Chapter 2

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Key Terms
Basis for trade The forces that give rise to trade between two nations. This was absolute advantage according to Adam Smith and comparative advantage according to David Ricardo Gains from trade The increase in consumption in each nation resulting from specialization in production and trading. Pattern of trade The commodities exported and imported by each nation. Mercantilism The body of writings prevailing during the seventeenth and eighteenth centuries that postulated that the way for a nation to become richer was to restrict imports and stimulate exports. Thus, one nation could gain only at the expense of other nations. Absolute advantage The greater efficiency that one nation may have over another in the production of a commodity. This was the basis for trade for Adam Smith. Laissez-faire The policy of minimum government interference in or regulation of economic activity, advocated by Adam Smith and other classical economists. Law of comparative advantage Explains how mutually beneficial trade can take place even when one nation is less efficient than, or has an absolute disadvantage with respect to, another nation in the production of all commodities. The less efficient nation should specialize in and export the commodity in which its absolute disadvantage is smaller (this is the commodity of its comparative advantage), and should import the other commodity. Labor theory of value The theory that the cost or price of a commodity is determined by or can be inferred exclusively from its labor content. Opportunity cost theory
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The theory that 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 more unit of the first commodity. Production possibility frontier A curve showing the various alternative combinations of two commodities that a nation can produce by fully utilizing of its resources with the best technology available to it. Constant opportunity costs The constant amount of a commodity that must be given up to produce each additional unit of another commodity. Relative commodity prices The price of one commodity divided by the price of another commodity. This equals the opportunity cost of the first commodity and is given by the absolute slope of the production possibility frontier. Complete specialization The utilization of all of a nations resources in the production of only one commodity with trade. This usually occurs under constant costs. Small-country case This situation where trade takes place at the pretrade-relative commodity prices in the large nation so that the small nation receives all of the benefits from trade. Summary 1This chapter examined the development of trade theory from the mercantilists to Smith, and Haberler and sought to answer two basic questions: (a) What is the basis for and what are the gains from trade? and (b) What is the pattern of trade? 2The mercantilists believed that a nation could gain in international trade only at the expense of other nations. As a result, they advocated restrictions on imports, incentives for exports, and strict government regulation of all economic activities. 3According to Adam Smith, trade is based on absolute advantage and benefits both nations. (The discussion assumes a two-nation, two-commodity world.) That is, when each nation specializes in the production of the commodity of its absolute advantage and exchanges part of its output for the commodity of its absolute disadvantage, both nation end up consuming more of both commodities. Absolute advantage, both
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nations end up consuming more of both commodities. Absolute advantage, however, explains only a small portion of international trade today. 4David Richard introduced the law of comparative advantage. This postulates that 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 (as long as the absolute disadvantage that the first nation has with respect to the second is not in the same proportion in both commodities). The less efficient nation should specialize in the production and export of the commodity in which its absolute disadvantage is less. (This is the commodity of its comparative advantage in terms of the labor theory of value, which is unacceptable. 5Gottfried Haberler came to the rescue by explaining the law of comparative advantage in terms of the opportunity cost theory. This states that the cost of a commodity is the amount of a second commodity that must be given up to release just enough resource to produce one additional unit of the first commodity. The opportunity cost of a commodity and is given by the (absolute) slope of the production possibility frontier. A straight-line production possibility frontier reflects constant opportunity costs. 6In the absence of trade, a nations 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 nation 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. 7 first empirical test of the Ricardian trade model was conducted by MacDougall The in 1951 and 1952 using 1937 data. The results indicated that those industries where labor productivity was relatively higher in the United States than in the United Kingdom were the industries with higher ratios of U.S. to U.K. exports to third markets. These results were confirmed by Balassa using1950 data, Stern using 1950 and 1959 data, Golub using 1990 data, and Golub and Hsieh using 1972-1991 data. Thus, it can be seen that comparative advantage seems to be based on a difference in labor productivity or costs, as postulated by Ricardo. However, the Ricardian model explains neither the reason for the difference in labor productivity or costs across
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nations nor the effect of international trade on the earnings of factors.

1. 2. 3. 4. 5. 6.==PPF

Questions for Review

1 1The basic questions that we seek to answer in this chapter are:What is the basis for trade and what are the gains from trade? What is the pattern of trade? 2 The model presented in this chapter is a simplification of the real word because the discussion in this chapter refer to only two nations and two commodities.The model can be generalized.We can extend the theory of comparative advantage first to the case of more than two commodities and then to the case of more than two nations.In each case,we will see that the theory of comparative advantage is easily generalized.

