International Economics

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International Economics. Chapter 2 The Law of Comparative Advantage. Organization. 2.1 Introduction 2.2 The Mercantilists' View on Trade 2.3 Trade Based on Absolute Advantage: Adam Smith 2.4 Trade Based on Comparative Advantage: David Ricardo2.5 Comparative Advantage and Opportunity Costs2.6 The Basis for and the Gains from Trade Under Constant Costs2.7 Empirical Tests of the Ricardian ModelChapter SummaryExercises.

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International Economics

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1. International Economics Li Yumei Economics & Management School of Southwest University

2. International Economics Chapter 2 The Law of Comparative Advantage

3. Organization 2.1 Introduction 2.2 The Mercantilists’ View on Trade 2.3 Trade Based on Absolute Advantage: Adam Smith 2.4 Trade Based on Comparative Advantage: David Ricardo 2.5 Comparative Advantage and Opportunity Costs 2.6 The Basis for and the Gains from Trade Under Constant Costs 2.7 Empirical Tests of the Ricardian Model Chapter Summary Exercises

4. 2.1 Introduction Historical Approach to Examine the Development of International Trade Theory (Mercantilism, Absolute Advantage, Comparative Advantage) Three Basic Questions Basis for Trade Gains from Trade Patterns of Trade

5. 2.2 The Mercantilists’ View on Trade Early Mercantilists Main Views on Trade Comments Conclusion Some Mercantilism Data

6. Early Mercantilists Mercantilism Mercantilism was established during the early modern period (starting in the 16th to the 18th century, which roughly corresponded to the emergence of the nation-state) . Mercantilism is an economic theory that holds the prosperity of a nation depends upon its supply of capital, and that the global volume of trade is “unchangeable.” Economic assets, or capital, are represented by bullion (gold, silver, and trade value) held by the state, which is best increased through a positive balance of trade with other nations (exports minus imports). Mercantilism suggests that the ruling government should advance these goals by playing a protectionist role in the economy, by encouraging exports and discouraging imports, especially through the use of tariffs. The economic policy based upon these ideas is often called the mercantile system.

7. Early Mercantilists Early Mercantilists The Early Mercantilists: Thomas Mun (1571–1641), Edward Misselden (1608–1634) And Gerard De Malynes (1586–1623) Thomas Mun(1571-1641) - Representative Works England’s Treasure by Foreign Trade published in 1664 - Experiences Thomas Mun , English Writer on Economics, was the third son of John Mun, mercer of London. He began by engaging in Mediterranean trade, and afterwards settled down in London, amassing a large fortune . He was a member of the committee of east India company and of the standing commission on trade appointed in 1622 . In 1621 Mun published A Discourse of Trade from England unto the East Indies

8. Main Views on Trade Why do nations trade? zero-sum gain—one nation gains at the expense of the other Main Views on Trade The Mercantilist School common outlook: (1) the idea of specie or bullion as the essence of wealth (2) the notion that a positive balance of trade (trade surplus) is an index of national welfare. (3) It is also associated with an emphasis on population growth and low wages, a concern with full employment (4) zero-sum gain — one nation gains at the expense of the other , denying foreign trade as a source of net gain to the world as a whole. (5) A permanent balance of trade surplus should be beneficial to a nation has been a source of discussion right down to the present day.

9. Comments Mercantilism led to some of the first instances of significant government intervention and control over market economies, and it was during this period that much of the modern capitalist system was established. Internationally, mercantilism encouraged the many European wars of the period, and fueled European imperialism, as the European powers fought over “available” markets. Mercantilism developed at a time when the European economy was in transition (Feudalism to capitalism) One single economic ideology Static view of the world economy The wealth of a nation measured by the stock of precious metals it possessed, while at present by its stock of human, man-made, and natural resources available for producing goods and services.

