Chapter Two: The Law of Comparative Advantage. 2.2 The Mercantilists’ View on Trade In the 17 th century a group of men (merchants, bankers, government.

Chapter Two:

The Law of Comparative Advantage

2.2 The Mercantilists’ View on Trade

In the 17th century a group of men (merchants, bankers, government officials, and philosophers) wrote essays on international trade that advocated an economic philosophy known as Mercantilism.

In their view, a country becomes rich if it exports more than it imports.

The surplus in trade balance will result in an inflow of precious metals; gold and silver.

The more precious metals means a richer and more powerful nation.

Countries have to do their best to increase exports and restrict imports.

Since all countries cannot have surplus at the same time and because the stock of metals is fixed in the short run, a country gains from trade only at the expense of others.

Wealth of nations was measured by the stock of metals they possess.

In contrast, today we measure wealth of a nation by its stock of human, man-made, and natural resources available for producing goods and services.

Mercantilits advocated strict government control of economic activity because gain from trade comes at the expense of other nations (i.e. zero-sum-game).

2.3 Trade Based on Absolute Advantage: Adam Smith (Wealth of Nations: 1776)

A. Absolute Advantage According to Adam Smith, trade between two nations

is based on absolute advantage. When one nation is more efficient than (has an

absolute advantage over) another in the production of one commodity but is less efficient than (has an absolute disadvantage with respect to) the other nation in producing a second commodity, 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 nations for the commodity of its absolute disadvantage.

By this process, resources are efficiently utilized and the output of both commodities will rise.

The growth in output measures the gains from specialization in production available to be divided between the two nations through trade.

In contrast to the mercantilists, Smith believed that all nations would gain from free trade and strongly advocated a policy of laissez-faire:

As little government interference with the economic system as possible.

Free trade would lead to efficient use of resources and would maximize world welfare.

Only few exceptions were allowed to this policy.

B. Illustration of Absolute Advantage Example:

The table shows that one hour of labor time produces 6 bushels of wheat in the US versus only 1 in the UK, while one hour of labor time produces 5 yards of cloth in the UK versus 4 in the US.

Thus, the US has an absolute advantage in producing wheat, while the UK has an absolute advantage in producing cloth.

With trade, the US specializes in producing wheat, while the UK specializes in producing cloth.

U.S. U.K.

Wheat (bushels/man-hour) 6 1

Cloth (yards/man-hour) 4 5

If the US exchanges 6 bushels of wheat (6W) for six yards of UK cloth (6C), it gains 2C or saves ½ hour of labor time (since it can only exchange 6W for 4C domestically).

Similarly, the 6W the UK receives from the US is equivalent to or would require 6 hours of labor time to produce in the UK.

These same 6 hours can produce 30C in the UK. The exchange of 6C for 6W with the US, the UK gains

24C, or saves 5 man-hours.

2.4 Trade Based on Comparative Advantage: David Ricardo (1815, Principles of Polit. Econ. & Taxation)

A. The Law of Comparative Advantage (LCA) According to LCA, 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.

This nation should specialize in the production and export of the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage in greater (this is the commodity of its comparative disadvantage).

Example:

The UK has an absolute disadvantage in the production of both commodities with respect to the US

However, since the UK is half as productive in cloth but 6 times less productive in wheat, it has a comparative advantage in cloth.

The US has an absolute advantage in the production of both commodities with respect to UK.

Since the US absolute advantage is greater in wheat (6:1) than in cloth (4:2), it has a comparative advantage in wheat.

U.S. U.K.

Wheat (bushels/man-hour) 6 1

Cloth (yards/man-hour) 4 2

2.5 Comparative Advantage and Opportunity Costs

A. Comparative Advantage and the Labor Theory of Value (LTV)

According the LTV, the value or price of a commodity depends exclusively on the amount of labor going into its production.

This implies that; 1) either labor the only factor of production or it is used in the same fixed proportion in the production of all commodities.

2) labor is homogeneous (i.e. of only one type). Since neither of the assumptions is true, we can’t

base the explanation of comp-adv. on the LTV.

B. The Opportunity Cost Theory (OCT) According to the OCT, the cost of a commodity is

the amount of a second commodity that must be given up to release just enough resources to produce one additional unit of the first commodity.

Thus, the nation with the lower opportunity cost in the production of a commodity has a comp-adv. in that commodity.

