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Global Economics Eco 6367 Dr. Vera Adamchik


Global Economics Eco 6367 Dr. Vera Adamchik Foundations of Modern Trade Theory: Comparative Advantage – PowerPoint PPT presentation

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Title: Global Economics Eco 6367 Dr. Vera Adamchik

Global EconomicsEco 6367Dr. Vera Adamchik
  • Foundations of Modern Trade Theory Comparative

Key questions about trade
  • Why do countries trade? More precisely, what
    determines the pattern of trade (what is exported
    and what is imported)?
  • How does trade affect the economic well-being of
    each country?
  • How does trade affect the distribution of
    economic well-being or income among various
    groups within the country?

Why do countries trade?
  • Demand and supply conditions differ between
    countries, so prices differ between countries if
    there is no international trade. Trade begins as
    someone conducts arbitrage to earn profits from
    the price difference between previously separated

Why would product prices differ with no trade?
  • Production conditions differ (technology, factor
    endowment, differences across products in the use
    of productive factors in producing the products)
    the relative shapes of the PPFs differ between
  • Demand conditions differ.
  • Some combination of these two differences.

  • While trade can be driven by differences in
    demand, most of our attention is on
    production-side differences. Production-side
    differences cause the countries PPFs to skew in
    different ways, reflecting different comparative
  • Sources of production-side differences
  • differences in technologies or factor
  • differences in factor endowments and differences
    across products in the use of productive factors
    in producing the products.

Leading theories of trade
  • Chapter 2
  • Mercantilism (gold and silver).
  • Adam Smiths theory (absolute advantage).
  • David Ricardos theory (comparative advantage).
  • The standard modern theory of trade (increasing
    marginal costs).
  • Chapter 3
  • 5. The Heckscher-Ohlin theory (factor endowment

Leading theories of trade (cont.)
  • 6. Product life-cycle theory (dynamic theory of
    technology and trade).
  • 7. Stolper-Samuelson Theorem
  • 8. New trade theory (scale economies)
  • - monopolistic competition product
  • - substantial internal scale economies and
    global oligopoly
  • - external scale economies (industries that
    concentrate in a few places).
  • 9. Gravity model of trade (a countrys size,
    distance between countries, impediments to trade).

1. Mercantilism
Mercantilism Older than Smith and Alive Today
  • Mercantilism was the philosophy that guided
    European thinking about international trade in
    the several centuries before Adam Smith published
    his Wealth of Nations in 1776.

  • Mercantilists viewed international trade as a
    source of major benefits to a nation.
  • Merchants engaged in trade, especially those
    selling exports, were good hence the name
  • A central belief of mercantilism was that
    national well-being or wealth was based on
    national holdings of gold and silver.
  • Given this view of national wealth, exports were
    viewed as good and imports (except for raw
    materials not produced at home) were seen as bad.

  • If a country exports more than imports, the gain
    in gold and silver increases the countrys
  • Also, gold and silver accruing could be
    especially valuable in maintaining a large
    military for the country.
  • Imports are undesirable because they reduce the
    countrys ability to accumulate gold and silver.
  • In addition, imports were feared because they
    might not be available to the country in time of

  • Mercantilists maintained that government
    regulation of trade was necessary to provide the
    largest national benefits.
  • Based on mercantilist thinking, governments, (1)
    imposed an array of taxes and prohibitions to
    limit imports and (2) subsidized and encouraged

A zero-sum game
  • Because of its peculiar emphasis on gold and
    silver, mercantilism viewed trade as a zero-sum
    activity one countrys gains come at the
    expense of some countries, since a surplus in
    international trade for one country must be a
    deficit for some other(s).

  • Before Adam Smith, David Hume showed that the
    goal of acquiring gold and silver can be
    self-defeating if this acquisition expands the
    domestic money supply and leads to domestic
    inflation of product prices.
  • Adam Smith and economists after him pointed out
    that mercantilist thinking turns social
    priorities upside down (will be discussed later
    see slides 26-28).

Still alive
  • Mercantilist thinking is very much alive today.
    It now has a sharp focus on employment.
    Neo-mercantilists believe that exports are good
    because they create jobs in the country, and
    imports are bad because they take jobs from the
    country. Neo-mercantilists continue to depict
    trade as a zero-sum activity.

  • In the late 18th and early 19th centuries, first
    Adam Smith and then David Ricardo explored the
    basis for international trade as part of their
    efforts to make a case for international trade.
    Their writings were responses to the doctrine of
    mercantilism prevailing at the time.

2. Adam Smiths theory of absolute advantage
  • In his Wealth of Nations, Adam Smith promoted
    free trade by comparing nations to households
  • It is the maxim of every prudent master of a
    family, never to attempt to make at home what it
    will cost more to make than to buy. The tailor
    does not attempt to make his own shoes, but buys
    them from the shoemaker
  • Hence, every country should produce a specific
    product if this country is better than the rest
    of the world at producing this product.

