The Origins of The Origins of Trade TheoryTrade Theory

Professor BrysonMarriott School

Smith and Absolute Smith and Absolute AdvantageAdvantage

Assume Two countries, the US and ROW producing wheat and cloth.

USUS Rest of the WorldRest of the World________________________________________________________________________________

Labor cost required to make:Labor cost required to make:1 bushel wheat 2 hours1 bushel wheat 2 hours < < 2.5 hours2.5 hoursI yard of clothI yard of cloth 4 hours 4 hours > > 1 hour1 hour

____________________________________________________________________________

Which country has an advantage in wheat? In Which country has an advantage in wheat? In cloth?cloth?

USUS Rest of the Rest of the WorldWorld

________________________________________________________________________________Labor cost required to make:Labor cost required to make:1 bushel wheat 2 hours1 bushel wheat 2 hours < < 2.5 hours2.5 hoursI yard of clothI yard of cloth 4 hours 4 hours > > 1 hour1 hour

____________________________________________________________________________

How much will each country produce if each has How much will each country produce if each has 40 hours of labor?40 hours of labor?

(Assume a division of labor in US of 10 and 30 (Assume a division of labor in US of 10 and 30 hours for wheat and cloth, 20 and 20 for ROW)hours for wheat and cloth, 20 and 20 for ROW)

So, each week we have US ROW

5 bushels (10 hours) 8 bushels (20 hours) (10/2 = 5) (20/2.5 =8)

TOTAL WHEAT = 13 BUSHELS

7.5 yards (30 hours) 20 yards (20 hours) (30/4 = 7.5) (20/1 =20)

TOTAL CLOTH = 27.5 YARDS

Absolute advantage is determined from productivity data (labor costs).

After specialization

United States ROW Total

20 bushels (40 hours) ---- 20 (>13) --- 40 yards (40 hours) 40 (>27.5) How much does output increase with

specialization? But let’s go back for a moment. Can you calculate

prices prevailing in the separate markets before the opening of trade?

Calculating pre-trade pricesCalculating pre-trade pricesBased on pre-trade labor costsBased on pre-trade labor costs

USUS ROW ROW1 bushel of wheat 2 hours1 bushel of wheat 2 hours < < 2.5 hours2.5 hoursI yard of clothI yard of cloth 4 hours 4 hours > > 1 1 hourhour

In the U.S. how much wheat will one give for a In the U.S. how much wheat will one give for a

yard of cloth?yard of cloth? How much cloth will the ROW give for a How much cloth will the ROW give for a

bushel of wheat?bushel of wheat?

Calculating pre-trade pricesCalculating pre-trade prices

United StatesUnited States ROW ROW Price of wheat 0.5 yard/bushel 2.5 yds/bush Price of wheat 0.5 yard/bushel 2.5 yds/bush (=2/4) (=2.5/1)(=2/4) (=2.5/1)

Price of cloth 2.0 bushels/yard 0.4 bush/yd Price of cloth 2.0 bushels/yard 0.4 bush/yd (= 4/2) (= 4/2) (=1/2.5)(=1/2.5)

Notice the difference in wheat prices.Notice the difference in wheat prices.

ARBITRAGE AND TRADE GAINSARBITRAGE AND TRADE GAINS

Now let trade be opened up. People notice Now let trade be opened up. People notice potential for arbitrage gains.potential for arbitrage gains.

The principle: As long as prices differ in two The principle: As long as prices differ in two places (by more than any cost of places (by more than any cost of transportation), one profits by arbitrage transportation), one profits by arbitrage (buying in one location and selling in (buying in one location and selling in another). another).

ARBITRAGE AND TRADE GAINSARBITRAGE AND TRADE GAINS

To arbitrage properly, sell your gains from To arbitrage properly, sell your gains from comparative advantage abroad. Take the comparative advantage abroad. Take the foreign product you purchased back home foreign product you purchased back home to trade for lots more of the original to trade for lots more of the original product.product.

ARBITRAGE AND TRADE GAINSARBITRAGE AND TRADE GAINS

Potential arbitrage gains:Potential arbitrage gains: Sell 1 US bushel in ROW for 2.5 yards Sell 1 US bushel in ROW for 2.5 yards

cloth, andcloth, and

Sell 2.5 yards cloth purchased in ROW for Sell 2.5 yards cloth purchased in ROW for 5 bushels in US.5 bushels in US.