If the US has to give up 2/3 of a unit of cloth to release enough resources to produce an additional unit of wheat, then the opp. cost of wheat is 2/3 of a unit of cloth (i.e. 1W=2/3 C)

If 1W=2C in the UK, then the opp. cost of wheat is lower in the US, and the US has a comparative (cost) advantage over the UK in wheat.

In a two-nation, two-commodity world, the UK would have a comp-adv. In cloth.

According to the LCA, the US should specialize in producing wheat and export some of it in exchange for British cloth.

C. The Production Possibility Frontier (PPF) under Constant Costs

The PPF: a curve showing the alternative combinations of the two commodities that a nation can produce by fully utilizing its resources with the best technology available to it.

US UK

Wheat Cloth Wheat Cloth

180 0 60 0

150 20 50 20

120 40 40 40

90 60 30 60

60 80 20 80

30 100 10 100

0 120 0 120

FIGURE 2-1 The PPFs of the United States and the United Kingdom.

The US has to give up 30W to produce an additional 20C (30W=20C), the opp. cost of W is 1W=2/3C.

The UK has to give up 10W to produce an additional 20C (10W=20C), the opp. cost of W is 1W=2C.

Constant opportunity costs arise when:

1. Resources are perfect substitutes or used in fixed proportions in the production of both commodities.

2. All units of the same factor are homogeneous. While opp. costs are constant in each nation, they

differ among nations, providing the basis for trade. The opp. cost is measured by the slope of the PPF,

also known as the marginal rate of transformation.

D. Opportunity Costs and Relative Commodity Prices

Figure 2-1 shows that the (absolute) slope of the US transformation curve is 120/180=2/3= opp. cost of wheat in the US and remains constant.

The (absolute) slope of the UK transformation curve is 120/60=2= opp. cost of wheat in the UK and remains constant.

Assuming prices equal costs and the nation produces both commodities, the opp. cost of wheat is equal to wheat price relative to cloth price (Pw /Pc).

In the US, Pw /Pc=2/3, and inversely Pc /Pw= 3/2=1.5.

In the UK, Pw /Pc=2, and inversely Pc /Pw= ½=1/2.

The lower Pw /Pc in the US reflects its comp-adv. in wheat.

The lower Pc /Pw in the UK reflects its comp-adv. in cloth.

Conclusion: the difference in relative commodity prices between the two nations is a reflection of their com-adv. and provides the basis for mutually beneficial trade.

2.6 The Basis for and the gains from Trade under Constant Costs

A. Illustration of the Gains from Trade With no trade, the US may produce a combination of

(90W-60C) on its PPF (point A in figure 2-2). The UK may produce a combination of (40W-40C) on its

PPF (point A/ in figure 2-2). With trade, the US would specialize in producing wheat

and produce at point B (180W-0C). The UK would specialize in producing cloth and produce

at point B / (0W-120C). If they trade 70W for 70C, US consumes 110W-70C

(point E), the UK consumes 70W-50C (point E /).

FIGURE 2-2 The Gains from Trade.

The US gains 20W and 10C from trade (E compared to A), UK gains 30W and 10C (E / compared to A /).

The increase in consumption resulted from the specialization of the two nations.

Without trade, total production of wheat is 130 (90+40), but with trade it is 180 (all in the US).

Without trade, total production of cloth is 100 (60+40), but with trade it is 120 (all in the UK).

Gains from trade come from the increase in production (50W and 20C) shared by both nations.

Without trade no nation would specialize in production because both need to consume some of the other commodity.

B. Relative Commodity Prices with Trade In the left panel of figure 2-3, SW(US+UK) is the

combined supply curve of wheat if the two countries used all of their resources to produce wheat only.

Distance 0B=180W represents maximum quantity the US can produce with complete specialization.

Distance BB*=60W the maximum quantity the UK can produce.

Thus, 240W is the maximum quantity both nations can produce using all o their resources, as a result SW(US+UK) is vertical at 240W.

Suppose that with trade, the combined demand curve for wheat is DW(US+UK)

FIGURE 2-3 Equilibrium-Relative Commodity Prices with Demand and Supply.

D and S intersect at point E to determine equilibrium quantity of 180W and equilibrium relative price of Pw/Pc=1 with trade.

The same for cloth in the right panel. SC(US+UK) is the combined supply curve of cloth if the

two nations used all resources to produce cloth only. The UK can produce 120C=0B/ , while the US can

produce another 120=B/ B//. Suppose that with trade, the combined demand curve

for cloth is DC(US+UK)

D and S intersect at point E / determining the equilibrium quantity of 120C and equilibrium relative price of Pc/Pw=Pw/Pc=1 with trade.