International Trade :Basis and Gains from Trade

Mercantilists Views on TradeAbsolute Advantage

Law of comparative Advantage

Mercantilists Views on Trade

• Writings of mercantilists on I.T preceded the wealth of nations of Adam Smith in 1776.

• A group of men: merchants, bankers, govt. officials and philosophers advocated an economic philosophy known MERCANTILISM: the way for a nation to become rich was through higher exports and less imports.

• Surplus earnings from higher exports would bring in more bullion and or other precious metals making the nation with higher exports richer and stronger.

• However all nations could not simultaneously practice this policy: “Encourage exports and restrict imports”.

• The Mercantilists philosophy encouraged economic nationalism.

• Mercantilists measured the wealth of a nation by its stock of precious metals, in contrast to current approach based on stock of human, man made and natural resources for producing goods and services.

• Higher exports, more precious metals meant higher national output and greater employment opportunities.

• Mercantilists favored strict govt. control of economic activity and economic nationalism.

• Believed a nation could gain in trade only at the expense of other nation i.e. trade a zero sum game.

Theory of Absolute Advantage

• Adam Smith: For two nations to trade with each other both must gain. How does this mutually beneficial trade take place?

• Trade between two nations based on absolute advantage. When one nation was more efficient than the other in production of one commodity but less in case of another good.

• In such a situation both nations can gain by each specialization in production of the commodity of its absolute advantage and exchanging its surplus with the other nation for the commodity of its absolute advantage.

Absolute Advantage

• By specialization output of both commodities will expand.

• Gains from specialization in production will be available for distribution through trade between the two nations.

• Based on hypothetical data, table on next slide shows the quantity of two goods A and B produced per man day in country 1 and country 2.

• Indicate the absolute advantage for each of the commodity/ country!

Absolute AdvantageProduction/ m. day Country 1 Country 2

Units of wheat 6 1

Units of corn 4 5

Comparative Advantage

• 1817- David Ricardo published his Principles of Political economy and Taxation and explained his theory of Comparative Advantage.

• According to this law even if one nation is less efficient in the production of both commodities there still exists a basis for mutually beneficial trade.

• Nation should specialize in production and export the commodity in which its absolute disadvantage is less and import the commodity in which its absolute disadvantage is greater.

Comparative AdvantageProduction/m .day Country1 Country 2 Ratio

Units of wheat 6 1 6:1

Units of corn 4 2 4:2

• As per the data in Table on last slide Country 1 has absolute advantage in producing both the commodities while country 2 is faced with a situation of absolute disadvantage.

• The country with lower productivity and less efficient in production will also face lower wage rate making its production of the commodity of lower comparative disadvantage cheaper than the other country.

Principle of Comparative Advantage, Developed by David Ricardo

• A nation gains from trade by exporting the goods and services in which it has greatest comparative advantage in productivity and importing the goods in which it has the least comparative (relative) advantage.

• Even if a nation is the most productive at producing anything and another is the least, both will gain by trading as long as their advantage in making different goods are different.

Cost of Wheat and Corn at Exchange Rate of 1:2 Between Currencies of Country 2 &

1

Cost [ Expressed in common international currency

Country 1 Country 2

Cost of one unit of wheat $ 1.00 $ 2.00

Cost of one unit of corn $ 1.5 $ 1.00

• In country 1, one man day can produce 6 units of wheat or 4 units of corn.

• In country 2 one man day can produce only one unit of wheat or 2 units of corn.

• These data suggest labor productivity to be much higher in country 1 as compared to country 2. Accordingly, wage rate has to be sufficiently lower in country 2 to make the cost of production of corn (the commodity with comparative advantage in country 2) lower in country 2.

• Assuming wage rate in country 1 at $6 per day COP of one unit of wheat works out to $1 and that of one unit of corn at $1.5.

• Given the wage rate of one Euro per day and exchange rate of $ 2 per Euro COP of one unit of wheat in country 2 comes to $ 2 and that of corn to $ 1 per unit.

• From the above data we conclude that country 1 has a comparative advantage in wheat in which its COP is lower. Country 2 has lower COP for corn and thus has comparative advantage in its production.