade benefits countries even if one country has an absolute
advantage in all goods.
In a two-country two-commodity world with constant resources costs within countries, a
country benefits by specializing in the production of the commodity for which it has a
comparative advantage and trading for the other commodity.
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We will examine the one factor case (we will use R for resource to represent all resources
such as labour, capital, or land but we could simply say L for labour) for two countries and for
two different commodities (F and M for Food and Manufactures but it could be any two
commodities). We begin with an algebraic overview of the issue for formalities sake but you
need only understand the solution of problems with particular numbers.
Define Q RFd Q RM as the output per unit of resource in Food and Manufacture respectively
for a country. Assume that there are no economies of scale or substitutions in production so that
Q RFd Q RM are constant.
Absolute Advantage in the production of a commodity means that the output per resource is
greater. Country A has an absolute advantage over Country B in the production of Food, for
example if Q RF > Q RMB.
Comparative advantage in the production of a commodity for country A relative to country
B means that the opportunity cost for A is less than that of B
→ Opportunity Cost of Q Mn terms of lost Q F ΔQ /FQ = MdQ /dQF) M
Since we assume that Q Fnd Q aMe constant, opportunity cost is simply Q /RF RM for M.
i.e., a shift of one unit of resource from Food to Manufacture reduces Food byFQ relative to a
gain in Manufacture of Q M
Opportunity Cost, therefore, represents the relative prices of the commodities and this is the
secret to the advantage of trade.
Note that the Opportunity Cost of M for F is simply the inverse of that of F for M.
→ Comparative Advantage for A over B in the production of Manufacture
=> Q RFA/QRMA < QRFB/Q RMB
University of Toronto (St. George) takes the output per unit of resource approach but a more common
approach, particularly in higher years of economics, is resource input per unit of output.
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The output per unit of resource times the amount of resources for each commodiRF (QF*R
+ Q RM )Mgives the total amount of output produced by the economy.
→ The amount of resources (F + RM) and the technology for output per resource for each
commodity (Q RFd Q ) RMmit the total output (Production Possibilities) of the country.
We can define the Production Possibilities function of a country at full employment as
PPC = Q RF +FQ *RRMor M ≤ R ≤ R Fnd R + R F R (Motal resources)
→ QRFR is the amount of QFif QM= 0 and Q RM isMthe amount of Q ifMQ = F
→ The slope of the Production Possibilities curve Fs ΔQM/ΔQRF QRMQif Food is the Y-Axis
The Production Possibilities function is linear because the opportunity costs are constant.
=> The slope of the function is ratio of the interRFpts QRMR/ M *R RFQ RM
Example 1a. Suppose that 1 unit of Resource produces 1/15 unit of Food and 1 unit of Resource
produce 1/5 unit of Manufactures in Canada and that Canada has 900 units of Resource
a) What is the opportunity cost of Manufacture?
Shifting 1 unit of Resource from Food to Manufacture produces 1/15 unit of Food at a cost
of 1/5 unit of Manufactures
= (1/15)/(1/5) = 1/3 Food for 1 Manufacture
b)What is the Production Possibilities Curve if Food is on the vertical axis?
→ The slope is –1/3 since Opportunity cost of Manufacture ΔQF/ΔQM= 1/3 units of Food
→ The Food intercept is 900*1/15 = 60 and the Manufactures intercept is 900*1/5 = 180
(ΔQ FΔQ M= 60/180 = 1/3)
→ PPC: Q = 900*1/15 – 5/15Q = 60 – Q /3