10. Conclusion Early mercantilist writers embraced bullionism, the belief that that quantities of gold and silver were the measure of a nation’s wealth. Later mercantilists developed a somewhat more sophisticated view. Many European economists between 1500 and 1750 are today generally considered mercantilists . “Mercantilist Literature” appeared in the 1620s in Great Britain. Economic Nationalism Belief in mercantilism began to fade in the late 18th century, as the arguments of Adam Smith and the other classical economists won favour in the British Empire

11. Mercantilism Data Exports of 'Treasure' and Merchandise to India By the British East India Company, in Pounds Sterling, Decennial Means, 1660-69 to 1710-19 Decade Treasure % Merchandise % Total in ? 1660-69 74,022.4 64.3% 41,085.2 35.7% 115,107.6 1670-79 234,091.4 72.2% 89,990.8 27.8% 324,082.2 1680-89 383,707.7 87.2% 56,170.2 12.8% 439,877.9 1690-99 166,561.4 69.8% 72,065.2 30.2% 238,626.6 1700-9 337,008.9 84.7% 60,876.5 15.3% 397,885.4 1710-19 371,418.1 79.2% 97,771.3 20.8% 469,189.4

12. Exports of Gold and Silver 'Treasure' to India By the British East India Company in Pounds Sterling Decade Silver Percent Gold Percent Total Value 1660-69 51,446.7 69.5% 22,575.7 30.5% 74,022.4 1670-79 102,038.1 43.6% 132,053.3 56.4% 234,091.4 1680-89 262,870.4 68.5% 120,837.3 31.5% 383,707.7 1690-99 163,230.2 98.0% 3,331.2 2.0% 166,561.4 1700-09 325,887.6 96.7% 11,121.3 3.3% 337,008.9 1710-9 369,340.3 99.4% 2,077.8 0.6% 371,418.10

13. 2.3 Trade Based on Absolute Advantage: Adam Smith Absolute Advantage Illustration of Absolute Advantage Main Views on Trade Comments Conclusion

14. Absolute Advantage Adam Smith(1723-90) Absolute advantage theory was proposed by Adam Smith (1723-90) . With The Wealth of Nations Adam Smith installed himself as the fountainhead of contemporary economic thought . Adam Smith was born in a small village in Kirkcaldy, Scotland. There his widowed mother raised him until he entered the University of Glasgow at age fourteen, as was the usual practice, on scholarship. He later attended Balliol College at Oxford, graduating with an extensive knowledge of European literature and an enduring contempt for English schools. He returned home, and after delivering a series of well-received lectures, was made first chair of logic (1751), then chair of moral philosophy (1752), at Glasgow University.

15. Adam Smith (1723-90) He left academia in 1764 , his famous works” The Wealth of Nations” was published in 1776, the same year the American Declaration of Independence was signed and in which his close friend David Hume died. In 1778 he was appointed commissioner of customs. This job put him in the uncomfortable position of having to curb smuggling(????), which, in The Wealth of Nations, he had upheld as a legitimate (?????) activity in the face of "unnatural" legislation. Adam Smith never married. He died in Edinburgh on July 19, 1790. An Inquiry into the Nature and Causes of the Wealth of Nations (Wealth of Nations)

16. Attack on the Mercantilism By the eighteenth century, the economic policies of the mercantilists were under strong attack. 1. David Hume’s price-specie-flow doctrine(1711-1776) : A favorable trade balance was possible only in short run, for over time it would automatically be eliminated. trade surplus ?inflow of gold and silver? the increase of money circulation ?relatively higher price of that trading partner ?more purchased foreign-produced goods for domestic consumers? the decline of exports? the elimination of trade surplus 2. Adam Smith Mercantilists’ static view of the world economy (constant size of the world’s economic pie or zero-sum game) was attacked by Adam Smith (mutually beneficial game). (industrial revolution from 1760 to 1832 )

17. Absolute Advantage Introduction Adam Smith coined (??) the term "mercantile system" to describe the system of political economy that sought to enrich the country by restraining imports and encouraging exports. This system dominated western European economic thought and policies from the sixteenth to the late eighteenth century. The goal of these policies was, supposedly, to achieve a "favorable" balance of trade that would bring gold and silver into the country. In contrast to the agricultural system of the physiocrats(?? ???), or the laissez-faire of the nineteenth and early twentieth centuries, the mercantile system served the interests of merchants and producers such as the British East India Company, whose activities were protected or encouraged by the state.

18. Absolute Advantage Smith’s Views on Mercantilism Smith made a number of important criticisms of mercantilist doctrine. First, he demonstrated that trade, when freely initiated, benefits both parties. In modern jargon it is a positive-sum game. Second, he argued that specialization in production allows for economies of scale, which improves efficiency and growth. Finally, Smith argued that the collusive relationship between government and industry was harmful to the general population. While the mercantilist policies were designed to benefit the government and the commercial class, the doctrines of laissez-faire, or free markets, which originated with Smith, interpreted economic welfare in a far wider sense of encompassing the entire population.

