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University of Toronto Mississauga

Principles of Economics: Comparative Advantage COMPARATIVE ADVANTAGE International Trade Historically, trade typically first occurred between communities rather than within communities where leaders of the family or the community usually determined the allocation of goods and services. Trade first occurs between Polynesian islands, rather than within islands, and between native Americans tribes, rather than within tribes, for example. This is also true for the th rise of the European market economy after the 11 century CE where periodic large fairs (such as at Champagne) for long distance trade dominated commercial activity and after the 14 th century when Atlantic shipping dominated European commercial development. In fact, the first capitalists were merchants who moved commodities from one place to another but did not initially change the existing individual and small-scale production of European farmers and craftsmen. This development of European merchants generated the theory of Mercantilism, the first th th integrated economic system, from the 16 to the 18 centuries. Mercantilism is most easily understood as the articulation of the merchant viewpoint, viewing profit as a consequence of exchange (circulation) by ‘buying cheap and selling dear’, rather than due to anything in production. There is no such thing as profit for a country as a whole, as a consequence, since someone’s gain in another’s loss. Mercantilists considered gold and silver as the only form of wealth in keeping with a merchant’s recognition that gold and silver was the capital necessary for buying and selling commodities. Most concluded that the only way for a country to increase wealth or profit was through exporting more goods to other countries than they imported from 1 This position, which Adam Smith attributed to Mercantilism, is actually a simplistic form called Bullionism. Mercantilist, for the most part, accepted any storable commodities as wealth, provided they could be easily exchanged for other goods. Ships and sailors were physical capital and labour, respectively but Mercantilist tended to ignore this in their focus of pure exchange. - 1 - Principles of Economics: Comparative Advantage those countries. They therefore favoured intervention in the market process through policies of tariffs (taxes to limit imports), bounties (subsidies) to simulate exports, and monopolies (such as the Hudson’s Bay Company) to control the inflow and outflow of trade. Adam Smith specifically attacked the Mercantilist notions of wealth, government controlled trade, and monopolies in his Wealth of Nations (1776), thereby initiating the modern analysis of trade. He began by defining wealth as a nation’s output relative to its population rather than as the sum of precious metals . He argued that competition and self-interest would drive free markets (laissez-faire) to optimal allocation of resources without government intervention. He famously argued that countries would mutually benefit if they specialized in commodities requiring the least local resources and traded for other commodities produced cheaper by foreign countries. In particular, he showed that Britain should export wool to France and import wine from France rather than pursue the Mercantilist policy of producing wool for export and wine for domestic use to avoid importing from France. If it took two people to produce a unit of wool and one person to produce a unit of wine in France due to warm and dry weather and one person to produce a unit of wool and two people to produce a unit of wine in Britain due to cool and wet weather, he showed that mercantilism would mean that each country would produce only 1 wool and 1 wine with 3 workers. Trade, however, would allow Britain to produce 3 wool and France to produce 3 wine with 3 workers each for a net world gain of 1 wine and 1 wool. Economists call this the Principle of Absolute Advantage and it is the first step in international trade theory. 2 As opposed to the modern definition of GDP (output) as the sum of consumption, government spending, investment and exports less imports, Smith defines GDP as C + I + G plus import minus exports because he focused on the goods available for consumption through trade and not simply on output. From the beginning of his book, he recognized that international trade would increase consumption possibilities by trading exports for relative more imports in terms of home resources used. - 2 - Principles of Economics: Comparative Advantage Smith campaigned for free trade more fundamentally in the first few chapters of his book. He argued that the division of labour, or specialization, was the direct effect of trade through the expansion of the market. Since specialization