The Law of Comparative Advantage Chapter 2

1. The Law of Comparative Advantage Chapter 2

2. 1 Introduction • Examine the development of trade theories • Discuss the law of absolute advantage • Analyze the comparative advantage • Analyze the opportunity costs • Know theroduction possibility frontiers

3. Key terms Mercantilism Laissez-faire Law of comparative advantage Opportunity cost theory Production possibility frontier Constant opportunity cost Relative commodity price Complete specialization 1 Introduction

4. 2 Mercantilists’ Views on Trade • Mercantilism • Representative: Thomas Munn (1571-1641) • Wealth: The way for a nation to become rich and powerful was to export more than it imported. The resulting surplus would then be settled by an inflow of bullion. The more gold and silver a nation had, the richer and more powerful it was. • Policy: free trade policy. • The nature of the trade: a zero-sum game.

5. 2 Mercantilists’ Views on Trade Purposes of Mercantilists’ Trade Theory • To maintain larger and better armies with more gold and silver and consolidate their power at home and acquire more colonies; • To do more business with more gold in circulation; • To stimulate national output, develop national economy and increase employment.

6. 3 Absolute Advantage • The basis for trade: Absolute advantage • If one nation is more efficient than another nation in the production of one commodity, the nation has absolute advantage in that commodity. Adam Smith (1723-1790)

7. 3.1 Where Do Gains Come From? • The pattern of trade: Both nations can gain by each specializing in the production of the commodity of its absolute advantage and exporting part of its output to the other nation for the commodity of its absolute disadvantage. • Policy: Free trade policy to make better use of resources and maximize world welfare. • By specialization, resources are utilized in the most efficient way and the output of both commodities will rise. The increased output measures the gains from specialization in production available to be divided between the two nations through trade.

8. 3.2 Mercantilists & Adam Smith Mercantilists: One nation could only gain at the expense of another nation and each government should take strict control of all economic activities and trade. They should adopt protectionist measures to stimulate exports and restrict imports. Some of the views are still alive and even thriving today in a sort of neo-mecantilism. Adam Smith: All nations could gain from free trade and each nation should adopt a laissez-faire policy.

9. 3.3 Illustration of Absolute Advantage

10. Can we use the theory to carry out foreign trade? 3.4 Comments on the Absolute Ad It can only explain small part of world trade today, it can not explain most of the trade between the developed and the developing countries. It can not even explain the trade between advanced countries because their productivities are almost the same.

11. 4 The Law of Comparative Advantage David Ricardo (1772-1823) Works: Principles of Political Economy and Taxation

12. 4.1 The Law of Comparative Advantage It explains how mutually beneficial trade can take place even when one nation is less efficient than ( has an absolute disadvantage) the other nation in the production of all commodities. The less efficient nation should specialize in and export the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage), and should import the other commodity. The more efficient nation should specialize in and export the commodity in which its absolute advantage is greater and import the other commodity.

13. 4.2 Illustration of Comparative Advantage

14. 4.3 How Can They Trade? How can they trade if one nation is in absolute disadvantage in the production of both commodities? They can still trade when the wage is sufficiently lower in one nation than it is in the other and when both commodities are expressed in the same currency.

15. 4.4 Exception to the Law of Comparative Advantage Even if one nation has an absolute disadvantage with respect to the other nation in the production of both commodities, there is still a basis for mutually beneficial trade, unless the absolute disadvantage is in the same proportion for the two commodities. This kind of exception is rare.

16. 4.5 Assumptions for Comparative Advantage • 2×2×1 • Free trade • Perfect mobility of labor within each nation but immobility between the two nations • Constant costs of production • No transportation costs • No technical change

17. 5 The Opportunity Cost Theory • It is the amount of a second commodity that must be given up in order to release enough resources to produce one additional unit of the first commodity (comp. cost stresses the opportunity cost). • The nation with lower opportunity cost in the production of a commodity has a comparative advantage in that commodity and a comparative disadvantage in the second commodity.

18. 5 The Opportunity Cost Theory Opportunity Costs of Wheat in Terms of Cloth 1W 2/3C 1W 2C Opportunity Costs of Cloth in Terms of Wheat 3/2W 1C 1/2W 1C

19. 5.1 Production Possibility Schedules in U.S. & U.K.

20. 5.2 PPF Under Constant Cost

21. 5.3 Consumption Frontier It shows the combination of consumption that the nation actually chooses to consume. In the absence of trade, the production possibility frontier is also the consumption frontier.

22. 6 Basis For & Gains From Trade Under Constant Costs

23. 6.1 Equilibrium Relative Commodity Prices With D & S

24. 6.2 Large and Small Country Large country: Its trade can influence the world price. Small country: Its trade can not affect the world supply and demand. When a small country trades with large nations, the trade will take place at the pretrade-relative commodity prices in the large nation. Then, the small nation receives all of the benefits from trade.

25. 7 Test of Ricardian Trade Model • MacDougall (using 1937 data) • Balassa (using 1950 data) • Stern (using 1950 and 1959 data) • Glub (using 1990 data) • Summary: • Comparative advantage seems to be based on a difference in labor productivity or costs, as postulated by Ricardo.

26. 7.1 Labor Productivity and Comparative Advantage

27. 7.2 Comments on Comparative Ad Ricardian trade model has to a large extent been empirically verified, but it has a serious shortcoming: it assumes rather than explains comparative advantage. Ricardo in general provided no explanation for the difference in labor productivity and comparative advantage between nations and no enough explanation about the effect of international trade on the earnings of factors of production.

28. What was the basis for and pattern of trade according to Adam Smith? How were the gains from trade generated? In what way was Ricardo’a law of comparative advantage superior to Smith’s theory of absolute advantage? How do gains from trade rise with comparative advantage? What is the relationship between opportunity costs and the production possibility frontier of a nation? 8 Questions for Discussion

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