19. Absolute Advantage Main Content of Absolute Advantage When one nation is more efficient than another in the production of one commodity but is less efficient than 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 nation for the commodity of its absolute disadvantage. By this process, resources are utilized in the most efficient way and the output of both commodities will rise. This increase in the output of both commodities measures the gains from specialization in production available to be divided between the two nations through free trade. (page 33) Trade only happens under the mutually beneficial gains ,otherwise, no trade.

20. Illustration of Absolute Advantage No Trade U.S. U.K. Wheat (bushels/man-hour) 6 1 Cloth (yards/man-hour) 4 5 With Trade U.S. U.K. Wheat (bushels/man-hour) 12 0 Cloth (yards/man-hour) 0 10 After Trade Output wheat increases 5 units(12-7,before trade) Output cloth increases 1 unit (10-9, before trade); The world output increases 5 units wheat and 1 unit cloth. U.S. gains 2 units wheat while U.K. gains 4 units cloth.

21. Main Views on Trade Under the heavy pressure of high smuggling and created variety of products during the industrial revolution, by 1860 England had removed the last vestiges of the mercantile era . Adam Smith's insight that free trade leads to international specialization of labor and, usually, to greater economic well-being for all nations. What do nations trade? (two-win games) What the gains from trade? ( the greater economic well-being) What is the pattern of trade? (import and export) (supposing with two nations, two products and one factor “labor” world. One nation should export the more efficient product and import the less efficient product compared with the other nation. In other words, the nation should export the less cost product and import the higher cost product)

22. Comments Further development of mercantilism 1. The world’s economic pie is not a fixed quantity 2. Mutually beneficial game Only applying to a small number of countries E.G. Developed countries to developing countries Shortcomings 1. 2×2×1 theory model is not enough 2. The cost advantage of trade reason is too absolute How to explain the trade happened among the developed countries and among the developing countries? How to explain a country without any cost advantage also trade with other countries?

23. Conclusion The Principle of Absolute Advantage (Cost Advantage) In a two-nation, two-product world, international trade and specialization will be beneficial when one nation has an absolute cost advantage (that is, uses less labor to produce a unit of output) in one good and the other nation has an absolute cost advantage in the other good. A nation will import those goods in which it has an absolute cost advantage; and it will export those goods in which it has an absolute cost advantage. Mutually beneficial game Each nation benefits by specializing in the production of the good that it produces at a lower cost than the other nation, while importing the good that it produces at a higher cost. Increase of the world’s output More efficient used resources as the result of specializing to increase the world’ output , which is distributed to the two nations through trade.

24. Comparison of Mercantilism and Absolute Advantage Mercantilism-zero sum game-one nation gains at the expense of the other Adam Smith-both nations can gain from trade Absolute Advantage-each nation should specialize in production of good which is the most efficient at producing

25. 2.4 Trade Based on Comparative Advantage: David Ricardo The Law of Comparative Advantage The Gains from Trade Exception to the Law of Comparative Advantage Comparative Advantage with Money Comments Conclusion

26. The Law of Comparative Advantage Introduction Countries engage in international trade for two basic reasons: They are different from each other in terms of climate, land, capital, labor, and technology. They try to achieve scale economies in production. The Ricardian model is based on technological differences across countries. These technological differences are reflected in differences in the productivity of labor.

27. The Law of Comparative Advantage David Recardo (1772-1823) David Ricardo was one of those rare people who achieved tremendous success and lasting fame. After his family disinherited him for marrying outside his Jewish faith, Ricardo made a fortune as a stockbroker and a loan broker. When he died, his estate was worth over $100 million in today's dollars. At age twenty-seven, after reading Adam Smith's The Wealth of Nations, Ricardo got excited about economics. He wrote his first economics article at age thirty-seven and then spent only fourteen years—his last ones—as a professional economist. His Principles of Political Economy and Taxation was published in 1817, in which he presented the law of comparative advantage, one of the most important and still unchallenged laws of economics, with many practical applications.

