EF310: International Trade and Business Theories of International Trade

Trade theory Two forces behind international trade: Differences between countries Economies of scale in production

Adam Smith According to Smith specialisation and the division of labour is the source of economic growth Trade brings specialisation to the international level Smith suggested that countries would specialise according to what they do best…

Adam Smith The theory of Absolute Advantage: specialise in activities that you do better than anyone else… (produce where most efficient)… Two countries trade with each other… specialise according to what each does better (more efficiently) than the other Leads to efficient allocation of resources… Higher productivity: greater output per unit input Both countries gain by increasing total output -- increasing consumption possibilities for consumers in all countries Thus, everyone benefits from trade

Adam Smith Problem with the theory of Absolute Advantage… What happens if one country has an absolute advantage in the production of all goods?? No incentive for the less efficient country to trade… (competition from a more efficient producer would simply wipe out ALL industry in the less efficient country) Does this mean there are no longer benefits from trade?!

Comparative Advantage David Ricardo put forward the theory of comparative advantage as a solution to this problem According to this theory, even if a country has no absolute advantage, there are still potential gains from trade if countries specialise according to what they do comparatively, or relatively best… i.e. where opportunity costs are lowest Ricardo demonstrated how both countries can benefit from trading with each other even if one is more efficient in the production of all goods

Comparative Advantage The theory is based on the idea of opportunity cost Opportunity cost of producing a good is the value of the best alternative foregone (or the value of other goods you could have produced in the same amount of time or using the same quantity of resources) What a country gives up in order to divide resources across different types of production Ricardo’s theory suggests that goods should be produced where (ie in the country where) opportunity cost is lowest

Comparative Advantage Ricardo’s model: Two countries, producing two goods One factor of production: labour Assume perfect mobility of factors within countries But perfect immobility of factors between countries (labour cannot transfer from one to the other) Ricardo took the example of England and Portugal producing wine and cloth Assume Portugal has an absolute advantage in the production of both goods (i.e. both wine and cloth can be produced using less labour per unit output in Portugal than in England)

Comparative Advantage Numerical Example: table shows units of labour (input) required to produce one unit of output (either wine or cloth) Cloth Wine England 5 Portugal 4 1

Comparative Advantage Clearly in this example Portugal has an absolute advantage in the production of both goods (it takes less inputs to produce a unit of either good in Portugal) What about Comparative Advantage? depends on the opportunity cost of production… Opportunity cost of producing wine: For England 1 extra unit of wine -> give up 1 unit of cloth For Portugal 1 extra unit of wine -> give up ¼ unit of cloth Opportunity cost of producing cloth: For England 1 unit of cloth -> give up 1 unit of wine For Portugal 1 unit of cloth -> give up 4 units of wine Result...?

Comparative Advantage Result is: opportunity cost of wine production higher in England opportunity cost of cloth production higher in Portugal So… Portugal has a comparative advantage in wine production, BUT England has a comparative advantage in cloth production… From the “world’s” point of view: have to give up less to produce cloth in England than in Portugal So CA theory suggests that it should be possible to specialise according to CA, trade and increase total “world” output

Comparative Advantage Example: If England reduces wine production by 1 unit… this frees up 5 units of labour… can produce 1 extra unit of cloth Portugal can reduce cloth production by 1 unit (total “world” production of cloth unchanged)… freeing up 4 units of labour… can produce 4 more units of wine… net “world” gain of 3 units of wine -> total “world” output has increased… the total size of the “economic pie” has increased so specialisation has increased the consumption possibilities of consumers in all countries!

Comparative Advantage The process of increasing total “world” output through specialisation can continue until either: 1. England is fully specialised in cloth production, or 2. Portugal is fully specialised in wine production, or 3. Both countries are fully specialised

Comparative Advantage Comparative advantage demonstrates, in theory at least, how countries can benefit from trade, even if they do not hold an absolute advantage in the production of any type of good However, the theory cannot tell us exactly what the pattern of production (and trade) will be… … this depends on demand… Say everyone wants to consume wine and nobody wants cloth… then there is no incentive for either country to produce cloth, both will produce only wine and thus there is no incentive to trade either (remember trade is motivated by differences between countries) If on the other hand, the world demand for wine is greater than Portugal’s ability to produce wine, using all its available resources, then England (with a comparative disadvantage) will, nevertheless, also produce some wine to satisfy the excess demand

Comparative Advantage Paul Samuelson (a Nobel laureate in economics) was once asked to provide a meaningful and non-trivial result from the economics discipline, he quickly responded with Comparative advantage. Samuelson’s lawyer/secretary example to illustrate how comparative advantage works…