International Economics Dr Doaa Akl Ahmed MSc and PhD in Economics University of Leicester - England

Chapter 2 THE LAW OF COMPARATIVE ADVANTAGE

Theory of international trade Lecture outcomes: 1. What is the basis for trade and what are the gains from trade? 2. How the gains from trade are generated and how these gains are divided among the trading nations? 3. What is the pattern of trade (which commodities are traded as exports and imports by a nation)?. The lecture covers: 2.2. The mercantilists views on trade Theory of Absolute advantage: Adam Smith 2.4. Theory of comparative advantage : the David Ricardo 2.5. Comparative advantage and opportunity cost.

2.2. The mercantilists views on trade During the seventeenth and eighteenth centuries, a group of bankers, merchants, government officials and philosophers) wrote essays about their thoughts of international trade. A nation should export more than its imports. The resulting export surplus will be stored as bullion of precious metal basically gold and silver. A government should do its best to encourage exports and restrict imports. All nations cannot simultaneously have an export surplus and the amount of gold and silver is fixed at any point of time, one nation can only gain from trade at the expense of other nations. Having exports surplus means more money in circulation and higher business activity which lead to raise national output and increase employment. These days, as nations suffer from higher levels of unemployment, they attempt to limit imports to stimulate domestic production and employment.

The mercantilists views on trade The mercantilists measured the wealth of a nation by the stock of precious metals it owned. This can be understood because the mercantilists were writing primarily for rulers and to enhance national power. With more gold, rulers could maintain larger and better armies and strengthen their power at home and get more colonies. In addition, more gold meant more money in circulation and greater business activity. By encouraging exports and restricting imports, the government would increase national output and raise employment. Today, we measure the wealth of nations by its stock of human, man-made, and natural resources available for producing goods and services. The greater the stock of useful resources, the greater the flow of goods and services to satisfy human wants and the higher the standard level of living in the nation.

The mercantilists views on trade Limitations of The mercantilists views on trade: 1. Trade surplus could be achieved in the short-run only and vanishes in the long run. As the exported surplus will increase the money in circulation, this should result in: Increasing spending increasing production increasing national income increasing imports (as the imports is positively related to national income) Increasing demands for goods and services increasing prices of locally produced goods and services decreasing exports. 2. It is not necessary that the gains of any country should be at the expense of other countries. International trade encourage specialization and division of labour, then these benefits could be shared between trade partners. Increasing imports +decreasing exports = cancellation of the export surplus

2.3. Trade based on Absolute Advantage: Adam Smith Trade between two countries is based on absolute advantage. When any country is more efficient in the production of one commodity, and the other country is more efficient in the production of the other commodity, then both countries can gain from specialization and trade. Thus, each of them will specialise in producing the good with absolute advantage and then they exchange part of the output with other nations with absolute disadvantage in producing these goods. In contrast with mercantilists views, all nations would gain from free trade (advocates laissez-faire policy excluding the protection of industries important to national defense)

2.3. Trade based on Absolute Advantage: Adam Smith Assumptions: 1.For a variety of reasons, including difference in technology and climate, countries differ in their ability to produce various commodities. 2.There are only two countries A and B and only two commodities wheat and cloth. 3.Perfect competition. 4.The theory depends on the labour theory of value (i.e., factor is the only factor of production or is used in the same proportion in the production of all commodities, and labour units are homogenous. 5.Labour is mobile inside the country and immobile between countries. 6.No barriers to trade between countries. 7.Constant return to scale between labour and output. 8.Each country could produce one commodity at a lower real cost than the other country.

Trade based on Absolute Advantage: Adam Smith CountryUSAUK wheat61 cloth45

Trade based on Absolute Advantage: Adam Smith countrywheatcloth USA1812 UK315 world21W27C

Trade based on Absolute Advantage: Adam Smith World production in the presence of trade (6 HOURs): countrywheatcloth USA UK world36W30C

Trade based on Absolute Advantage: Adam Smith Shortcomings of the theory of absolute advantage: 1.The theory focuses on the supply side and ignore the demand side. 2.The theory considered the labour as the only relevant factor of production. However, Labour is only one factor combined with other factors of production to produce the commodity. Labour does not enter the production of the two commodities with a constant ratio Labour units are not considered standardised. 3. The theory failed to explain the situation in which one country has an absolute advantage over the two commodities.