28. Ricardo first gained notice among economists over the "bullion controversy." In 1809 he wrote that England's inflation was the result of the Bank of England's propensity to issue excess bank notes. In short, Ricardo was an early believer in the quantity theory of money, or what is known today as monetarism. In his Essay on the Influence of a Low Price of Corn on the Profits of Stock (1815), Ricardo articulated what came to be known as the law of diminishing returns. One of the most famous laws of economics, it holds that as more and more resources are combined in production with a fixed resource—for example, as more labor and machinery are used on a fixed amount of land—the additions to output will diminish. Ricardo also opposed the protectionist Corn Laws(???), which restricted imports of wheat. In arguing for free trade, Ricardo formulated the idea of comparative costs, today called comparative advantage (LTV: Labor Theory of Value). Comparative advantage—a very subtle idea—is the main basis for most economists' belief in free trade today. The idea is this: a country that trades for products that it can get at lower cost from another country is better off than if it had made the products at home.

29. The Law of Comparative Advantage The Concept of Law of Comparative Advantage In a two-nation and two-commodity world economy, even if one nation is less efficient than the other nation in the production of both commodities, there is still a basis for mutually beneficial trade. The first nation should specialize in the production of and export the commodity in which its absolute disadvantage is smaller (the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (the commodity of its comparative disadvantage). Note that in a two-nation, two-commodity world, once it is determined that one nation has a comparative advantage in one commodity, then the other nation must necessarily have a comparative advantage in the other commodity.

30. The Law of Comparative Advantage Assumptions of the model: Only two countries and two commodities in the world (Home and Foreign) Free Trade Perfect mobility of labor within each nation but immobility between the two nations Constant costs of production No transportation cost No technical change The labor theory of value

31. The Law of Comparative Advantage The Illustration of Comparative Advantage Without Trade U.S. U.K. Wheat (bushels/man-hour) 6 1 Cloth (yards/man-hour) 4 2 Explanation: US has an absolute advantage of both wheat and cloth with respect to UK, but the absolute advantage is greater in wheat(6:1) than cloth (4:2), US has a comparative advantage in wheat. On the contrary , UK’s comparative advantage in cloth ( smaller absolute disadvantage).

32. The Gains from Trade If the trade exchange rate is equal to the domestic exchange rate , no trade happens. Only trading partners can gains by each specializing in the production and exporting the commodity of its comparative advantage, international trade happens. E.G. (page table 2.2) With Trade (specialization) U.S. U.K. Wheat (bushels/man-hour) 12 0 Cloth (yards/man-hour) 0 4 Explanation: If US exports 6w for 4c from UK, and UK exports 2c for 1w from US, no trade happens since it is the same with domestic exchange without trade .

33. If US exports 6w for the exchange of 6c (more than 4c) from UK, US gains 2c ( or save one-half hour work). While UK exports 6c for the exchange of 6w , UK can gains 6c ( 6w=12c in UK, 6c for 6w, 6c surplus). Trade can happen between 4c ? 6w ?12c ( it is measured in terms of cloth, and also can measured in terms of wheat). The spread between 12c and 4c represents the total gains from trade available to be shared by the two nations by trading 6w. The closer the rate of exchange is to 4c=6w, the smaller is the share of the gain going to the US and the larger going to UK, and verse versa

34. Exception to the Law of Comparative Advantage When the absolute disadvantage that one nation has with respect to another nation is the same in both commodities. E.G. see table 2.2 If UK produces wheat 3w per hour not 1w, no mutually beneficial Trade between US and UK. The modification of the law of comparative advantage 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, unless the absolute disadvantage ( that one nation has with respect to the other nation) is in the same proportion for the two commodities.

35. Comparative Advantage with Money The comparative advantage can be expressed in terms of currency of either nation (Price difference) E.G. See table 2.2 U.S. U.K. Wheat (bushels/man-hour) 6 ($1) 1($2) Cloth (yards/man-hour) 4 ($1.5) 2 ($1) Suppose that the wage rate in US is $6 dollar per hour, since one man-hour produces 6w in US, the price of a bushel of wheat is Pw = $1, Pc=$1.5; Suppose UK 1pound per hour, Pw=1pound, Pc=0.5pound. If the exchange rate 1pound =$2, Pw=$2, Pc=$1 Business people would buy the lower price of wheat in US and sell them in UK; on the contrary buying the lower price of cloth in UK and sell them in US.

