Level 1 CFA® Exam:
Theories of Trade
As you probably know, some countries have an advantage over other countries as far as the production of certain goods is concerned. We distinguish between:
- absolute advantage, and
- comparative advantage.
Absolute advantage refers to a country’s ability to produce a particular good at a lower cost or use fewer resources in its production, as compared with another country.
Comparative advantage occurs when the opportunity cost of production of a good in the country is lower than the opportunity cost of production of the same good in another country.
The table provides information about the maximum production capacity of 2 European countries – Spain and Poland. We assume that 2 goods can be produced in both these countries: wine and bread. Decide which country has an absolute advantage and comparative advantage in the production of bread and which in the production of wine.
| Spain | Poland | |
|---|---|---|
| Wine (bottles) | 2,000 | 900 |
| Bread (loaves) | 1,000 | 900 |
(...)
There are 3 main theories of trade:
- Adam Smith’s theory of absolute advantage,
- David Ricardo’s theory of comparative advantage (Ricardian model), and
- Heckscher-Ohlin model.
Adam Smith said that trade with another country can be beneficial if our country has an absolute advantage in the production of a certain good.
On the other hand, David Ricardo stated that trade between countries can be also beneficial if a given country has a comparative advantage in the production of a certain good. So, according to Ricardo, a country doesn’t need to have an absolute advantage in the production of a certain good to gain from the trade with another country – the comparative advantage is enough.
The table provides information about the maximum production capacity of 2 European countries – Spain and Poland. We assume that 2 goods can be produced in both these countries: wine and bread. Analyze the data from the perspective of Adam Smith’s theory of absolute advantage and David Ricardo’s theory of comparative advantage.
| Spain | Poland | |
|---|---|---|
| Wine (bottles) | 2,000 | 900 |
| Bread (loaves) | 1,000 | 900 |
(...)
Theories of Trade in CFA Exam: Ricardian Model vs Heckscher-Ohlin Model
star content check off when doneIn the Ricardian model, there is only one factor of production, i.e. labor.
In the Ricardian model, differences in labor productivity (thanks to technology level) are the main source of comparative advantage.
According to the Heckscher-Ohlin model, there are 2 factors of production, i.e. labor and capital.
In the Heckscher-Ohlin model, both capital and labor are factors of production. According to this model, a country’s comparative advantage depends on relative differences in the quantity of these factors. A country with a relatively big ratio of labor to capital will export labor-intensive goods and import capital-intensive goods, and vice versa. A country with a relatively big ratio of capital to labor will export capital-intensive goods and import labor-intensive goods.
- Absolute advantage refers to a country’s ability to produce a particular good at a lower cost or use fewer resources in its production, as compared with another country.
- Comparative advantage occurs when the opportunity cost of production of a good in the country is lower than the opportunity cost of production of the same good in another country.
- There are 3 main theories of trade: Adam Smith’s theory of absolute advantage, David Ricardo’s theory of comparative advantage (Ricardian model), and the Heckscher-Ohlin model.
- Adam Smith said that trade with another country can be beneficial if our country has an absolute advantage in the production of a certain good. On the other hand, David Ricardo stated that trade between countries can be also beneficial if a given country has a comparative advantage in the production of a certain good.
- In the Ricardian model there is only one factor of production, i.e. labor.
- In the Ricardian model, differences in labor productivity are the main source of comparative advantage.
- According to the Heckscher-Ohlin model, there are 2 factors of production, i.e. labor and capital.
- According to the Heckscher-Ohlin model, a country with a relatively big ratio of labor to capital will export labor-intensive goods and import capital-intensive goods.