2 mercantilists maintained that the way for a nation to become rich and powerful The
was to export more than it imported.They believed the government had to do all in its power to stimulate the nations exports and discourge and restrict imports. The mercantilists measured the wealth of a nation by the stock of precious metals it possessed.In contrast,today we measure the wealth of a nation by its stock of human,man-made,and natural resources available for producing goods and services.

3It is important to study the mercantilists views on trade for two reasons.First,the
idea of Adam Smith,David Ricardo,and other classical economists can best be understood if they are regarded as reations to the mercantilistsviews on trade and on the role of the government.Second,today there seems to be a resurgence of neomercantilism,as nations plagued by high levels of unemployment seek to restrict imports in an effort to stimulate domestic production and employment.
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While the mercantilists believed that one nation could gain only at the expense of another nation and advocated strict government control of all economic activity and trade,Adam Smith believed that all nations would gain from free trade and strongly advocated a policy of laissez-faire. The relevance of all this is mercantilism is alive and well in the twenty-first century.

4 According to Adam Smith,trade between two nations is based o absolute

advantage.The pattern of trade is each nation produces only that commodity that he can produce most efficiently and then exchanges part of his out for the other commodities he needs or wants.That is ,a nation will export the commodity of its absolute advantage and import the commodity of its absolute disadvantage. By international trade,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 trade. Adam Smith believed that all nations would strongly advocated a policy of laissez-faire.He think the government should interfere the economic as little as possible.

5Absolute advantage,however,can explain only a very small part of world trade

today,such as some of the trade between developed and developing countries.The law of comparative advantage can explain most of world trade,especially trade among developed countries,but absolute advantage can not. Each nation can gain by specializing in the production of and exporting the commodity of its comparative advantage and importing the commodity of ies comparative disadvantage. A nation that is less efficient than another nation in the production of all commodities should specialize in the production of and export the commodity in which its absolute advantage is smaller and import the commodity in which its absolute disadvantage is greater.

6When the absolute disadvantage that one nation has with respect to another nation
is the same in both commodities,the exception to the law of comparative advantage occurs.In this situation,both nations would then have a comparative 10.advantage in neither commodity,and no mutually beneficial trade can take place.The exception is not very common. Its occurrence is rare. 7.Ricardo explained the law of comparative in terms of the labor theory of value, which is unacceptable. Under the labor theory of value, the value of a commodity depends exclusively on the amount of labor going into the production of the commodity. But in fact, labor is not only factor of production ,nor is it used in the same fixed proportion in the production of all commodities. In addition, labor is obviously not homogeneous but varies greatly in training, productivity, and wages. We cannot base the explanation of comparative advantage on the labor theory of value
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because of its untruthful assumption. But we can explain it on the basis of the opportunity cost theory. 8. The opportunity cost of a commodity is the amount of a second commodity that must be given up to release just enough resources to produce one more unit of the first commodity. It is given by the (absolute) slop of the production possibility frontier.

Under the constant opportunity costs,the production possibility frontier is a downward, or negative ly sloped straight line. The opportunity costs of a commodity equals to the relative price of that commodity. this can be shown in the figure above. The figure above shows that the slope of production possibility frontier in US is 120/180=2/3=opportunity cost of wheat and remains constant. On the assumption that prices equal costs of production and that the nation does produce both some wheat and some cloth , the opportunity cost of wheat is equal to the price of wheat relative to the price of cloth.

In the figure above, the slope of the U.S. transformation curve is 120/180=2/3=opportunity cost of a commodity and remains constant. On the assumption that prices equal costs of production and that the nation does produce two commodities, the opportunity cost is equal to the price of one commodity relative to the price of another commodity. 9. In the absence of trade, a nation can only consume the commodities that it produces. As a result, the nations production possibility frontier also represents its consumption frontier. Which combination of commodities the nation actually chooses to produce and consume depends on the peoples tastes, or demand considerations. 10. Complete specialization means that the utilization of all of a nations resources in the production of only one commodity with trade. This usually occurs under constant costs. Incomplete specialization is that the continued production of both commodities in both nations with increasing costs, even in a small nation with trade. Under constant costs, both nations specialize completely in production of the commodity of their comparative advantage and exchange part of the commodity of its
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comparative disadvantage. By so doing, both nations end up consuming more of both commodities than without tarde. That is to say, both nations gain from trade with complete specialization. However, under increasing opportunity costs, there is incomplete specialization in production in both nations. Thus, as each nation specializes in producing the commodity of its comparative advantage, relative commodity prices move toward each other until they are identical in both nations. Because the small nation doesnt affect relative prices in the large nation, the small nation captures all the benefits from trade.

