Session 3

Why Everybody Trades:Comparative Advantage

Why Do Countries Trade ?

Country A Country B

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.

1) Government should imposed and array of taxes and prohibition designed to limit import.

2) Government should subsidized and encouraged exports.

Proposals from the Mercantilist

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.

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.

Trade freely transacted between countries generally leads to gains for all countries trade is a positive sum activity.

Import are part of expanding national consumption that a nation seeks, not an evil to be suppressed.

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

Adam Smith Focused on Labor Productivity

Productivity:

In the United States

In the Rest of the World

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 unit of cloth

1 unit of wheat

4.0

2.0

1.0

2.5

><

In the United States

In the Rest of the World

Clothes

Wheat Export

Export

What if the foreigners are better at producing everything than we are ?

Will they want to trade ?

In the United States

In the Rest of the World

Ricardo’s Theory of Comparative AdvantageThere 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

Productivity:

In the United States

In the Rest of the World

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 unit of cloth

1 unit of wheat

4.0

2.0

1.0

1.5

>>

In the United States

In the Rest of the World

1 units of cloth

1 units of wheat

1.0

1.5

4.0

2.0

Labor hour to make:

National prices with on international trade:

Price of cloth

Price of wheat

2.0 W

0.5 C

0.67 W

1.5 CExport

Export

What will the equilibrium international price be ?

2.0 W 0.67 W

1.5 C0.5 C

In the United States

In the Rest of the World

≥ International price of cloth ≥

≤ International price of wheat ≤

Productivity:

In the United States

In the Rest of the World

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 units of cloth

1 units of wheat

4.0

2.0

1.0

1.5

>>

Ricado’s Constant Cost and The Poduction-posibility Curve

It is assumed that both have 100 billion hour of labor.

United States

Wheat (billion of unit per year)

Cloth(billion of unit per year)

0

Rest of the world

Wheat (billion of unit per year)

Cloth(billion of unit per year)

0

20

15

S0

16

76

S0S1

S1

30

20

C

20

80

C

50

25

PPC

67

100

PPC

50

Trade line

100

Trade line

It is assumed the trade price for both products equal one.