The Origins of Trade Theory

1
The Origins of Trade Theory
Professor Bryson Marriott School
2
Smith and Absolute Advantage
3

• Assume Two countries, the US and ROW producing
  wheat and cloth.
• US Rest
  of the World
• ________________________________________
• Labor cost required to make
• 1 bushel wheat 2 hours lt 2.5 hours
• I yard of cloth 4 hours gt 1
  hour
• ______________________________________
• Which country has an advantage in wheat? In
  cloth?

4

• US Rest
  of the World
• ________________________________________
• Labor cost required to make
• 1 bushel wheat 2 hours lt 2.5 hours
• I yard of cloth 4 hours gt 1
  hour
• ______________________________________
• How much will each country produce if each has
  40 hours of labor?
• (Assume a division of labor in US of 10 and
  30 hours for wheat and cloth, 20 and 20 for ROW)

5

• US 10 and 30 hours for wheat and cloth,
• ROW 20 and 20 hours.
• So, each week we have
  US ROW
• 5 bushels (10 hours) 8 bushels (20 hours)
  (10/2 5) (20/2.5
  8)
• TOTAL WHEAT 13 BUSHELS
• 7.5 yards (30 hours) 20 yards (20 hours)
  (30/4 7.5) (20/1 20)
• TOTAL CLOTH 27.5 YARDS
• Absolute advantage is determined from
  productivity data (labor costs).

6

• After specialization
• United States ROW
  Total
• 20 bushels (40 hours) ----
  20 (gt13)
• --- 40 yards (40 hours)
  40 (gt27.5)
• How much does output increase with
• specialization?
• But lets go back for a moment. Can you
  calculate
• prices prevailing in the separate markets
  before the
• opening of trade?

7
Calculating pre-trade prices

• Based on pre-trade labor costs
• US ROW
• 1 bushel of wheat 2 hours lt 2.5 hours
• I yard of cloth 4 hours gt 1 hour
• In the U.S. how much wheat will one give for a
  yard of cloth?
• How much cloth will the ROW give for a bushel of
  wheat?
  United States
  ROW
• Price of wheat 0.5 yard/bushel 2.5
  yds/bush
• (2/4)
  (2.5/1)
• Price of cloth 2.0 bushels/yard 0.4
  bush/yd ( 4/2)
  (1/2.5)
• Notice the difference in wheat prices.
• Price of wheat 0.5 yard/bushel 2.5
  yds/bush

8
ARBITRAGE AND TRADE GAINS

• Now let trade be opened up. People notice
  potential for arbitrage gains.
• The principle As long as prices differ in two
  places (by more than any cost of transportation),
  one profits by arbitrage (buying in one location
  and selling in another).

9
ARBITRAGE AND TRADE GAINS

• To arbitrage properly, sell your gains from
  comparative advantage abroad. Take the foreign
  product you purchased back home to trade for lots
  more of the original product.

10
ARBITRAGE AND TRADE GAINS

• Potential arbitrage gains
• Sell 1 US bushel in ROW for 2.5 yards cloth, and
• Sell 2.5 yards cloth purchased in ROW for 5
  bushels in US.
• Or, Sell 2.5 ROW yards for 5 bushels in the US
  and
• Sell 5 bush in US for 12 yards cloth in ROW

11

• Opening trade will lead under Ricardian
  conditions to specialization.
• What determines the boundaries of trade prices,
  i.e., the lowest and highest number of yards per
  bushel?
• 0.5 ? International price of wheat ? 2.5
  (yards/bu.)
• (If the US gets .5 or less from ROW, it will just
  take .5 at home.)
• (If wheat isnt cheaper through trade, ROW would
  simply buy at home.)

12

• Suppose that the ratio settles at the price of
• 1 bushel 1 yard.
• Both nations will gain from trade after having
  pursued specialization where they have absolute
  advantages.

13
But what if there is no absolute advantage?
14
David Ricardo and Comparative Advantage
15

• The principle of comparative advantage a nation,
  like a person, gains from trade by exporting the
  goods or services in which it has its greatest
  comparative advantage in productivity (where it
  can produce at lower cost relative to potential
  trading partners) and importing those in which it
  has the least comparative advantage.
• This holds even if one country is worse in
  producing both traded goods.

16

• US ROW
• 1 bushel of wheat 2 hours gt 1.5 hours
• 1 yard of cloth 4 hours gt 1 hour
  
• Here, as in Ricardo's original illustration, the
  US has inferior productivity in both goods,
  requiring more labor hours to produce both wheat
  and cloth.

17

• US ROW
• 1 bushel of wheat 2 hours gt 1.5 hours
• 1 yard of cloth 4 hours gt 1 hour
• Now, each week we have
• US ROW
• 5 bushels (10 hours) 13 bushels (20 hours)
  Total 18
• 7.5 yards (30 hours) 20 yards (20 hours)
• Total 27.5

18

• US
  ROW
• 1 bushel of wheat 2 hours gt 1.5 hours
• 1 yard of cloth 4 hours gt
  1 hour
• Here, as in Ricardo's original illustration, the
  US has inferior productivity in both goods,
  requiring more labor hours to produce either
  wheat or cloth.
• After specialization
• US ROW
• 20 bushels (40 hours) ---- 20
• --- 40 yards (40
  hours) 40

19
Ricardian Trade GainsAfter Specialization

• Assume an exchange rate, again, of 1 yard for 1
  bushel.
• Note from the data on production before
  international trade that the U.S. can produce one
  bushel for each 0.5 yards of cloth
• but it can get a full yard internationally for
  that bushel.

20
Ricardian Trade GainsAfter Specialization

• For each half yard of cloth not produced, we can
  gain a full yard through specialization and
  trade.
• The rest of the world makes each extra yard of
  cloth by giving up only 0.67 bushels of wheat. It
  gains a full bushel for each additional yard
  produced

21
Ricardian Trade GainsAfter Specialization

• For each .67 bushel of wheat not produced, the
  rest of the world gains a full bushel of wheat
  through specialization and trade.

22
Mercantilism vs. The Wealth

• Review the trade practice of Smiths day as the
  motivating force for Smiths free trade doctrine.
  
• The Mercantilist objective inflows of gold.
• The methodology run positive trade balances.
• Refuting the doctrine.