Pw/Pc

Pc/Pw

11 . The combined supply curve of both nations for each of the traded commodities is the combined supply curve of the commodity in both nations when both countries use all of their resources to produce only this commodity. The demand curve of one commodity interscets the supply curve of that commodity, determing the equilibrium-relative price with trade. This can be shown with a figure. As shown in the figure below, Dw(us+uk) intersected Sw(us+uk) at point E, determing the quilibrium-relative price of Pw/Pc=1 with trade.

12. The first empirical test of Ricardian trade model was conducted by MacDougall in 1951 and 1952 using 1937 data. The results indicated that those industries where labor productivity was relatively higher in the United States than in the United Kingdom were the industries with the higher ratios of U.S. to U.K. exports to third markets. These results were confirmed by Balassa using 1950 data , Stern using 1950 and 1959 data , Golub using 1990 data .and Golub and Hsieh using 19721991 data. Thus, it can be seen that comparative advantage seems to be bases on a difference in labor productivity or costs, as postulated by Ricardo. But it has a serious shortcoming in that it assumes rather than explains comparative advantage. The Ricardian model explains neither the reason for the difference in labor productivity or costs across nations nor the effect of international trade on the earning of factors. Problems: 1 In case A, the United States has an absolute advantage in wheat while the United Kingdom has an absolute advantage in cloth.
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In case B, the United States has an absolute advantage in both wheat and cloth. In case C, the United States has an absolute advantage in wheat while neither the United States nor the United Kingdom has an absolute advantage in cloth. In case D, the United States has an absolute advantage in both wheat and cloth. 2 In caseA, the United States has a comparative advantage in wheat and the United Kingdom has a comparative advantage in cloth. In case B, the United States has a comparative advantage in wheat and the United Kingdom has a comparative advantage in cloth. In caseC, the United States has a comparative advantage in wheat and the United Kingdom has a comparative advantage in cloth. In case D, the United States and the United Kingdom have a comparative advantage in neither commdity because the absolute advantage that United Kingdom has with respect to another nation is the same in both commodities. 3. According to the law of comparative advantage, 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 (as long as the absolute disadvantage that the first nation has with respect to the second is not in the same proportion in both commodities). The less efficient nation should specialize in the production and export of the commodity in which its absolute disadvantage is less. In case A, trade is possible since the United States has a comparative advantage in wheat while the United Kingdom has a comparative advantage in cloth. In case B, trade is also possible because the United States has a comparative advantage in wheat and the United Kingdom has a comparative advantage in cloth. In caseC, trade is also possible because the United States has a comparative advantage in wheat while the United Kingdom has a comparative advantage in cloth. In case D, trade is not possible since the United States and the United Kingdom have a comparative advantage in neither commdity as the absolute advantage that United Kingdom has with respect to another nation is the same in both commodities.

4a. The United States gains 1C. b. The United Kingdom gains 4C. c. The range for mutually beneficial trade is 3C<4W<8C. d. If they exchanged 4W for 6C,the United States would gain 3C while the United Kingdom would gain 2C. 5 In the United States, the cost in terms of labor content of wheat is 3/4 of a unit of a cloth and the cost of cloth is 4/3 of a unit of wheat. In the United Kingdom, the cost of wheat is 2 unit of cloth and the cost of cloth is 1/2 of a unit of wheat. bIf the wage rate is $6, the dollar price of wheat in the United States is Pw=$1.5, and the price of cloth is Pc=$2.
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c the wage rate is 1,the pound price of wheat in the United Kingdom is Pw=1, If and the price of cloth is Pc=0.5 . 6 aThe dollar prices of wheat and cloth in the United Kingdom are Pw=$2, Pc=$1 if the exchange rate is 1=$2. Since the dollar price of wheat is lower in the United States(Pw=$1.5)than in the United Kingdom(Pw=$2), the United States is able to export wheat to the United Kingdom at this exchange rate. Smilarly, the dollar price of cloth is lower in the United Kingdom(Pw=$1) than in the United States(Pw=$2), the United Kingdom is able to export cloth to the United States. bIf the exchange rate is 1=$4, the dollar price of wheat is lower in the United States(Pw=$1.5)than in the United Kingdom(Pw=$4), the United States is able to export wheat to the United Kingdom. But the dollar price of cloth in the United States (Pw=$2) is the same as in the United Kingdom(Pw=$2), so the United Kingdom is not able to export cloth to the United States. cIf the exchange rate is 1=$1, both the dollar price of wheat and cloth in the United Kingdom (Pw=$1, Pc=$0.5) are lower than in the United States(Pw=$1.5, Pc=$2), as a result, the United States is not able to export wheat or cloth to the United Kingdom while the United Kingdom is able to export wheat and cloth to the United States. d. The range of exchange rates is $1.5<1<$4. 7 .

