Question 1 - Why everybody trades?

Absolute and comparative advantage

a) Adam Smiths theory of absolute advantage Two countries: US and the rest of the world and two goods: wheat and cloth Production of goods requires one resource (labor) only US is better in producing wheat and rest of the world is better in producing cloth International trade can create benefits, because both US and rest of the world can focus production on what they do best and export it: wheat and cloth respectively. Two ways to measure countrys ability to produce each product: 1) Labor productivity: number of units of output a worker can produce in one hour 2) Reciprocal labor productivity: number of hours necessary to produce one unit of output

In this example the US has an absolute advantage in producing wheat The rest of the world has an absolute advantage in producing cloth If there is free trade, each country can shift its labor resources toward producing the good in which it has the absolute advantage total world production increases Adam Smith showed benefits of free trade by showing that global production efficiency is enhanced because trade allows each country to exploit its absolute advantage. Absolute advantage: each country exports product in which it has the higher labor productivity b) David Ricardos theory of comparative advantage But what if a country has no absolute advantage at all? Ricardo explained that there is a basis for beneficial trade whether or not countries have any absolute advantage, by examining the theory of opportunity costs. Opportunity costs: o the value of goods/services that are not produced because resources are instead used to produce other good or o Opportunity costs of producing more of a product in a country is the amount of production of the other product that is given up. Principle of comparative advantage: o A country will export the goods/services that it can produce at a low opportunity cost and import the goods and services that it would otherwise produce at a high opportunity cost Basis for trade: relative differences in labor (resource) productivity o A country will benefit from trade by exporting products in which it has greatest relative advantage (or least relative disadvantage) and import the other good. Example:

 US has absolute disadvantages in both goods, but a comparative advantage in wheat Relative price: the ratio of one product price to another product price (i.e. 2.0 wheat/cloth)

The production possibility curve (ppc) a countrys production capabilities: o Shows all combinations of amounts of different products that an economy can produce with full employment of its resources and maximum feasible productivity of these

Note: slope (steepness) of the ppc is constant and reflects the opportunity cost of cloth: o 50/25 W/C = 2 W/C for the US o 67/100 W/C = 2/3 W/C for the rest of the world No trade: each country only consumes combinations of W and C that are on/below the ppc With trade: each nation can trade at a price between 2/3 and 2 W/C Assumption: demand conditions make free-trade price equal 1 W/C Each country specializes in producing only the good with its comparative advantage Slope of the trade line is 1 W/C Explanation: o If the US specializes in making only what, at S1, it can export wheat for cloth imports at world price ration, moving along the trade line o If world price is 1 W/C, the US could consume anywhere along this trade line o This is a better set of consumption options than if the US did not trade. The US gains from trade! o Same holds for the rest of the world Shortcoming of Ricardos theory: we assume constant marginal costs