36. Comparative Advantage with Money The exchange rate influences the international trade E.G. If 1 pound = $1, in UK Pw=$1 and Pc=$0.5 No trade happens in Wheat from US to UK, and UK would export more cloth to US. Trade would be unbalanced in favor of the UK, and the exchange rate between the dollar and the pound would have to rise. E.G. If 1 pound =$3, in UK Pw=$3 and Pc=$1.5( the same with US) No trade happens in Cloth from UK to US, and US would export more wheat to UK. Trade surplus in UK would decrease while US trade deficit would decrease, and imbalance trade between the two countries would decrease. Therefore , each country need pay attention to its own currency exchange rate to other nation’s.

37. Comparative Advantage with Money Against One Argument in US The argument that could be advanced in the United States that it needs to protect the high wages and standard of living of its workers against cheap labor is generally false. At the same time, the protection of the labor against more efficient labor is also false. Reasons: high wages means high cost of products, less competition of products. Protection of less efficient labor means less efficiency in production, resulting high cost of products, less competition.

38. Comments The law of comparative advantage coined the absolute advantage , and absolute advantage can be view as the special situation of comparative advantage . On foreign trade, Ricardo set forth his famous theory of comparative advantage. Ricardo's argument was that there are gains from trade if each nation specializes completely in the production of the good in which it has a "comparative" cost advantage in producing, and then trades with the other nation for the other good. Ricardo took economics to an unprecedented degree of theoretical sophistication.  He formalized the Classical system more clearly and consistently than anyone before had done

39. Comments Theory of value Three periods of time 1. The first began with his acquaintance with systematic economic writing and extended through the bullion controversy, and might be described as a consistent exposition of Adam Smith's original concept of value. 2. The second phase of Ricardo's treatment of value is directly traceable to the corn-law controversies of 1813-17 . 3. Ricardo's Principles of Political Economy and Taxation was published in the spring of 1817, but more fundamentally to vindicate "embodied labour" as the soundest theoretical and the best practical measure of value.

40. Conclusion We examined the Ricardian model, the simplest model that shows how differences between countries give rise to trade and gains from trade. In this model, labor is the only factor of production and countries differ only in the productivity of labor in different industries. In the Ricardian model, a country will export that commodity in which it has comparative (as opposed to absolute) labor productivity advantage.

41. Conclusion The fact that trade benefits a country can be shown in either of two ways: We can think of trade as an indirect method of production. We can show that trade enlarges a country’s consumption possibilities. The distribution of the gains from trade depends on the relative prices of the goods countries produce.

42. Conclusion Extending the one-factor, two-good model to a world of many commodities makes it possible to illustrate that transportation costs can give rise to the existence of nontraded goods. The basic prediction of the Ricardian model-that countries will tend to export goods in which they have relatively high productivity- has been confirmed by a number of studies.

43. 2.5 Comparative Advantage and Opportunity Costs Comparative Advantage and the Labor Theory of Value The Opportunity Cost Theory The Production Possibility Frontier under Constant Costs Opportunity Costs and Relative Commodity Prices Comments Conclusion

44. Comparative Advantage and the Labor Theory of Value One-Factor Theory With comparative advantage, only the factor of labor is used to measure the cost of the produced commodity, then a nation exports the lower cost commodity and import the higher cost commodity compared with its trading partner. In other words, the comparative advantage is explained by the labor theory of value. It means: 1. Labor is the only factor of production and used in the same fixed proportion in the production of all commodities (constant cost); 2. Labor is homogeneous Unreality in the Real World Labor not only one factor of production ( capital, land….); different produced commodities having different proportion inputs of factor; labor not homogeneous ( training, productivity, wages)

45. The Opportunity Cost Theory Introduction the Marginalist Revolution of 1871-74 represented the beginning of Neoclassical Economic Theories. It attacked the one-factor theory ( comparative advantage with the explanation of labor theory of value). It was Gottfried von Haberler(1900- )in 1936 that he explained the theory of comparative advantage on the opportunity cost theory. In this form, the law of comparative advantage is sometimes referred to as the law of comparative cost.