The United States 4 6 cloth 2

The United Kingdom

cloth 3 0

Wheat

Wheat

The production frontiers of the United States and the United Kingdom a. The production frontiers of the United States and the United Kingdom are as shown above. bThe relative price of wheat is Pw/Pc=3/4 in the United States and Pw/Pc=2 in the United Kingdom. cThe relative price of cloth is Pc/Pw=4/3 in the United States and Pc/Pw=1/2 in the United Kingdom.
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8.
Cloth Cloth United States 3 2 1 0 1 2 3 E A 2 1 B 4 Wheat 0 B` A` E` 3 U.K.

Wheat

In the absence of trade , the US produces and consumes at A, and the UK produces and consumes at A' . With trade, the US specializes in the production of wheat and produces at B, while the UK specializes in the production of cloth and produces at B'. By exchanging 1W for 1C with the UK, the US ends up consuming at E and gains 1/4C, while the UK ends up consuming at E' and gains 1/2W.

9.

As shown in the figure above, if Dw(us+uk) shifted up by one-third in the left panel of Figure 2.3 , the Dw(us+uk) intersects Sw(us+uk) at point E0 , resulting the equilibrium-relative commodity price of wheat changes from Pw/Pc=1 to Pw/Pc=4/3. So the US produces 180W and 0C, while the UK produces 0W and 120C . The answer to part(a) implies the equilibrium-relative commodity price of proportionately changes from Pc/Pw=1 to Pc/Pw=3/4, so the Dc(uk+us) in the right panel of the Figure2.3 would shift down by one quarter and intersects Sw(uk+us) at point E0'

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10. If Dw(us+uk) at Pw/Pc=2/3 and 120W in the left panel of Figure 2.3, this would mean that the US would not be specializing completely in the production of wheat. The UK , on the other hand ,would be specializing completely in the production of cloth and exchanging 20C for 30W with the US. Since the UK trades at the US pretrade-relative commodity price of Pw/Pc=2/3, the UK receives all of the gains from trade. 11

Cloth

Cloth

US

UK

The figure above shows that the United Kingdom is half the size shown in the right panel of Figure 2.2, and trades with the United States at Pw/Pc=2/3. The UK has a comparative advantage in cloth , so the UK specializes in cloth and produces at point B'(0W, 60C). Without trade, the UK produces and consumes at point A'(20W,20C), By exchanging 20C for 30W, the UK consumes at pointE' (30W,40C) and gains 10W and 20C. However, the US gains nothing. That means the UK will get all the benefit from the trade. Wheat Wheat

12.(a) The empirical test of the Ricardian trade was conducted by Macdougall in 1951 and 1952 using 1937 data. (b) The results indicated that those industrial where labour productivity was relatively higher in the United States than in the United Kingdom were the industries with the higher ratios of US to UK exports to third markets .These results were confirmed by Balassa using 1950 data,Stern using 1950 and 1959 data , Golub using 1990 data, and Golub and Hsieh using 1972-1991 data.Thus ,it can be seen that comparative advantage seems to be based on a difference in labour productivity or costs, as postulated by Ricardo.

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(c) Even though the simple Ricardian trade model has to a large extent been empirically verified, it has a serious shortcoming in that it assumes rather than explains comparative advantage.That is ,Ricardo and classical economists in general provided no explanation for the difference in labour productivity and comparative advantage between nations ,and they could not say much about the effect of international trade on the earnings of factors of production. So we need other trade models . 13. It is known that international trade is quite important to the nation's standard of living. However,the increase in imports of textile may reduce the employment and wages of the workers in those sectors.Trade restrictions are advocated by the few industries and their workers who are hurt by imports . Free trade would cause world resources to be utilized most efficiently and would maximize world welfare. As such, trade restrictions benefit the few at the expense of the many (who will have to pay higher prices for competing domestic goods). In a word ,it's not wisdom to restrict the textile imports in order to save American jobs.

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