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Lecture 2

POLI 441 Lecture Notes - Lecture 2: Opportunity Cost, William Davenant, Invisible Hand

Political Science
Course Code
POLI 441
Krzysztof Pelc

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Debate over Cotton from India
Flood of cheap cotton from the colony.
Protectionists called for barriers to protect British industries
The imports from Britain were seen as diminishing employment and hurting
opposing voices
Davenant publishes the 1696 “Essay on the East-India Trade"
sees restrictions as leading to unnatural prices and unnatural occupations
no talk yet of this being directly related to the market, at least not explicitely, but the
concept is rather sophisticated
if silk can be produced elsewhere more cheaply than domestic workers are best
employed elsewhere
intervening to support some industries at the expense of others is like forcing a child
to a study it has no inclination to
these are close ideals to the notion of comparative advantage, but aren’t quite there
has to go beyond absolute advantage
Henry Martyn
Publishes the 1701 essay “Considerations Upon the East India Trade”:
“The East India trade destroys no profitable English manufacture, it deprives
the people of no employment which we should wish to be preserved.”
Thought experiment likening the East India trade with technological advance.*
Martyn on Trade and Labour
Protection “is to oblige the things to be provided by the labour of many, which might
as well be done by few
“... it is also to lose the labour of so many hands which might be employed to the profit
of the Kingdom”.
compensation principle
faced with losses in the cotton industry, Decker arrives at the compensation
principle in 1743
“let their salary be continued to them upon the same foot they have it now, or
during their lives, and this perhaps would induce them to look with a
favourable eye on our design"
Pareto optimality
if we have more pie, and then some reform happens, and we’re getting
as much pie as before, there has to be some pie left over by definition,
because there’s more pie than before
because some ppl are afraid of getting a smaller slice of the pie that the
pie is not increased
doesn’t say anything about the distribution of the pie, only about
increasing the size of the pie
it does entail that each person will have the same amount as before, and
still have leftovers
efficient breach talks about Pareto optimality
if I profit from breaking the rules so much that I can render those hurt by
it whole, and still gain from it myself, then it is pareto optimal
economists spend a lot of time thinking about how you arrive at that cost
of the breach
The Physiocrats
first ppl to call themselves economists
them + Br. moral philosophers will posit that people going about their ways contribute
to the common wealth
starts out the idea of laissez-faire
flip the mercantilist idea over commodity composition on their head
raw materials and agricultural products are best exported, and manufactured goods
are best imported
don’t want to busy themselves with manufacturing, because it is prone to competition
advocates of free trade, because France had a comparative advantage in agri.
manufacturers prone to competitors
if you let ppl do their own thing, everything will be just fine, because ppl know what’s
best for them
British Moral Philosphers
reacting ag. Hobbes (and this time it’s more explicit)
see reconciliation b/w self-interest and the social welfare
let everyone do what’s in their self-interest and it aggregates to the social good
Mandeville, “The Fable of the Bees”:
“No number of Men, when once they enjoy quiet, and no Man needs to fear his
Neighbour, will be long without learning to divide and subdivide his labour."
here, within a minimal institutional framework, there is reconciliation between these
two forces, self-interest and social welfare
Adam Smith
takes the view of the country as a whole
Wealth of Nations in 1776
right when Declaration of Independence, the peak of humanism and intellectual
big year for big ideas
one of the central insights in WoN is the taking of the entire commonwealth/economy
as the unit of analysis, which had not been done before
agrees with mercantilists that a tariff raises output and employment in the industry
concerned, but:
whether it tends either to increase that general industry of the society or
to give it the most advantageous direction is not, perhaps, altogether so
evident” (Book IV)
the relevant opportunity cost of policy has changed
no longer comparing restrictions before and after protection in cotton industry,
but to all other industries in the kingdom
the premise is that those individuals will find employment in other sectors more
advantageous to the economy
now it’s a general equilibrium story, rather than a partial one
Adam Smith (ii)
comparative advantage?:
“if a foreign country can supply us with a commodity cheaper than we ourselves