through expanding markets increased the output of society by increasing productivity, trade increased total output relative to the population. This is a very powerful argument but Marx pointed out that the division of labour might mean that some people would have menial low-paying positions while others had skilful high-paying positions that captured the extra output for themselves. Absolute Advantage Definition: A country can produce cheaper in terms of resources than another country Adam Smith showed that countries benefit if they trade commodities for which they have an absolute advantage (e.g., Britain should trade wool to France and France should trade wine to Britain) → increases in consumption per capita, i.e., the wealth per capita This is a criticism of the Mercantilist perspective that countries should minimize imports and maximize exports to accumulate wealth defined as gold and silver Comparative Advantage → A country can produce cheaper in terms of opportunity cost than another country David Ricardo showed that trade benefits countries even if one country has an absolute advantage in all goods. In a two-country two-commodity world with constant resources costs within countries, a country benefits by specializing in the production of the commodity for which it has a comparative advantage and trading for the other commodity. - 3 - Principles of Economics: Comparative Advantage We will examine the one factor case (we will use R for resource to represent all resources such as labour, capital, or land but we could simply say L for labour) for two countries and for two different commodities (F and M for Food and Manufactures but it could be any two commodities). We begin with an algebraic overview of the issue for formalities sake but you need only understand the solution of problems with particular numbers. Define Q RFd Q RM as the output per unit of resource in Food and Manufacture respectively 3 for a country. Assume that there are no economies of scale or substitutions in production so that Q RFd Q RM are constant. Absolute Advantage in the production of a commodity means that the output per resource is greater. Country A has an absolute advantage over Country B in the production of Food, for example if Q RF > Q RMB. Comparative advantage in the production of a commodity for country A relative to country B means that the opportunity cost for A is less than that of B → Opportunity Cost of Q Mn terms of lost Q F ΔQ /FQ = MdQ /dQF) M Since we assume that Q Fnd Q aMe constant, opportunity cost is simply Q /RF RM for M. i.e., a shift of one unit of resource from Food to Manufacture reduces Food byFQ relative to a gain in Manufacture of Q M Opportunity Cost, therefore, represents the relative prices of the commodities and this is the secret to the advantage of trade. Note that the Opportunity Cost of M for F is simply the inverse of that of F for M. → Comparative Advantage for A over B in the production of Manufacture => Q RFA/QRMA < QRFB/Q RMB 3 University of Toronto (St. George) takes the output per unit of resource approach but a more common approach, particularly in higher years of economics, is resource input per unit of output. - 4 - Principles of Economics: Comparative Advantage Production Possibilities The output per unit of resource times the amount of resources for each commodiRF (QF*R + Q RM )Mgives the total amount of output produced by the economy. → The amount of resources (F + RM) and the technology for output per resource for each commodity (Q RFd Q ) RMmit the total output (Production Possibilities) of the country. We can define the Production Possibilities function of a country at full employment as PPC = Q RF +FQ *RRMor M ≤ R ≤ R Fnd R + R F R (Motal resources) → QRFR is the amount of QFif QM= 0 and Q RM isMthe amount of Q ifMQ = F → The slope of the Production Possibilities curve Fs ΔQM/ΔQRF QRMQif Food is the Y-Axis The Production Possibilities function is linear because the opportunity costs are constant. => The slope of the function is ratio of the interRFpts QRMR/ M *R RFQ RM Example 1a. Suppose that 1 unit of Resource produces 1/15 unit of Food and 1 unit of Resource produce 1/5 unit of Manufactures in Canada and that Canada has 900 units of Resource a) What is the opportunity cost of Manufacture? Shifting 1 unit of Resource from Food to Manufacture produces 1/15 unit of Food at a cost of 1/5 unit of Manufactures = (1/15)/(1/5) = 1/3 Food for 1 Manufacture b)What is the Production Possibilities Curve if Food is on the vertical axis? → The slope is –1/3 since Opportunity cost of Manufacture ΔQF/ΔQM= 1/3 units of Food → The Food intercept is 900*1/15 = 60 and the Manufactures intercept is 900*1/5 = 180 (ΔQ FΔQ M= 60/180 = 1/3) → PPC: Q = 900*1/15 – 5/15Q = 60 – Q /3 F
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