Session 3

1. Session 3 Why Everybody Trades:Comparative Advantage

2. Why Do Countries Trade ? Country A Country B

3. History Mercantilisms : Older than Smith – and Alive Today • At that time, it was believed that International trade is a source of major benefit to a nation. • Export were good. • The government regulation of trade was necessary to provide the largest nation benefit. • The central belief of mercantilism was that nationwell-being or wealth was based on national holding of gold and silver.

4. Proposals from the Mercantilist • 1) Government should imposed and array of taxes and prohibition designed to limit import. • 2) Government should subsidized and encouraged exports.

5. Arguments from David Hume toward Mercantilism • The gold of acquiring gold and silver can be self-defeating if this acquisition expands the domestic money supply and leads to domestic money inflation of product prices.

6. Arguments from Adam Smith toward Mercantilism • National well-being is based on the ability to consume product(and other goods such as leisure and clean environment) now and in the future. • Import are part of expanding national consumption that a nation seeks, not an evil to be suppressed. • Trade freely transacted between countries generally leads to gains for all countries trade is a positive sum activity.

7. Adam Smith’s Theory of Absolute Advantage In the “Wealth of Nation”, Smith promoted this idea as follows. “ It is maxim of every prudent master of a family, never to attemptto make at home what it will cost….more to make than to buy. The tailor does not attempt to make his own shoes, but buy them from the shoes maker” VS

8. Adam Smith Focused on Labor Productivity In the United States In the Rest of the World Productivity: < Units of cloth per labor hour 0.25 1.0 > Units of wheat per labor hour 0.5 0.4 Labor hour to make: > 1.0 1 unit of cloth 4.0 < 1 unit of wheat 2.5 2.0

9. In the United States In the Rest of the World Clothes Export Export Wheat

10. What if the foreigners are better at producing everything than we are ? In the United States In the Rest of the World • Will they want to trade ?

11. Ricardo’s Theory of Comparative Advantage There is a beneficial trade whether or not countries have any absolute advantage. The concept is based on ‘opportunity cost’. In the United States In the Rest of the World Import Export

12. In the United States In the Rest of the World Productivity: < Units of cloth per labor hour 0.25 1.0 < Units of wheat per labor hour 0.5 0.67 Labor hour to make: > 1.0 1 unit of cloth 4.0 > 1 unit of wheat 1.5 2.0

13. In the United States In the Rest of the World 1.0 1 units of cloth 4.0 1 units of wheat 1.5 2.0 Labor hour to make: National prices with on international trade: Price of cloth 2.0 W 0.67 W Export Price of wheat 0.5 C Export 1.5 C

14. What will the equilibrium international price be ? In the United States In the Rest of the World 2.0 W ≥ International price of cloth ≥ 0.67 W 0.5 C 1.5 C ≤ International price of wheat ≤

15. Ricado’s Constant Cost and The Poduction-posibility Curve In the United States In the Rest of the World Productivity: < Units of cloth per labor hour 0.25 1.0 Units of wheat per labor hour < 0.5 0.67 Labor hour to make: > 1.0 1 units of cloth 4.0 > 1 units of wheat 1.5 2.0

16. It is assumed that both have 100 billion hour of labor. Wheat (billion of unit per year) Wheat (billion of unit per year) 100 Rest of the world United States S1 50 Trade line 67 C 30 PPC 20 C S0 Trade line 20 16 S0 PPC S1 0 0 15 20 25 50 80 100 76 Cloth(billion of unit per year) Cloth(billion of unit per year) It is assumed the trade price for both products equal one.