The Classical Theories of Trade Merchantilists (1500-1800) Thought the key benefit of trade is trade surplus, accumulation of money. Merchantilists (1500-1800) Critics: David Hume: countries can maintain surplus only for a short-time because the accumulation of money would lead to inflation and thus a lower demand for the goods of the country. The Theory of Absolute advantage (Adam Smith) Adam Smith (l776): specialization thru the division of labor increases world output and world welfare. compares the amount of resources used to produce a unit of a given output among trade partners. The country that uses the least amount of resources in the production of the good should specialize in that product. A country has absolute advantage in a good if compared to other countries it can produce it using few resources David Ricardo (1772-1823): Comparative advantage compares the opportunity costs of production of trading partners. A country has a comparative advantage in the good if it can produce it at a lower opportunity cost than other countries. David Ricardo (1772-1823): Comparative advantage The country with the least opportunity cost of production should specialize in the product. The Ricardian Theory of Trade Assumptions: constant opportunity cost labor is the only input of production competitive markets Trade due to differences in Technology The Ricardian Theory of Trade Trade is based on comparative advantage comparative advantage due to differences in technology: labor productivity 3/2 dvd player ( 1.5 dvd player) 2/3 computers (0.67 computers ) 3 2 B 5/3 dvd player ( 1.67 dvd player) 3/5 computers ( 0.6 computers ) 5 3 A Price of Computers Price of dvd player computers dvd player Country Autarky price Autarky price Hours of labor per computer Hours of labor per dvd player Production Possibility Frontier (PPF) The maximum amount of a good that can be produced using all inputs of production. example: Total labor hours available = 15000 (hours) Takes 3 hours to produce a dvd player Takes 5 hours to produce a computer If all labor hours are used on computers the country can produce 15000/5= 3000 computers If all labor hours are used on dvd players, the country can produce 15000/3= 5000 dvd players Production Possibility Frontier dvd players computers 5000 3000 0 Production Possibility Frontier dvd players computers 5000 3000 0 The slope of the curve equals the opportunity cost of computers in terms of dvd players (= 1.5) Production Possibility Frontier (PPF) Where: ad= labor hours required per unit of dvd player ac= labor hours required per unit of computer L= total available labor hours Qd and Qc= production of dvd players and computers respectively The PPF is given by: adQd + acQc= L Using the numbers given above 3Qd + 5Qc= 15000 where H is home country, F is the foreign country: Absolute Advantage in dvd players for home: Absolute Advantage in computers for home: where H is home country, F is the foreign country: Comparative advantage in dvd players for home (the relative price of dvd player lower at home): Comparative advantage in computers for home: In autarky A country produces and consumes based on its ppf and preferences (its indifference curves) Production and consumption in autarky A Y YA XA X U1 U2 U3 (conti.) Under zero trade, a country consumes what ever it produces. produces and consumes at point A: produces & consumes YA of Y and XA of X Production and consumption under free trade Y YT XT X U1 U2 A1 A2 Slope = (PX / PY)T X2 (conti.) Under free trade, consumes at point A2: produces X2 & consumes YT and XT . The Ricardian Theory of Trade Gains from Trade: gain from specialization: increased production, total world output rises The Ricardian Theory of Trade gain from exchange: increased consumption due to lower foreign price. each country consumes above its ppc. The Distribution of Consumption Gains among trade partners not always same for both countries the smaller the difference between the international price and the domestic price, the smaller the consumption gain. The Distribution of gains to different groups in a country Some group could lose from trade Assuming price with trade falls between the autarky prices of the trade partners Prices of exportables rise: groups with taste for the exportables lose with trade? they pay higher prices than before. The Distribution of gains to different groups in a country Some group could lose from trade Assuming price with trade falls between the autarky prices of the trade partners Prices of imported goods fall: groups with taste for the imported goods gain from trade? they pay lower prices than before.
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