  • What do we mean by better at producing?
  • We can indicate each countrys ability to produce
    a product as (i) labor productivity, that is, the
    number of units of output per hour or (ii) the
    number of hours it takes a worker to produce one
    unit of output.
  • Country with a higher labor productivity is said
    to have an absolute advantage in producing the

  • Adam Smith showed the benefits from free trade by
    showing that global production efficiency is
    enhanced because trade allows each country to
    exploit its absolute advantage.
  • At least one country is better off with trade
    (not at the expense of the other country) in
    many cases both countries will gain from trade.

In-class exercise
  • Exercise 1 (handout).

  • Yet Smiths arguments failed to address the
    following fears What if a country has no
    absolute advantage? What if the foreigners are
    better off at producing everything than we are?
    Will they want to trade? If they do, should we
    want to?
  • We turn next to the theory that first answered
    these fears and established a fundamental
    principle of international trade.

3. David Ricardos theory of comparative advantage
  • David Ricardos main contribution to our
    understanding of international trade was to show
    that there is a basis for beneficial trade
    whether or not countries have any absolute
  • Ricardo carefully examined the concept of
    opportunity cost and demonstrated the principle
    of comparative (meaning relative and not
    necessarily absolute) advantage.

In-class exercise
  • Exercise 2 (handout)

Key points that refute mercantilist thinking
  • 1. National well-being is based on the ability to
    consume products now and in the future. Imports
    are part of the expanding national consumption
    that a nation seeks, not an evil to be suppressed.

Key points that refute mercantilist thinking
  • 2. The importance of national production and
    exports is only indirect. They provide the income
    to buy products to consume. Exports are not
    desirable on their own rather, exports are
    useful because they pay for imports.

Key points that refute mercantilist thinking
  • 3. Trade freely transacted between countries
    generally leads to gains for all countries
    trade is a positive-sum activity.

In-class exercise
  • Exercise 3 (handout) Comparative Advantage
    Extended to Many Products and Countries

  • Criticism Simple theories of trade rely on
    a set of many unrealistic assumptions (see p.
    32). Among others
  • A simple world in which there are only two
    countries and two goods.
  • In each nation, labor is the only input, fixed
    and homogeneous.
  • Labor can move freely from the production of one
    good to another good within a country, but cannot
    move between nations.
  • The level of technology is fixed for both nations.

  • 5. Costs do not vary with the level of production
    and are proportional to the amount of labor used
    (that is, constant returns to scale). In reality,
    both diminishing and increasing returns to
    specialization exist.

4. The standard modern theory of trade (based on
increasing marginal costs)
  • This extension of the Ricardian model relaxes
    assumption 3 and 5 (on page 32).
  • The standard theories of trade (that is, Smith
    and Ricardo) assume constant returns to scale
    (CRS). With CRS, average cost does not change
    when the quantity of output changes, assuming
    both adjustments of all factor inputs and
    constant factor input prices.

  • In reality, however, many industries incur
    rising, rather than constant, marginal
    opportunity costs.
  • Reasons
  • (1) Resources are specialized, of different
    quality, and do not always move easily from one
    economic activity to another.
  • (2) Different goods use resources in different

  • For instance, efforts to expand U.S. wheat
    production would fairly quickly run into rising
    costs caused by limits on
  • (1) how much more land could be drawn into
    wheat production and how suitable this additional
    land would be for wheat production
  • (2) the availability of additional workers
    willing and suitable to work on the farms
  • (3) the availability of seeds, fertilizers,
    and other material inputs.

  • Hence, as one industry expands at the expense of
    others, increasing amounts of the other products
    must be given up to get each extra unit of the
    expanding industrys product.
  • Increasing marginal costs are illustrated by a
    bowed-out PPF.

The PPF with increasing opportunity costs /
diminishing returns
  • The PPF tells us how much of one good we must
    sacrifice in order to make available the
    resources to produce one more of the other good.

In-class exercise
  • Exercise 4 (handout) Example with a non-linear

  • The standard modern theory of trade shows that it
    is not feasible for a country to specialize to
    the degree suggested by the simple trade
    theories. The gains from specialization are
    likely to be exhausted before specialization is
    complete. In reality, most countries do not
    specialize but, instead, produce a range of
  • The basic conclusion that unrestricted free trade
    is beneficial still holds, although the gains may
    not be as great as suggested in the constant
    returns case.

  • Comparative-advantage theory of trade focuses on
    technology or resource productivity differences
    as a production-side basis for trade /
    comparative advantage.
  • According to comparative-advantage theory,
    nations that are similar in their production-side
    capabilities (and in their general demand
    patterns) should trade little with each other.
  • In reality, we observe the opposite.

  • Industrialized countries (which are similar in
    many aspects in their technologies, technological
    capabilities, and factor endowment) trade
    extensively with each other.
  • Trade between industrialized countries is nearly
    half of all world trade.
  • Over 70 of the exports of industrialized
    countries go to other industrialized countries,
    and about 4/5 of these exports are nonfood
    manufactured products.
  • These facts appear to be inconsistent with
    comparative-advantage theory.

  • Furthermore, technology quickly spreads
    internationally because it is difficult for a
    country to keep its technology secret. Hence,
    many countries usually have access to the same
    technologies for production and are capable of
    achieving similar levels of resource
  • We turn next to the theory that focuses on
    another important source of production-side
    differences (that is, international differences
    in the shapes of bowed-out PPFs).
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