Global Economics

Eco 6367
Dr. Vera Adamchik

Chapter 2

Foundations of
Modern Trade
Theory:
Comparative
Advantage
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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 wellbeing of each country?
How does trade affect the distribution of
economic well-being or income among
various groups within the country?
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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 markets.

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 countries.
Demand conditions differ.
Some combination of these two differences.
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 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 advantages.
Sources of production-side differences:
differences in technologies or factor
productivities;
differences in factor endowments and
differences across products in the use of
productive factors in producing the products.
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Leading theories of trade

Chapter 2:
1. Mercantilism (gold and silver).
2. Adam Smiths theory (absolute advantage).
3. David Ricardos theory (comparative
advantage).
4. The standard modern theory of trade (increasing
marginal costs).
Chapter 3:
5. The Heckscher-Ohlin theory (factor endowment
& factor-use).
6

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 differentiation;
- 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).
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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 mercantilism.
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.
10

 If a country exports more than imports, the

gain in gold and silver increases the
countrys well-being.
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 war.
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 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 exports.

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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).

13

Criticism
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).
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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. Neomercantilists continue to depict trade as a
zero-sum activity.
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 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.

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2. Adam Smiths theory of

absolute advantage

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 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.
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 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 good.
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 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.
20

In-class exercise
Exercise # 1 (handout).

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Criticism
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.
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3. David Ricardos theory of

comparative advantage

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 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 advantage.
Ricardo carefully examined the concept of
opportunity cost and demonstrated the
principle of comparative (meaning
relative and not necessarily absolute)
advantage.
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In-class exercise
Exercise # 2 (handout)

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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.

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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.

27

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.

28

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

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1.
2.
3.

4.

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.
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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.

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4. The standard modern theory of

trade (based on increasing
marginal costs)

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 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.
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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 proportions.
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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.
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 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.

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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.

Food
400
350
300
200
100
PPF

100

200 300 350 400

Clothing

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In-class exercise
Exercise # 4 (handout): Example with a
non-linear PPF.

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 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 goods.
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.

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Criticism
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 productionside capabilities (and in their general demand
patterns) should trade little with each other.
In reality, we observe the opposite.
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 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.

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 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 productivity.
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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