Why do Countries Trade?

Part II

AED/IS 4540

International Commerce

and the World Economy

Professor Sheldon

sheldon.1@osu.edu

Adam Smith

and Absolute Advantage

Adam Smith (1776) writing in the “Wealth of

Nations” argued in favor of free trade as a response

to the doctrine of mercantilism

Mercantilism based on premise that a nation’s well-

being was based on its holdings of gold and silver –

as a consequence mercantilists viewed exports as

“good” and imports as “bad”

Think of two countries (US and China), with two

goods (wheat and textiles), each being produced with

one resource (labor)

Adam Smith

and Absolute Advantage

Suppose the US is better at producing wheat and

China is better at producing textiles

From this there should be gains from trade, i.e., the

US specializes in producing and exporting wheat in

exchange for textiles, and vice-versa for China

Typically we think of “better at producing” in terms

of labor productivity, e.g., how many units of wheat

or textiles can be produced by a worker?

From this idea, we can get at Smith’s idea that

countries will trade on the basis of their absolute

advantage

David Ricardo

and Comparative Advantage

Smith’s arguments persuaded some countries to

reduce their tariffs in late 18th Century and on

There was still a nagging concern – what happens if

one country has an absolute advantage in producing

both wheat and textiles?

Ricardo introduced notion of opportunity cost of

producing one good in terms of foregone production

of the other good

In his “Principles of Economy and Taxation” (1817),

Ricardo demonstrated idea of comparative advantage

David Ricardo

and Comparative Advantage

Marginal product of labor higher in US for both

textiles and wheat, i.e., US has absolute advantage in

producing both products

Suppose US has = 25 workers, and China has

Labor

Productivity

US

China

Units of

Textiles

MPLT = 2 > MPL*T = 1

Units of Wheat MPLW = 4 > MPL*W = 1

MPL = marginal product of labor, T= textiles, W= wheat, *= China

L

=*L 100 workers

David Ricardo

and Comparative Advantage

Textiles

Wheat

=50

US

=100

Production possibility frontier (PPF) for US country has constant

slope due to constant marginal product of labor:

TMPL L.

WMPL L.

∆QW =1

∆QT =1/2 PPF

MPL .L50 1TSlope of PPF - - -100 2MPL .L

W

= = =

Slope is opportunity cost of producing more wheat in US

David Ricardo

and Comparative Advantage

Textiles

Wheat =100

China =100

Production possibility frontier (PPF*) for China also has constant

slope due to constant marginal product of labor:

WMPL L. *

TMPL L. *

∆Q*W =1

∆Q*T =1 PPF*

MPL .L100 TSlope of PPF - - -1100 MPL .L

W

* **

* *= = =

Slope is opportunity cost of producing more wheat in China

David Ricardo

and Comparative Advantage Textiles

Wheat

50

US

100

Opportunity cost of wheat in US should equal relative price of wheat

labor hired to point where value of hiring extra worker is equal to wage,

P.MPL = ω, and if wages are equalized across both industries, ωW = ωT :

U2

U1

U0

• 25

50

A

P .MPL P .MPLW W T T

P /P MPL /MPL 1/2W T T W

=

= =

David Ricardo

and Comparative Advantage

Textiles

Wheat 100

China 100

Opportunity cost of wheat in China should equal relative price of wheat

Again, labor is hired to point where value of hiring extra worker is equal

to wage, and if wages are equalized across industries:

U*1

U*2

U*0

• A* 50

50

P .MPL P .MPLW W T T

P /P MPL /MPL 1W T T W

* * * *

* * * *

=

= =

David Ricardo

and Comparative Advantage

Under autarky, US’s relative price of wheat is lower

than that for China, i.e., the US has a comparative

advantage in producing wheat

Likewise, relative price of textiles is lower in China

than in the US, i.e., China has a comparative

advantage in producing textiles

US will export wheat and import textiles, and vice-

versa for China

Relative price of wheat will rise in US and fall in

China with trade, until they are equal at say 2/3

David Ricardo

and Comparative Advantage

Textiles

Wheat

50

US

100

U2

U1 • 25

50

A

• 40 C

B

40

PW/PT =2/3

0

US Textile

Imports (40)

US Wheat exports (60)

For each industry, wage is equal to marginal value of hiring extra unit of labor,

All US labor shifts to producing wheat with higher wage, specialization at B

ω

ω

P .MPL 2 4 8W W W . , i.e., P .MPL > P .MPLW W T TP .MPL 3 2 6

T T T

= = =

David Ricardo

and Comparative Advantage

Textiles

Wheat 100

China 100

U*1

U*2 •

A* 50

50

For each industry, wage is equal to marginal value of hiring extra unit of labor,

All Chinese labor shifts to producing textiles, specialization at B*

ω

ω

1

3

P .MPL 2 2W W W . , i.e., P .MPL < P .MPLW W T T3 1P .MPL

T T T

= = =

*

* *

*

• C*

B*

60

60

Chinese Textile

Exports (40)

Chinese Wheat Imports (60)

PW/PT =2/3

0

David Ricardo

and Comparative Advantage

Textiles

Wheat

50

US – Production/Consumption

100

U2

U1 • 25 A

• 40 C

B

40

PW/PT =2/3

0

US wheat exports (60 at PW/PT=2/3)

Wheat

PW/PT

PW/PT =1/2

1/2

2/3

50 50 60

•

•

US – Export Supply of Wheat

A' B'

C'

If world relative price was 1/2, US wheat exports would be 0 to 50,

but if world relative price rises to 2/3, US wheat exports increase to 60

0

US wheat exports (0-50 at PW/PT=1/2)

US Export

Supply

David Ricardo

and Comparative Advantage

Textiles

Wheat 100

China – Production/Consumption

100

U*1

U*2 •

A* 50

50

• C*

B*

60

60

PW/PT =2/3

PW/PT =1/1

PW/PT

Wheat

2/3

1

0 0

If world relative price was 1, Chinese wheat imports would be 0 to 50,

but if world relative price falls to 2/3, Chinese wheat imports increase to 60

China – Import Demand for Wheat

50 60

A*' B*'

C*'

•

•

Chinese wheat imports (0-50 at PW/PT=1)

Chinese wheat imports (60 at PW/PT=2/3)

Chinese Import

Demand

David Ricardo

and Comparative Advantage

Wheat

PW/PT

1/2

2/3

50 60

International Market for Wheat

C'

0

US Export

Supply

•

1

Chinese Import

Demand

International market for wheat clears at relative price of 2/3, with US exports

equaling Chinese imports, i.e. 60

David Ricardo

and Comparative Advantage

Similar analysis shows China exports textiles of 40

to US at a relative price of 3/2

With trade, each country specializes in the good in

which it has a comparative advantage based on

technology

Consumers and labor are better off in each country

as a result of specialization

Ricardo’s model is very powerful, but is based on

assumption of constant marginal productivity of

labor and predicts complete specialization