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Adam Smith. Promoted laissez-faire approach by government meaning don’t create monopolies don’t mandate low wages for workers don’t force people into professions based on ancestry don’t allow sub-groups to control the economy. Adam Smith. Moral philosopher

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Adam Smith

  • Promoted laissez-faire approach by government

  • meaning

    • don’t create monopolies

    • don’t mandate low wages for workers

    • don’t force people into professions based on ancestry

    • don’t allow sub-groups to control the economy


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Adam Smith

  • Moral philosopher

  • Described the capitalist system in detail

  • Changed the definition of “Wealth of Nations”

  • taught that economies work best when people are permitted to pursue own self-interest

  • taught that monopoly is dangerous to prosperity


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Trade as a positive-sum game

  • taught that trade can create wealth for all partners, both sides could win at the same time

  • Example: where one country is better at producing one good and another is better at producing a second,

    • more is produced and consumed if each country specializes in production and trades than if each country produces only for its own market


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Absolute Advantage: Example

Absolute Advantage: Example

Country Cloth Wine

England 1 hr/yd 4 hrs/bbl

Portugal 2 hrs/yd 3 hrs/bbl

England has absolute advantage in production of cloth

Portugal has absolute advantage in production of wine

If England produces its own wine:

Producers of cloth can buy wine at a ratio of 1W=4C

Consumers of wine can buy cloth at ratio of 1W=4C


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Country Cloth Wine

England 1 hr/yd 4 hrs/bbl

Portugal 2 hrs/yd 3 hrs/bbl

If England produces its own wine:

Producers of cloth can sell cloth at a ratio of 1C=1/4W

Consumers of wine can buy wine at ratio of 1W=4C

Assume trade with Portugal at price 1W=3C

Producers of cloth can sell cloth at ratio of 1C=1/3 W

Consumers of wine can buy wine at ratio of 1W=3C, save money

Class: Reproduce example for Portugal


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Absolute Advantage 300 hrs each country

  • England - produces and consumes either 300 cloth or 75 wine, or some combination

  • Portugal - produces and consumes 150 cloth or 100 wine, or some combination

  • with trade:

  • England: produces 300 cloth, consumes up to 100 wine

  • Portugal: produces 100 wine, consumes up to 300 cloth


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Absolute Advantage 300 hrs each country

  • With trade:

  • England: produces 300 cloth, can buy up to 100 wine

  • Portugal: produces 100 wine, can buy up to 300 cloth

  • Assume country consumed half of its potential output / trade purchase for each good.

    • before trade, England produced 150 C and 37.5 W, consumes the same.

    • with trade produces 300 cloth, sells 150 to buy wine

    • consumes 150 cloth & 50W


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David Ricardo

  • successful stockbroker

  • later became member of parliament

  • greatly influenced by “Wealth of Nations”

  • opposed Britain’s corn laws restricting imports of corn

  • wrote “The Principles of Political Economy and Taxation


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Comparative Advantage

  • two countries can benefit from specialization and trade as long as one country is relatively better at producing a good relative to the second country

  • this is the principle of division of labour taken to an international context

  • Ricardo saw that Adam Smith’s analysis could extend to the case where one nation had absolute advantage in the production of both goods.


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How does it work?

  • Simple example needs two countries, two goods, say Canada Mexico, cloth and wine

  • Assume Canada is absolutely more productive in the output of both goods, relatively more productive in wine-making


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  • Canada should specialize in wine

  • Mexico should specialize in cloth

  • The two countries can trade to satisfy demand

  • NOTE: If wages were included, Canada would have higher buying power than Mexico with or without trade

    • because it is more productive,

    • NOT as a result of trade


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Terminology

  • Autarky

    • no trade

  • Terms of trade

    • price of exports over price of imports

  • Complete specialization

    • country only produces one good, buys other good(s) through imports




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