can make it, better buy it of them with some part of the produce of our industry,
employed in a way in which we have some advantage"
better off buying the cheap cotton with us doing what we have an advantage in
barriers’ effect on allocation of resources:
“the industry of the country, therefore is thus turned away from a more to a
less advantageous employment, and the exchangeable value of tis annual
produce, instead of being increased,must necessarily be diminished by every
such regulation
by imposing these barriers on cheap imports coming from abroad, because
they’re seen as destroying domestic employment/industry, we’re getting away
from this, buying fewer imports with our exports
division of labour at an int’l level:
“the division of labour is limited by the extent of the market"
“a more extensive market () encourages them to improve its productive
insistence that what matters is production
what matters is how much we can consume in exchange of our production
Adam Smith (iii)
and yet, Smith does not advocate laissez-faire
gov’t needs to provide a system of law
gov’t needs to provide public works
non-rival, non-excludable
gov’t needs to provide defense
the biggest exception to free trade was in terms of defense of the country
Adam Smith (iv)
“defenseis of much more importance than opulence (wealth)”:
if an industry contributed to defense, there may be reason to protect it ag. import
contemporary parallels?
the greater point is about possible tradeoffs between wealth and other objectives
article 21 of GATT is nat’l security exception; article 20 of GATT is general security
Adam Smith (v)
other possible reasons for protectionism:
if domestic goods were subject to purely domestic taxes
market opening: retaliatory tariffs
transitionary tariffs (delayed implementation of free trade)
when countries commit to shedding tariffs in the WTO, there is a
remarkably long transition period
Adam Smith and the Invisible Hand
traditionally thought to be a justification of laissez-faire:
yet only comes up once in Wealth of Nations and once in Theory of Moral
used to argue that the self-interest of one is turned into social benefit
or seen as force behind the price mechanism, that which makes markets clear
Grampp’s reading suggests otherwise
against conventional wisdom
market prices do adjust to “natural” prices according to Smith, but this has nothing to
do with the invisible hand
the invisible hand is not a rule, but the description of a situation which is observed
So what is it?
“It is self-interest operating in particular circumstances. The owner of capital acts in the
public interest if acting in his private interest is profitable and happens to provide a
public benefit.” (Grampp 2000, 460)
The invisible hand acts when it fortuitously leads merchants to keep capital at home,
where it contributes to defense
doing so is “no less profitable”: Smith seems to be thinking of capital’s security and
On Comparative Advantage
while implying it, Smith did not understand the notion of comparative advantage and
its generalizability
Robert Torrens first formulates it in 1815, referring to opportunity costs
David Ricardo adds the comparison on cost ratios in 1817
What does comparative advantage actually denote?
The Crusoe Economy I
Crusoe on his desert island can either catch 4 fish a day, or find 8 coconuts
he comes upon Friday, who can catch 6 fish day, or find 7 coconuts
Is trade beneficial?
Yes: Friday fishes, Crusoe goes after coconuts
Each is absolutely better at one activity
The Crusoe Economy II
now imagine Friday can catch 10 fish, or find 10 coconuts, i.e. he is better at both
Crusoe is still at 4 fish, and 8 coconuts
Is trade beneficial?
as long as their productivity is different (not 1:1), it is beneficial to trade
1 fish costs 1 coconut
1 coconut costs 1 fish
1 fish costs 2 coconuts
1 coconut costs 1/2 fish
Would both agree to a price of a awash for e.g. 1.8 coconuts?
Just above 1 and just below 2
It’s about how my fish cost to my coconuts; I do what is relatively cheaper to me, you
do the same, and we exchange and are both better off
Comparative Advantage
the step forward is emphasizing not what the country produces, but what it consumes
(in exchange of that production)
maximize what we get in exchange of the optimal allocation of our production and
James Mill (1821):
“The cost at which a country can import from abroad depends, not upon the
cost at which the foreign country produces the commodity, but upon what the
commodity costs which it sends in exchange."
The State of the Debate
though Smith’s contribution changes the debate, there is further debate around the
corn laws (repealed in 1846)
the question of whether free trade, in policy concerns, is optimal remains vital:
“The question of free trade is, next to the Reformation, next to the question of
free religion, the most momentous that has ever been submitted to human
decision” (Senior 1828)
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