The Origins of Trade Theory Professor Bryson Marriott School

Smith and Absolute Advantage

Assume Two countries, the US and ROW producing wheat and cloth. US Rest of the World US Rest of the World________________________________________ Labor cost required to make: 1 bushel wheat 2 hours <2.5 hours I yard of cloth 4 hours >1 hour ______________________________________ Which country has an advantage in wheat? In cloth?

US Rest of the World US Rest of the World________________________________________ Labor cost required to make: 1 bushel wheat 2 hours <2.5 hours I yard of cloth 4 hours >1 hour ______________________________________ How much will each country produce if each has 40 hours of labor? (Assume a division of labor in US of 10 and 30 hours for wheat and cloth, 20 and 20 for ROW) (Assume a division of labor in US of 10 and 30 hours for wheat and cloth, 20 and 20 for ROW)

So, each week we have USROW 5 bushels (10 hours) 8 bushels (20 hours) (10/2 = 5) (20/2.5 =8) TOTAL WHEAT = 13 BUSHELS 7.5 yards (30 hours) 20 yards (20 hours) (30/4 = 7.5) (20/1 =20) TOTAL CLOTH = 27.5 YARDS Absolute advantage is determined from productivity data (labor costs).

After specialization United States ROW Total 20 bushels (40 hours) (>13) yards (40 hours) 40 (>27.5) How much does output increase with specialization? But let’s go back for a moment. Can you calculate prices prevailing in the separate markets before the opening of trade?

Calculating pre-trade prices Based on pre-trade labor costs US ROW US ROW 1 bushel of wheat 2 hours <2.5 hours I yard of cloth 4 hours >1 hour In the U.S. how much wheat will one give for a yard of cloth? How much cloth will the ROW give for a bushel of wheat? How much cloth will the ROW give for a bushel of wheat?

Calculating pre-trade prices United States ROW United States ROW Price of wheat 0.5 yard/bushel 2.5 yds/bush Price of wheat 0.5 yard/bushel 2.5 yds/bush (=2/4) (=2.5/1) (=2/4) (=2.5/1) Price of cloth 2.0 bushels/yard 0.4 bush/yd (= 4/2) (=1/2.5) Price of cloth 2.0 bushels/yard 0.4 bush/yd (= 4/2) (=1/2.5) Notice the difference in wheat prices.

ARBITRAGE AND TRADE GAINS Now let trade be opened up. People notice potential for arbitrage gains. Now let trade be opened up. People notice potential for arbitrage gains. The principle: As long as prices differ in two places (by more than any cost of transportation), one profits by arbitrage (buying in one location and selling in another). The principle: As long as prices differ in two places (by more than any cost of transportation), one profits by arbitrage (buying in one location and selling in another).

ARBITRAGE AND TRADE GAINS To arbitrage properly, sell your gains from comparative advantage abroad. Take the foreign product you purchased back home to trade for lots more of the original product. To arbitrage properly, sell your gains from comparative advantage abroad. Take the foreign product you purchased back home to trade for lots more of the original product.

ARBITRAGE AND TRADE GAINS Potential arbitrage gains: Potential arbitrage gains: Sell 1 US bushel in ROW for 2.5 yards cloth, and Sell 1 US bushel in ROW for 2.5 yards cloth, and Sell 2.5 yards cloth purchased in ROW for 5 bushels in US. Or, Sell 2.5 ROW yards for 5 bushels in the US and Or, Sell 2.5 ROW yards for 5 bushels in the US and Sell 5 bush in US for 12 yards cloth in ROW

Opening trade will lead under Ricardian conditions to specialization. Opening trade will lead under Ricardian conditions to specialization. What determines the boundaries of trade prices, i.e., the lowest and highest number of yards per bushel? 0.5 ≥ International price of wheat ≤ 2.5 (yards/bu.) (If the ROW offers the US.5 or less, it will just take.5 at home.) (If wheat isn’t cheaper through trade, ROW would simply buy at home.)

Suppose that the ratio settles at the price of 1 bushel = 1 yard. 1 bushel = 1 yard. Both nations will gain from trade after having pursued specialization where they have absolute advantages.

But what if there is no absolute advantage?

David Ricardo and Comparative Advantage

The principle of comparative advantage: a nation, like a person, gains from trade by exporting the goods or services in which it has its greatest comparative advantage in productivity (where it can produce at lower cost relative to potential trading partners) and importing those in which it has the least comparative advantage. The principle of comparative advantage: a nation, like a person, gains from trade by exporting the goods or services in which it has its greatest comparative advantage in productivity (where it can produce at lower cost relative to potential trading partners) and importing those in which it has the least comparative advantage. This holds even if one country is worse in producing both traded goods. This holds even if one country is worse in producing both traded goods.

US ROW US ROW 1 bushel of wheat 2 hours > 1.5 hours 1 yard of cloth 4 hours > 1 hour 1 yard of cloth 4 hours > 1 hour Here, as in Ricardo's original illustration, the US has inferior productivity in both goods, requiring more labor hours to produce both wheat and cloth.

US ROW 1 bushel of wheat2 hours > 1.5 hours 1 yard of cloth4 hours > 1 hour Now, each week we have USROW 5 bushels (10 hours) 13 bushels (20 hours) Total: yards (30 hours) 20 yards (20 hours) Total: 27.5

US ROW US ROW 1 bushel of wheat 2 hours > 1.5 hours 1 bushel of wheat 2 hours > 1.5 hours 1 yard of cloth 4 hours > 1 hour 1 yard of cloth 4 hours > 1 hour Here, as in Ricardo's original illustration, the US has inferior productivity in both goods, requiring more labor hours to produce either wheat or cloth. After specialization USROW 20 bushels (40 hours) yards (40 hours) yards (40 hours) 40

Ricardian Trade Gains After Specialization Assume an exchange rate, again, of 1 yard for 1 bushel. Note from the data on production before international trade that the U.S. can produce one bushel for each 0.5 yards of cloth; but it can get a full yard internationally for that bushel.

Ricardian Trade Gains After Specialization For each half yard of cloth not produced, we can gain a full yard through specialization and trade. The rest of the world makes each extra yard of cloth by giving up only 0.67 bushels of wheat. It gains a full bushel for each additional yard produced

Ricardian Trade Gains After Specialization For each.67 bushel of wheat not produced, the rest of the world gains a full bushel of wheat through specialization and trade.

Mercantilism vs. The Wealth Review the trade practice of Smith’s day as the motivating force for Smith’s free trade doctrine. The Mercantilist objective: inflows of gold. The methodology: run positive trade balances. Refuting the doctrine.