International Trade Theory The Law of Comparative Advantage MC 2009

slide 1 OUTLINE  2.1 Introduction  2.2 The Mercantilists ’ Views on Trade  2.3 Trade Based on Absolute Advantage: Adam Smith  2.4 Trade Based on Comparative Advantage: David Ricardo  2.5 Comparative Advantage and Opportunity Costs  2.6 The Impact of Trade  2.7 Empirical Tests of the Ricardian Model

slide Introduction  Two Basic questions of international trade theory.  This presentation examines the development of trade theory from the mercantilists to Adam Smith and David Ricardo, and seeks to answer the basic questions. (1) What is the basis for trade and what are the gains from trade? (2) What is the pattern of trade?

slide 3 Export pattern of Korea

slide The Mercantilists ’ Views on Trade  The more gold and silver a nation had, the richer and more powerful it was.  Thus the way for a nation to become rich is to export more than it imported.  The resulting export surplus would then be settled by an inflow of precious metals such as gold and silver. Thus the mercantilists advocated restrictions on imports and incentives for exports.

slide The Mercantilists ’ Views on Trade  A nation can gain in international trade only at the expense of other nations.  i.e., “ Trade is a zero-sum game. ”  Criticism: (1) The measure of the wealth of a nation? (2) Rulers vs. common people

slide Trade Based on Absolute Advantage: Adam Smith  Adam Smith, The Wealth of Nations,  2.3A. Absolute Advantage When one nation is more efficient than (or has an absolute advantage over) another in the production of one commodity but is less efficient than (or has an absolute disadvantage with respect to) the other nation in producing a second commodity, …

slide Trade Based on Absolute Advantage: Adam Smith …then both nations can gain by each specializing in the production of the commodity of its absolute advantage and exchanging part of its output with the other nation for the commodity of its absolute disadvantage.  Examples: (1) Nations (2) Individuals  Thus, Adam Smith believed that all nations would gain from free trade and strongly advocated a policy of laissez- faire and free trade.

slide Trade Based on Absolute Advantage: Adam Smith  2.3B. Illustration  The U.S. is more efficient than (or has an absolute advantage over) the U.K. in the production of Wheat but is less efficient than (or has an absolute disadvantage with respect to) the U.K. in producing Cloth. U.S.U.K. Wheat (bushels/hour)61 Cloth (yards/hour)45 Table 1 The number of units produced by each hour of labor time

slide Trade Based on Absolute Advantage: Adam Smith  With trade, the U.S. would specialize in the production of wheat and exchange part of it for British cloth.  The opposite is true for the U.K.  Note: Absolute advantage can explain only a very small part of world trade.

slide Trade Based on Comparative Advantage: David Ricardo  David Ricardo, Principles of Political Economy and Taxation,  The Law of Comparative Advantage If one nation has an absolute disadvantage with respect to the other nation in the production of both commodities, the first nation should specialize in the production of and export the commodity in which its absolute disadvantage is small (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (this is the commodity of its comparative disadvantage).

slide 11 Illustration Suppose there are two countries of equal size, Northland and Southland, that both produce and consume two goods, Wheat and Jeans. The productive capacities and efficiencies of the countries are such that if both countries devoted all their resources to Wheat production, output would be as follows:  Northland: 100 tonnes  Southland: 400 tonnes If all the resources of the countries were allocated to the production of Jeans, output would be:  Northland: 100 tonnes  Southland: 200 tonnes

slide 12 The Opportunity Cost Theory The cost of a good is the amount of a second good that must be given up to release just enough resources to produce one additional unit of the first good. Northland's opportunity cost of producing one tonne of Wheat is one tonne of Jeans and vice versa. Southland's opportunity cost of one tonne of Wheat is 0.5 tonne of Jeans. The opportunity cost of one tonne of Jeans is 2 tonnes of Wheat. Northland has a comparative advantage over Southland in the production of jeans, the opportunity cost of which is higher in Southland with respect to wheat than in Northland.

slide Trade Based on Comparative Advantage: David Ricardo  Illustration: Different opportunity cost lead to mutual benefit, if countries specialize. WheatJeans Northland 50 Southland Total Production and consumption before trade

slide 14 Trade Based on Comparative Advantage: WheatJeans Northland0100 Southland30050 Total Production after trade WheatJeans Northland7550 Southland Total Consumption after trade: (Exchange rate: 1 tonne of Wheat for 2/3 tonne of Jeans)

slide Comparative Advantage and Opportunity Costs  Assumptions of the Ricardian Model 1)Only two nations and two goods 2)Free trade 3)Perfect mobility of labor within each nation but immobility between the two nations 4)Constant costs of production 5)No transportation costs 6)No technical change Both countries benefit, and now consume at points outside their production possibility frontiers.

slide The Impact of Trade CD F Demand Supply $350 $250 AB E Supply Demand ChinaUnited States Thousands of Suits per Month Price (Dollars) Price (Dollars) Thousands of Suits per Month Exports $350 $500 Imports

slide The Impact of Trade in the Exporting/Importing Country  When opening of trade results in increased exports of a good – Producers of the good are made better off – Consumers of the good in exporting country will be made worse off  When opening of trade results in increased imports of a product – Domestic producers of the product are made worse off – Consumers of the good in importing country are better off