46. The Opportunity Cost Theory The Representative and Works Haberler's two major works - Theory of International Trade (1936) and Prosperity and Depression (1937) – were hailed as masterly tomes(???????) which, for the first time in either field, drew together numerous scattered ideas into a single theoretical treatment which was both encyclopaedic(?????????) and rigorous(???). His rewriting of the theory of comparative advantage in terms of opportunity cost, rather than real cost, led to a long debate with Jacob Viner

47. The Opportunity Cost Theory Concept of Opportunity Cost Theory It means the cost of 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. Consequently, the nation with the lower opportunity cost in the production of a commodity has a comparative advantage in that commodity ( and a comparative disadvantage in the second commodity) . (No assumption one production factor of labor and of homogeneous; no assumption the price or cost of production depending on the labor content exclusively.) E.G. Table 2.2 If in the absence of trade, US must give up two-thirds of a unit of cloth to release just enough to produce one additional unit of wheat domestically, then the opportunity cost of wheat is two-thirds of a unit of cloth, while 2 in UK, so US’s comparative advantage in wheat.

48. The Opportunity Cost Theory Conclusion According to the law of comparative advantage, US should specialize in producing wheat and export some of it in exchange for British cloth. This is exactly what we conclude earlier with the law of comparative Advantage based on the labor theory of value, but now the explanation is based on the opportunity cost theory. How to show or illustrate the opportunity costs? Answer: production possibility frontier (PPF) or transformation curve

49. The Production Possibility Frontier under Constant Costs Production Possibility Frontier It is a curve that shows the alternative combinations of the two commodities that a nation can produce by fully utilizing all of its resources with the best technology available to it. See table 2.4 (page 42) to show: 1. US’s opportunity cost of wheat is two-thirds of a unit of cloth, while the opportunity cost of cloth is one and one-second units of wheat; 2. UK’s opportunity cost of wheat is two units of cloth, while the opportunity cost of cloth is one-second of a unit of wheat;

50. The Production Possibility Frontier under Constant Costs Illustration of PPF

51. The Production Possibility Frontier under Constant Costs Explanation of PPF 1. Points inside or below, the PPF is also possible but is inefficient, in the sense that the nation has some idle resources and / or is not using the best technology available to it; On the other hand, points above the PPF cannot be achieved with the resources and technology currently available to the nation. 2. The downward, or negative, slope of the PPF It indicates that one nation wants to produce one commodity more , another production of commodity must be given up some. 3. The straight line of PPF It means the opportunity costs are constant .

52. The Production Possibility Frontier under Constant Costs Constant Opportunity Costs It happens : 1. Resources or factors of production are either perfect substitutes for each other or used in fixed proportion in the production of both commodities. 2. All units of the same factor are homogeneous or of exactly the same quality. Conclusion: the constant opportunity costs differ among nations, providing the basis for trade. But constant costs are not realistic, They are discussed only because they serve as a convenient introduction to the more realistic case of increasing costs, discussed in the next chapter.

53. Opportunity Costs and Relative Commodity Prices The opportunity cost of a commodity is given by the (absolute) slope (vertical / horizontal ) of the production possibility frontier, or transformation curve, and is sometimes referred to as the marginal rate of transformation (MRT). E.G. Figure 2.1 (page 44) shows that the (absolute of slope of US transformation curve is 120/180=2/3= opportunity cost of wheat in US and remain constant; while UK is 120/60=2=opportunity cost of wheat in UK and remains constant. If suppose the prices equal costs of production and the nation produces both some wheat and some cloth, the opportunity cost of wheat is equal to the price of wheat relative to the price cloth (Pw/Pc). Thus in US Pw/Pc=2/3 and Pc/Pw=1.5, while in UK Pw/Pc=2 and Pc/Pw=1/2.

55. Opportunity Costs and Relative Commodity Prices Conclusion: The lower Pw/Pc in US means the comparative advantage in the production of wheat, and verse versa. The lower Pc/Pw=1/2 in UK means the comparative advantage in the production of cloth. The difference in relative commodity prices between the two nations (given by the difference in the slope of their transformation curves) is a reflection of their comparative advantage and provides the basis for mutually beneficial trade.

56. Comments Opportunity cost theory further explains the basis for mutually beneficial trade from marginalism . The assumption of the constant opportunity cost is unrealistic. The constant cost is exclusively decided by production, or supply. Demand consideration do not enter in the determination of relative commodity prices.

