WHY is WHAT produced WHERE and traded to WHOM for WHAT?

Size: px

Start display at page:

Download "WHY is WHAT produced WHERE and traded to WHOM for WHAT?"

Randall Matthews
5 years ago
Views:

1 AGEC Lecture 1 WHY TRADE? INTRODUCTION TO COMPARATIVE ADVANTAGE The study of international trade attempts to answer many related questions: WHY is WHAT produced WHERE and traded to WHOM for WHAT? But WHY is the question that makes the study of international trade both challenging and interesting.

2 Mercantilism 16 th and 17 th Centuries The Mercantilist School held that the only way for a country to become rich and powerful was to export more than it imports. Trade was not considered mutually beneficial but rather a transfer of wealth from importing to exporting countries. Economic nationalism gave rise to strict government control of trade in the belief that a nation gains wealth only at the expense of others through trade. European trade policies were designed to extract wealth from the colonies. Colonies were to provide raw materials and semifinished goods and Home countries then processed them for resale to colonies.

3 Why Do Countries Trade? Adam Smith's Hypothesis Absolute Advantage A country has an absolute advantage in the production of a commodity over another country if it produces that commodity more cheaply. Law of Absolute Advantage A country will gain economically if it specializes in the production of that commodity which it can produce most cheaply (in terms of input per unit of output) and then trades with other countries for other commodities. World production of all commodities will also increase as a consequence.

4 Example of Adam Smith's Absolute Advantage 1. Production Possibilities Assume: 2 countries (US and EU) 2 commodities (wheat and corn) 10 million acres of land in each country 2. Self Sufficiency (No Trade) Each country has half its land in wheat and half in corn. (Completely arbitrary.) US 200 or 1250 EU 250 or 600 US EU Specialization and Trade Each country produces only the crop it can produce more cheaply than the other country and trades some for the other crop. US EU

5 Why Do Countries Trade? David Ricardo's Answer Comparative Advantage A country has a comparative advantage in the production of a commodity over another country if it produces the commodity relatively more cheaply. Law of Comparative Advantage A country will gain economically if it specializes in the production of that commodity for which it has the greatest relative advantage or least relative disadvantage and then trades with other countries. Total world production of the commodity will increase as a consequence.

6 Absolute Advantage in Both Crops Why Trade? 1. Production Possibilities Assume: 2 countries (US and EU) 2 commodities (wheat and corn) 10 million acres of land in each country 2. Self Sufficiency (No Trade) Each country has half its land in wheat and half in corn. (Completely arbitrary.) US 250 or 1250 EU 200 or 600 US EU Specialization and Trade Each country produces only the crop it can produce relatively more cheaply (in terms of input per unit of output) than the other country and trades some for the other crop. US EU

7 CONCLUSIONS Even a country that is a higher cost producer of everything can still export something! Countries may import commodities they can produce more cheaply than the country from which they import. Comparing costs of production among countries will not reveal the pattern of comparative advantage even with free trade.

8 Comparative Advantage: The Most Lofty Theorem of Them All One reason that trade economists have an almost-religious attachment to free trade may be the aura that attaches to the doctrine of comparative advantage. A well known story illustrates the point. Paul Samuelson was once confronted by a prominent mathematician who doubted that economics was a science and challenged Samuelson to produce one result in economics that was at once true and non-trivial. Samuelson confesses to scratching his head for a while, but eventually he had his answer: the doctrine of comparative advantage. A mathematician can easily figure out that the doctrine is true. And it is certainly non-trivial: look at how many people don't get it. ( But we cannot possibly gain from trade; we have nothing to export since we produce everything more expensively than rich countries ) Trade economists tend to feel that they are the guardians of this most lofty theorem of them all. That makes them very protective of the doctrine and contemptuous of the barbarians who do not get it. D. Rodrik, Rafiq Hariri Professor of International Political Economy, Harvard Kennedy School (

COMPARATIVE ADVANTAGE. 2.2 Mercantilists Views on Trade Case Study 2-1 Mercantilism Is Alive and Well in the Twenty-First Century

COMPARATIVE ADVANTAGE. 2.2 Mercantilists Views on Trade Case Study 2-1 Mercantilism Is Alive and Well in the Twenty-First Century *CHAPTER 2 (Core Chapter) COMPARATIVE ADVANTAGE OUTLINE 2.1 Introduction 2.2 Mercantilists Views on Trade Case Study 2-1 Mercantilism Is Alive and Well in the Twenty-First Century 2.3 Trade Based on Absolute