Free Trade Theory Why Nations Trade

Basics of Trade Exports: goods/services leave country Defined: 2 Countries engage in economic activity Exports: goods/services leave country Imports: goods/services enter country Trade Surplus: Export more than import Trade Deficit: Import more than export

Why Trade?

Ways to Limit Trade Tariffs– taxes on imports Quotas- limits on quantity imported Protectionism: Gov’t policy which seeks to limit trade Globalization: the “global” movement towards free trade Trade without Tariffs & Quotas free market capitalism on a global scale

Adam Smith In his 1776 book Wealth of Nations, Adam Smith talked about specialization

Adam Smith on Specialization When each worker made their own pins, they produced 20 pins per day each Adam Smith noted that when each worker specialized in a production stage, the output by the factory increased to 4,800 pins per worker (Page 11, Wealth of Nations) Also known as Division of Labor

+ Specialization works! Idaho Florida Texas Nevada Any illegal activity you can think of…

David Ricardo In his 1816 book David Ricardo developed the free trade theory based on comparative advantage Absolute Advantage: when a country can produce a good more efficiently produce a good using fewer resources Comparative Advantage: when a country can produce a good at a lower opportunity cost country gives up less when they produce a good

Ricardo’s Trade Theory Here is my great theory! Ricardo’s Trade Theory Countries should produce (specialize) in goods where they have a comparative advantage Trade benefits both parties (each country gets “more”) Free Trade promotes a more “efficient” world economy Absolute Advantage is not relevant in deciding which country should produce a good

Practice Problems