Chapter 3.

Why Everybody Trades: Comparative Advantage

1. mercantilism (17th – 18th century)

Richness: recording trade surplus and accumulation of gold.
--- > Developed countries tried to record trade surplus by promoting exports and
restricting imports. mercantilists: “exports: good and imports: bad”
--- > country A’s trade surplus = country B’s trade deficit
--- > If A gains, then B loses.
--- > “beggar-thy-neighbour” policy, or a “zero-sum” game

mercantilism: supporting ‘trade protectionism’.

gold: international currency --- > trade surplus = inflow of gold
e.g. Spain as the leader

criticism: Happiness comes from the ‘consumption’ of goods and services, not
from the accumulation of gold.
 ..

2. (price-)specie-flow-mechanism by David Hume (mid-18th Century)

--- > automatic adjustment of the balance of payments (BOP)

trade surplus --- > gold inflow --- > money supply increases
--- > price level rises --- > price of domestically produced goods rises
--- > relative price of the domestic products rises
--- > losing price competitiveness
--- > Exports fall and imports rise. --- > Trade surplus disappears.
--- > return to the BOP equilibrium (i.e. exports = imports)

The BOP equilibrium can be achieved automatically

without any government policy.
--- > Don’t worry about the trade deficit situation.
 .

3. absolute advantage by Adam Smith (late 18th Century)

--- > international trade: based on ‘absolute advantage (AA)’
--- > application of the idea of ‘gain from division of labor’ to int’l trade

If A is more ‘efficient’ (higher labor productivity, or having abs. adv.) in producing x and B is more efficient (having
abs. adv.) in producing y,
then by A’s (B’s) specialization in x (y) and A’s exporting x and B’s exporting y, both gain from trade.
- less efficient: absolute disadvantage
- ‘specialization’: mobilizing all (most) resources to produce one good

A. Smith supported free trade and laissez-faire (no gov’t intervention).

criticism: If A (B) is more (less) efficient in both goods, A (B) should export (import) both goods. ---> no trade, but
trade occurs actually.
aLj (bLj ) : input coefficient, i.e. units of labor required to produce 1 unit of
good j in country A (B).

example:
If aLx > bLx, B: more efficient in producing x --- > B: AA in producing x.
If aLy < bLy, A: more efficient in producing y. --- > A: AA in producing y.
--- > B: exports x and A: exports y. ---- > international trade occurs.

example: If aLx = 4, bLx = 1, aLy = 1, bLy = 2,

A: AA in y and B: AA in x. --- > A exports y and B exports x.
--- > trade occurs.

example: If aLx > bLx and aLy > bLy, then B: AA in both x and y. A: absolute
disadvantage in x and y --- > B: exports both x and y. A: imports both
x and y. --- > A cannot pay for imports.
--- > Int’l trade does not occur according to Adam Smith.
4. comparative advantage (CA) by David Ricardo (early 19th Century)

Ricardian trade model based on the concept of comparative advantage

can explain the occurrence of int’l trade even if one country has AA in
both goods and the other country has abs. disadvantage in both goods.
--- > application of the concept of ‘opportunity cost’ to int’l trade

assumptions:
only one production factor: labor (L) (‘labor theory of value’);
Technologies differ across countries;
no transaction cost and no tariffs; 2 countries: A, B;
2 goods: x, y; full employment; constant labor productivity;
L: completely mobile among industries within a country,
but immobile across countries.
LA (LB): labor endowment in country A e.g. LA = 6

comparative advantage:
Suppose aLx = 2, aLy = 4, bLx = 1, bLy = 1.

Compare the labor requirement ratios of the two countries. --- >
aLx/aLy = 2/4 = 0.5 < bLx/bLy = 1/1 = 1

opportunity cost of producing 1y = 2x (1x) in A (B).

--- > A: very costly to produce y vs. B: not so costly to produce y.
--- > A: relatively easy to produce x vs. B: relatively easy to produce y.

--- > A: comparative advantage in x;

B: comparative advantage in y
 .

B: abs. adv. in both x and y; A: abs. disadvantage in x and y.

However, B: comp. advantage in y and comp. disadvantage in x;

A: comp. advantage in x and comp. disadvantage in y.
--- > Adam Smith: int’l trade does not occur.

e.g. UK: abs. adv. in both goods and India: abs. disadv. in both goods.
--- > Actually, int’l trade occurred.

Ricardo: “If a country specializes in a good that it has a comp. adv.,

then gains from trade.”
example: LA = 6, LB = 2
(1) autarky (self-sufficiency, i.e. no trade)
A: aLx = 2 and aLy = 4 --- > A can produce 1x and 1y.
--- > In case of self-sufficiency, consumption = production.
--- > consumption pattern: (1x, 1y)

B: bLx = 1 and bLy = 1 --- > B can produce 1x and 1y.

--- > In case of self-sufficiency, consumption pattern: (1x, 1y)

(2) specialization based on comparative advantage and trade

A: comp. adv. in x --- > specialize in x --- > produce 3x and 0y.
B: comp. adv. in y --- > specialize in y --- > produce 0x and 2y.
If A exports 1.5x and imports 1y, then B imports 1.5x and exports 1y.
--- > consumption pattern: A: (1.5x, 1y), B: (1.5x, 1y)
--- > specialization based on comp. adv. and trade > self-sufficiency.

--- > Int’l trade based on comparative advantage

is better than self-sufficiency.