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 wellbeing 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 Smith s arguments persuaded some countries to reduce their tariffs in late 18 th 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
Labor Productivity US China Units of Textiles MPL T = 2 > MPL* T = 1 Units of MPL W = 4 > MPL* W = 1 MPL = marginal product of labor, T= textiles, W= wheat, *= China 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 L = 25 workers, and China has L*= workers
Textiles US MPL T. L= Q W =1 Q T =1/2 PPF MPL W L= Production possibility frontier (PPF) for US country has constant slope due to constant marginal product of labor: MPL.L Slope of PPF = - - T - 1 = MPL.L = 2 W Slope is opportunity cost of producing more wheat in US.
MPL T. L * Textiles = China PPF* Q* W =1 Q* T =1 MPL W. L * = Production possibility frontier (PPF*) for China also has constant slope due to constant marginal product of labor: MPL *.L* Slope of PPF* = - = - T = -1 MPL *.L * W Slope is opportunity cost of producing more wheat in China
Textiles US U 0 25 A U 1 U 2 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.MP L = ω, and if wages are equalized across both industries, ω W = ω T : P.MPL = P.MPL W W T T P /P = MPL /MPL = 1/2 W T T W
Textiles China A* U* 1 U* 2 U* 0 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: P *.MPL* = P *.MPL* W W T T P * /P* = MPL * /MPL* = 1 W T T W
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 viceversa for China Relative price of wheat will rise in US and fall in China with trade, until they are equal at say 2/3
Textiles US P W /P T =2/3 40 C US Textile Imports (40) 25 A U 2 U 1 0 40 B US exports (60) For each industry, wage is equal to marginal value of hiring extra unit of labor, ω P.MPL W 2 4 8 = W W =. =, i.e., P.MPL > P.MPL ω P.MPL 3 2 6 W W T T T T T All US labor shifts to producing wheat with higher wage, specialization at B
Chinese Textile Exports (40) Textiles B* 60 A* China C* U* 2 U* 1 P W /P T =2/3 0 60 Chinese Imports (60) For each industry, wage is equal to marginal value of hiring extra unit of labor, ω P.MPL * W ω = W W 2 1. 2, i.e., P.MPL < P.MPL P.MPL = 3 1 = * * * 3 W W T T T T T All Chinese labor shifts to producing textiles, specialization at B*
Textiles 40 C 25 A 0 P W /P T =1/2 David Ricardo US Production/Consumption 40 P W /P T =2/3 U 2 U 1 B 0 60 US wheat exports (60 at P W /P T =2/3) P W /P T 2/3 1/2 US wheat exports (0- at P W /P T =1/2) A' US Export Supply of B' C' If world relative price was 1/2, US wheat exports would be 0 to, but if world relative price rises to 2/3, US wheat exports increase to 60 US Export Supply
Textiles B* 60 China Production/Consumption A* C* U* 1 U* 2 P W /P T =2/3 P W /P T 1 2/3 A*' China Import Demand for B*' C*' Chinese Import Demand P W /P T =1/1 0 60 0 Chinese wheat imports (0- at P W /P T =1) 60 Chinese wheat imports (60 at P W /P T =2/3) If world relative price was 1, Chinese wheat imports would be 0 to, but if world relative price falls to 2/3, Chinese wheat imports increase to 60
International Market for P W /P T 1 2/3 1/2 C' US Export Supply Chinese Import Demand 0 60 International market for wheat clears at relative price of 2/3, with US exports equaling Chinese imports, i.e. 60
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