Why nations trade

The principle of comparative advantage

  Nations trade with each other for fundamentally the
same reason that individuals or regions engage in the
exchange of goods and services: to obtain the benefits
of specialization.
introduction  Since nations, like individuals, are not equally suited to
produce all goods, all countries would benefit if each
specializes in what it could do best and obtained its
other needs through exchange.
 European
writers during
1500 – 1800.

They emphasized Static view of trade – world’s wealth

the zero-sum was fixed. Believed favorable trade
aspect of economic balance promoted a nation’s best
Mercantilist: development and
trade.
interests ( a surplus of exports over
imports)
Who were
they?

Thus, a nation would
receive net gain in
gold and silver
To promote favorable
trade balance,
mercantilists advocated
government regulation of
trade (tariffs or taxes,
import and export quotas)
Critics to the
mercantilists
 • Adam Smith believed free trade promoted the
international division of labor
◦ free trade – a system of open markets between
countries in which nations concentrate their
Why nations production on goods they can make most cheaply
◦ Labor is the only factor of production
trade?
• Cost differences govern the international movement
of goods
◦ What a country supplies: Climate, soil, mineral
wealth, special skills and techniques
  When a nation is more efficient than (or has an absolute
advantage over) another in the production of one
commodity, but is less efficient than (or has an absolute
disadvantage with respect to) the other nation introducing a
second commodity, then both nations can gain by each
Adam Smith specializing in the production of the commodity of its
absolute advantage, and exchanging part of its output with
and the the other nation for the commodity of its absolute
Absolute disadvantage.

Advantage
 Table 1 In 6 hours of work:

Exchange of US 6W for UK 6C.

 One hour of labor in the UK
and one hour of labor in the US gains 2C or saves 30 min
US produce labor time.
UK gains 24C or saves almost 5
Absolute hrs. labor time.
Advantage
 Most Basis for
important mutual
and law of beneficial
inter econ. trade:

Law of An individual has a

Comparative CA in producing a
Advantage good or opportunity
cost of producing
this is lower for that
individual than for
other people.
 A model of two
countries (the US and
the UK) Each country
produces two
commodities: wheat
and textiles

Law of
Comparative One factor of
production: Transport costs are

Advantage homogenous labor.

The value of each
product is determined
exclusively by its labor
also assumed not to
exist. Technology is
presumed to remain
constant
content

Goods move freely

between the two
countries, but labor is
mobile only
domestically
  Table 2: One hour of labor in the UK and one hour of labor in the US
produce the following:

Law of
Comparative
Advantage US has an absolute advantage in both goods. However, its absolute
advantage is greater in wheat (6:1) than in cloth (4:2).
So the US has comparative advantage in wheat.
Opportunity cost of producing wheat is greater for the UK than for the
US.
Opportunity cost of producing cloth is greater in the US than for the
UK.
  To show the gains of trade, lets assume that the US exchanges
6W for 6C from the UK.
 The US would gain 2C (save 30 minutes labor time).
 Suppose that UK receives 6W from the US, to produce this the UK
would have required 6 hours labor time.

Gains from  The UK could use this 6 hours to produce 12C and give up only 6C
for 6W from the US, and save 3 hour labor time from the
Trade production of wheat.
 The US will always gain from trade as long as the exchange of 6W
is higher than 4C.
 The UK will always gain from trade as long as the exchange of 2C
is higher than 1W or at least no less than 1W.
  How can any country with absolute disadvantage can export anything
to the world?
 The answer is that wages in the disadvantageous country must be
sufficiently lower than wages in the other country.
 Suppose that the wage rate in the US is &6 per hour. Since one hour
produces 6W in the US, the price of a bushel of wheat is Pw= $1.
Comparative  Additionally, since one hour produces 4C in the US, Pc=&1.50 (from
$6/4C).
Advantage  The wage rate in England is £1 per hour. Since one hour produces 1W
with Money in the UK, the Pw=£1.
 Similarly, since one hour produces 2C, Pc=£0.50.
 If the exchange rate between the dollar and the pound is £1 = $2, then
Pw= £1 =$2. And Pc=£0.50 = $1.
 It means that the price of wheat is lower in the US compared with the
UK. On the other hand, the dollar price of cloth is lower in the UK
thank in the US:
  The opportunity cost of wheat is equal to the amount of cloth that
the nation must give up to release enough resources to produce
one additional unit of wheat.
 This is given by the absolute slope of the production possibility
frontier, or the transformation curve: marginal rate of
transformation
Opportunity
Cost
Production
Possibility
Frontier and
Opportunity The opportunity cost of one unit of Wheat in the US is 1W = 2/3C
Costs (120/180 = 2/3)
FOR EACH ADDITIONAL 1W TO BE PRODUCE THE US MUST
GIVE UP 2/3 OF CLOTH
On the other hand, the opportunity cost of wheat in the UK is 1W =
2C (120/60 = 2)
FOR EACH ADDITIONAL 1W TO BE PRODUCE, THE UK MUST
GIVE UP 2 CLOTH.
 In the absence of trade, the US and the UK might choose to
produce and consume any combination of the table. Let´s
assume that they both decide combination A (US = 90W and
60C and the UK = 40W and 40C)

With trade, the US specializes in the production of Wheat and

produce at point B (180W and 0C).

Gains from Similarly, the UK would specialize in Cloth and produce in

point B´(0W and 120C).
Trade
US exchanges 70W for 70C from the UK. Consumption is as
follows

The US 110W and 70C. The UK 70W and 50C. The US gains
20W and 10C, and the UK gains 30W and 10C
Gains from
Trade
The end