57. Conclusion To explain the basis for mutually beneficial trade Labor theory of value (David Ricardo) ?Opportunity cost theory (marginalism) ? (absolute) slope of the production possibility frontier (Transformation Curve)? the relative price of the commodity (price difference)? trade basis Opportunity cost of a commodity is equal to the relative price of that commodity and is given by the (absolute) slope of the production possibility frontier.

58. 2.6 The Basis for and the Gains from Trade Under Constant Costs Illustration of the Gains from Trade Relative Commodity Prices with Trade Comments Conclusion

59. Illustration of the Gains from Trade Without Trade ( production possibility frontier also represents its consumption frontier With trade, how the two nations gain from trade (figure 2-2)

60. Explanation of Figure 2-2 1. Without trade, A represents the combination (90w and 60c) of US ; A’ represents the combination (40w and 40c) of UK. 2. With trade, US specializes in the production of wheat according to comparative advantage theory; UK specializes in the production of cloth . 3. US by exchanging 70w for 70c with UK, US ends up consuming at E ( gains 20w and 10c); while UK by exchanging 70c for 70w with US, UK ends up consuming at E’ (30w and 10c). Conclusion The increased consumption of both wheat and cloth in both nations was made possible by the increased output (50w and 20c) at resulted as each nation specialized in the production of the commodity of its comparative advantage.

61. Relative Commodity Prices with Trade Another Figure(2-3 page 46) shows relative commodity prices with trade

62. Explanation How the equilibrium-relative commodity price with specialization in production and trade is determined? 1. Left panel E is the equilibrium-relative commodity price with production of wheat and trade is determined. Pw/Pc=1. It means that the equilibrium quantity of 180w is produced in US. 2. Right panel E’ is the equilibrium –relative commodity price with production of cloth and trade is determined. Pc/Pw=1. It means that the equilibrium quantity of 120cloth is produced in UK. 3. With trade, wheat is only produced in US and US specializes completely in the production of wheat; while cloth is only produced in UK and UK specializes completely in the production of cloth.

63. Comments With trade each country can specialize in the production of its comparative advantage completely and benefit from the international trade . In reality, it is impossible , while partial specialization is common.

64. Conclusion In the absence of trade, a nation’s production possibility frontier is also its consumption frontier. With trade, each nation can specialize in producing the commodity of its comparative advantage and exchange part of its output with the other nation for the commodity of its comparative disadvantage. By so doing, both nations end up consuming more of both commodities than without trade. With complete specialization, the equilibrium-relative commodity prices will be between the pretrade-relative commodity prices prevailing in each nation.

65. 2.7 Empirical Tests of the Ricardian Model Examination of empirical tests of Ricardo Model If we allow for different labor productivities in various industries in different nations, Ricardo trade model does a reasonably good job at explaining the patter of trade. 1. Mac Dougall in 1951 and 1952 using labor productivity and export data for 25 industries in US and UK for the year 1937 Relative Labor Productivities and Comparative Advantage–United States and United Kingdom. Conclusion: Positive relationship between labor productivity and exports, higher productivity more exports. (see figure 2-4)

67. 2.7 Empirical Tests of the Ricardian Model 2. Golub study in 1995 The conclusion is that in general , relative unit labor costs( the ratio of wages to unit labor productivity) and exports were inversely related. That is to say, the lower labor costs more exports, and verse versa. The color line shows a clear negative correlation between relative unit labor costs and relative exports for the 33 industries . Supporting Ricardo model. (See figure 2-5)

69. Chapter Summary This chapter examined the development of trade theory from the mercantilism to Smith, Ricardo, and Haberler and sought to answer three basic questions: (1) what is the basis for trade? (2) What are the gains from trade? (3) what is the pattern of trade? Although Ricardo theory was confirmed by many empirical studies, the model explains neither the reason for the difference in labor productivity or costs across nations nor the effect of international trade on the earnings of factors.

70. Exercises Additional Reading: 1. Comments on Mercantilism 2. Free Trade & Trade Protection Arguments

71. Exercises Discussion Questions: 1. Explain the contribution of mercantilism to economic theory 2. Explain the contribution of classical free trade theories to economic theory 3. Explain the main argument on free trade

72. Internet Materials http://www.iie.org http://www.wto.org http://www.oecd.org http://www.citizen.org/trade/index.cfm http://www.un.org/depts/unsd/mbsreg.htm

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