2.   What is the pattern of Trade?
- What commodities are exported and imported?

Trade theories:
1. Mercantilism (18th and 19th century)
- Nation becomes rich when export > import
- More export, more inflow of bullion (gold and silver), thus more power
(today, nation’s power is reflected by its stock of human, man-made and natural resources)
- But, not all nations can have export > import simultaneously.
- Thus, a nation can gain only at the expense of others.
- Neo-mercantilism, restrict imports to stimulate domestic production and employment.

2.  Absolute Advantage (Adam Smith)
- A country has an absolute advantage in good X if one unit of labor produces more X than is produced by one unit of labor in the other country.
- 2 nations trade voluntarily, both gains
- Nation A produces product X of which it has absolute advantage and imports product Y of which it has absolute disadvantage (from the other nation B, which has absolute advantage of producing Y), then both nation A and B will gain.
- Nations’ efficiency in producing certain products differ due to many reasons such as climate, type of soil etc.
- Example Canada (efficient in prod. Wheat but not banana), while Nicaragua (efficient in prod. Banana but not wheat).
- Thus Canada specializes in Wheat while Nicaragua in Banana and total output (Banana and Wheat) as well as welfare of all people maximized.
- Adam Smith (AA) promote Laissez-faire (minimum govmt intervention)
- Illustrative Example of Absolute Advantage: Table 2.1
                                              U.S.         U.K.
Wheat (bushels / man-hour)        6          1
Cloth  (yards / man-hour)            4          5

3. Comparative Advantage
- A country has a comparative advantage in X if  its absolute disadvantage is smaller (opportunity cost of X in terms of Y is less than in the other country).
- Initially introduced by David Ricardo, 1817

Law of Comparative Advantage:
- there will be gains from trade, even if only one country has an absolute advantage in all goods
- In other words, if one country less efficient than the other nation in the production of both goods, it is still possible to achieve a mutually beneficial trade
- How? A nation should specialize in production and export of good that in which its absolute disadvantage is smaller (opportunity cost of producing is smaller), and import the good in which it has greater absolute disadvantage.
 
 

Example for Comparative Advantage (one nation (US) has the AA in both products):

                                                   U.S.           U.K.
Wheat (bushels / man-hour)            6              1
Cloth  (yards / man-hour)                4              2

- U.S. has AA in the prod of Wheat (1 man-hour produce 6W, >1 in UK)
- and U.S. also has AA in the prod of Cloth (1man-hour produces 4C, >2 in UK)
- UK has Absolute disadvantage in production of both commodities

- U.S. is more efficient and has CA in the prod of Wheat (opportunity cost of producing W in the U.S. is 4/6 or 2/3 (compared to 2 in the UK)

But…
- U.K. is more efficient and has CA in the prod of Cloth because opportunity costs of producing C is smaller in UK, i.e. ½ of W (as compared to 1.5 in U.S.)

-  Thus U.S. specializes in Wheat and U.K. specializes in Cloth
- Say both nations agree to trade 6W with 6C.
- Without trade, US can exchange 6W with 4C (domestically).  Meaning with trade US can gain 2 extra C or  ½ hour of labor.
- Without trade UK will need 6 man-hours to produce 6W (and sacrifice 12C), but with trade, UK will receive 6W from US in exchange of 6C, meaning UK could save 6C or 3 hours of labor.
- Note that UK gain more than the US but this is not important, the important point is that both nations could gain from the trade.
 

- The Range of exchange rate is not necessarily 6W = 6C.  It can be anything so long as both nations benefit from the trade:

- For US, since domestically 6W = 4C, so US is ready to trade so long as 4C < 6W

- For UK, since domestically 6W = 12C, so UK is ready to trade so long as 6W < 12C

-  Acceptable terms of trade:   4C < 6W < 12C
such as 5C = 6W (most benefit to the UK, note in UK 12C = 6W)
or 6W = 8C or 6W = 9C or 6W = 10C or
6W = 11C (most benefit to the US, note in US 6W = 4C)

Exception to the Law of Comparative Advantage:
What  if  absolute advantage for two nations are same?  Say, 1 man hour produces 3W in UK instead of 1W such that:

                                                   U.S.           U.K.
Wheat (bushels / man-hour)            6              3
Cloth  (yards / man-hour)                4              2
In this very unique and rare case, no mutually beneficial trade can take place because the AA (that one nation has with respect to the other nation) is the same proportion for the two commodities (6/4 = 3/2).
 

Modification of Comparative advantage Law
as long as some pattern of comparative advan-tage exists (i.e. the countries have different opportunity costs or different level of AA), there will be gains from trade, even if only one country has an absolute advantage in all goods.
Or in other words
There is still basis for mutually beneficial trade even if one nation has the AA in production of both goods (say X and Y) unless or except that if the AA (that one nation has with respect to the other nation) is in the same proportion for the two commodities.
#############################################################################
Comparative Advantage with money:
- If wage rate in US is $6/hour, and since 1 manhour produces 6W, so the price of
1W is 1$ or Pw = $1,   and since 1 manhour produces 4C, Pc =  $1.50 (6 ? 4C).
- If the wage rate in UK is £1.00, and if 1 man hour can produce 1W, then
Pw = £1.00, while Pc = £0.50 (as 1 man hour produces 2C, Table 2.2)
- If currency exchange  rate between $ and £ is  1£  =  2$, then in UK Pc = 1$, while Pw = 2$.

Table 2.3: Dollar price of W and C in US and UK when  1£  =  2$

                                                                  US           UK
Price for 1 bushel of wheat (Pw):             $1.00           $2.00

Price for 1 bushel of cloth (Pc):                  $1.50       $1.00
 

- Price of W is cheaper in US  while price of C is cheaper in UK.  International traders will buy W from US and sell it in UK, and buy C from Uk and sell it in US.
 

3.  Comparative Advantage (David Ricardo- initially based on the “labour theory of value”), then improved by Haberler (explaining in terms of opportunity cost theory as in PPF or transformation curve.

Ricardo used the following Simplifying Assumptions :
1. Only 2 nations and 2 commodities
2. Free trade
3. Perfect mobility of labor between 2 nations
4. Constant costs of productions
5. No transportation costs
6. No technical change
7. Labor theory of value (Unfortunately, this theory does not hold)
 
Labor theory of value states that price of commodity depends exclusively on labor which implies:
1. labor is the only factor of production or labor is used in the same fixed proportion in the production of all commodities.
2. Labor is homogeneous
Both of the above are true, thus we can not explain Comparative Advantage on labor theory of value.

Thus, Haberler (1936), base the CA on the opportunity cost theory.
“Cost of a commodity is the amount of second commodity that must be given up to release just enough resources to produce one additional unit of the first commodity”