Or, Sell 2.5 ROW yards for 5 bushels in the Or, Sell 2.5 ROW yards for 5 bushels in the US and US and

Sell 5 bush in US for 12 yards cloth in Sell 5 bush in US for 12 yards cloth in ROWROW

Opening trade will lead under Ricardian conditions Opening trade will lead under Ricardian conditions to specializationto specialization..

What determines the boundaries of trade prices, i.e., the lowest and highest number of yards per bushel?

0.5 ≥ International price of wheat ≤ 2.5 (yards/bu.)

(If the ROW offers the US .5 or less, it will just take .5 at home.)

(If wheat isn’t cheaper through trade, ROW would simply buy at home.)

Suppose that the ratio settles at the Suppose that the ratio settles at the price ofprice of

1 bushel = 1 yard. 1 bushel = 1 yard.

Both nations will gain from trade after Both nations will gain from trade after having pursued specialization where having pursued specialization where they have absolute advantages. they have absolute advantages.

But what if there is no But what if there is no absolute advantage?absolute advantage?

David Ricardo and David Ricardo and

Comparative AdvantageComparative Advantage

The principle of comparative advantage: The principle of comparative advantage: a nation, like a person, gains from trade a nation, like a person, gains from trade by exporting the goods or services in by exporting the goods or services in which it has its greatest comparative which it has its greatest comparative advantage in productivity (where it can advantage in productivity (where it can produce at lower cost relative to produce at lower cost relative to potential trading partners) and importing potential trading partners) and importing those in which it has the least those in which it has the least comparative advantage.comparative advantage.

This holds even if one country is worse This holds even if one country is worse in producing both traded goods.in producing both traded goods.

USUS ROWROW

1 bushel of wheat 2 hours > 1.5 hours1 bushel of wheat 2 hours > 1.5 hours

1 yard of cloth1 yard of cloth 4 hours > 1 hour 4 hours > 1 hour

Here, as in Ricardo's original illustration, the US Here, as in Ricardo's original illustration, the US has inferior productivity in both goods, requiring has inferior productivity in both goods, requiring more labor hours to produce both wheat and more labor hours to produce both wheat and cloth. cloth.

US ROW 1 bushel of wheat 2 hours > 1.5 hours 1 yard of cloth 4 hours > 1 hour

Now, each week we haveUS ROW

5 bushels (10 hours) 13 bushels (20 hours) Total: 18

7.5 yards (30 hours) 20 yards (20 hours) Total: 27.5

US ROWUS ROW 1 bushel of wheat1 bushel of wheat 2 hours 2 hours > 1.5 hours > 1.5 hours 1 yard of cloth1 yard of cloth 4 hours > 1 hour 4 hours > 1 hour

Here, as in Ricardo's original illustration, the US has inferior productivity in both goods, requiring more labor hours to produce either wheat or cloth.

After specializationAfter specializationUSUS ROWROW

20 bushels (40 hours)20 bushels (40 hours) ---- ---- 2020

--- 40 yards (40 hours)--- 40 yards (40 hours) 40 40

Ricardian Trade GainsRicardian Trade GainsAfter SpecializationAfter Specialization

Assume an exchange rate, again, of 1 yard for 1 bushel.

Note from the data on production before international trade that the U.S. can produce one bushel for each 0.5 yards of cloth;

but it can get a full yard internationally for that bushel.

Ricardian Trade GainsRicardian Trade GainsAfter SpecializationAfter Specialization

For each half yard of cloth not produced, we can gain a full yard through specialization and trade.

The rest of the world makes each extra yard of cloth by giving up only 0.67 bushels of wheat. It gains a full bushel for each additional yard produced

Ricardian Trade GainsAfter Specialization

For each .67 bushel of wheat not produced, the rest of the world gains a full bushel of wheat through specialization and trade.

Mercantilism vs. The WealthMercantilism vs. The Wealth

Review the trade practice of Smith’s day as the motivating force for Smith’s free trade doctrine.

The Mercantilist objective: inflows of gold. The methodology: run positive trade

balances. Refuting the doctrine.