ABSOLUTE AND COMPARATIVE ADVANTAGE MERCANTILISM Mercantilism is a theory developed by the merchants; hence the name.

It rests on the role of a strong state in supporting (state-granted) monopolies and protecting shipping and trading lanes. Mercantilism encourages exports and discourages imports. Gold and silver are used to keep score of the game played between nation-states, and represent the wealth of the nation. ABSOLUTE ADVANTAGE THEORY Adam Smith, 1776 Adam Smith, The Wealth of Nations, London, 1776. The theory of absolute advantage was advanced to buttress Smith's argument that if there was no government involvement in trade, and if each individual was left to do what in his or her own best interest, then there would be more goods and services available, prices would be reduced, and the wealth of each nation, measured as the welfare of the citizens, would increase. Smith's theory was offered to replace mercantilism. The Theory of Absolute Advantage and the Theory of Comparative Advantage rest on very strong assumptions, as follows: (1) Two countries, two commodities - assumed in both theories. The theories are obvious for this case. The three-by-three case (and those beyond) cannot be established analytically, and it is not even clear how the principle should be formalized. (See p. 3 of Ronald Jones, "The Positive Theory of International Trade," Handbook of International Economics, R. Jones and P. Kenen (eds.), 1984.) (2) Efficiency objective - The Absolute and Comparative Advantage theories assume that total world production, and therefore efficiency, is the objective. Efficiency is not always a country goal. (3) Zero Transportation Costs - both theories presume that transportation costs between and within countries are zero. (4) Factor Mobility/Immobility - both theories presume that resources are absolutely mobile within a country and absolutely immobile between countries. (5) Full employment - Both theories assume full employment in each country. These are very strong assumptions.

The USUAL EXAMPLE - PART 1 Suppose we have a two country world composed of Sweden and Colombia. Suppose, as per the text, there are two goods in this world, engines and coffee. The production rate table is as follows: (hrs./unit) Engines Coffee Sweden 10 300 Colombia 200 50

Suppose, further, that each country has 6,000 hours of labor. Finally, suppose that each country follows a crude form of mercantilism and devotes half of its labor resource to each good. Then the production in each country is as follows: Sweden 3000 hrs./(10 hrs./engine) = 300 engines 3000 hrs./(300 hrs./kg.) = 10 kg. of coffee Colombia 3000 hrs./(200 hrs./engine) = 15 engines 3000 hrs./(50 hrs./kg.) = 60 kg. of coffee Thus, world production is 315 engines and 70 kg. of coffee. Now, suppose that each country is enlightened by Smith and pursues its absolute advantage. Clearly, Sweden has an absolute advantage in engines and Colombia has an absolute advantage in coffee. Then Sweden would devote all of its labor resource to engines and Colombia all of its labor resource to coffee. Then production in each country is as follows: Sweden 6000 hrs./(10 hrs./engine) = 600 engines 0 hrs./(300 hrs./kg.) = 0 kg. of coffee Colombia 0 hrs./(200 hrs./engine) = 0 engines 6000 hrs./(50 hrs./kg.) = 120 kg. of coffee Thus, world production is increased form 315 to 600 engines and from 70 kg. to 120 kg. of coffee. Clearly, world production has increased and each country can be made better off if trade is free. This example is arbitrary in that the division of the labor resource into halves was arbitrary. Here is an exercise. Show that if Sweden allocates s% of its labor to engines and (1-s)% to coffee, and if Colombia allocates (1-c)% of its labor to engines and c% to coffee, then total world

production is maximized at s = 1 and c = 1, i.e., at the Absolute Advantage solution. (Hint: Use linear programming.) Smith is correct. If government got out of the business of supporting inefficient production (e.g., coffee in Sweden and engines in Colombia) and left each decision maker to his or her own devices, then world production would increase. Indeed, in our example, it nearly doubles in each good. Sources of absolute (and comparative) advantage Natural - climatic, resource endowment, etc. The British import tea for this reason; Idaho has a natural (absolute) advantage in producing Idaho trout, Idaho white pine, and Idaho potatoes. Acquired - a technique or process technology. The Swiss have an acquired (absolute) advantage in mechanical watches, the Belgians in chocolate and beer, the Japanese in electronic watches, the Germans in machine tools, the Americans and Europeans in airplanes, etc.) COMPARATIVE ADVANTAGE THEORY David Ricardo, 1817 See David Ricardo, The Principles of Political Economy and Taxation, London, 1817. The theory of comparative advantage advances and refines Smith's theory of absolute advantage. Ricardo agreed with Smith's view that if there was no government involvement in trade, and if each individual was left to do what is in his or her own best interest, then there would be more goods and services available, prices would be reduced, and the wealth of each nation would increase. Ricardo's comparative advantage theory extends Smith's view to the case where one of the two countries has an absolute advantage in both commodities, and shows that even here trade is good for both countries. As noted above, Ricardo's Comparative Advantage Theory rests on the same very strong assumptions that underlie Smith's Absolute Advantage Theory.

THE USUAL EXAMPLE - PART 2 The following is a variation on the example advanced by Ricardo. (Reference: David Ricardo, The Principles of Political Economy and Taxation, London: J. M. Dent & Sons, Ltd., date not listed, p. 82.) Suppose

England and Portugal each have 6,000 hours of labor available, and the production possibilities are as follows: (hrs./unit) Cloth Wine England 100 120 Portugal 90 80

Notice that Portugal has an absolute advantage in both commodities. First, suppose, in the style of mercantilism, that the countries (arbitrarily) allocate half of their 6,000 hours of labor to each good. Then we have the following: England 3000 hrs./(100 hrs./cloth) = 30 units of cloth 3000 hrs./(120 hrs./wine) = 25 units of wine Portugal 3000 hrs./(90 hrs./cloth) = 33 1/3 units of cloth 3000 hrs./(80 hrs./wine) = 37 1/2 units of wine Thus, world production is 63 1/3 units of cloth and 62 1/2 units of wine. Clearly, Portugal is more efficient than England in the production of both cloth and wine. Note, however, that Portugal's greater efficiency is not the same in both commodities. Rudely put, one English laborer is worth 90/100 (= 0.9) of a Portuguese laborer in the production of cloth, and 80/120 (= .66) of a Portuguese laborer in the production of wine. Thus, although English workers are less efficient than Portuguese workers in the production of both goods, the English workers are less worse in the production of cloth than they are in the production of wine. (Put differently, the degree of efficiency of the Portuguese workers is greater in the production of wine than in the production of cloth.) Thus, England has a comparative advantage in the production of cloth, and Portugal has a comparative (and absolute) advantage in the production of wine. This is summarized as follows: England has a comparative advantage in the production of cloth because 90/80 > 100/120, i.e., because
hrs. unit of cloth hrs. unit of wine Portugal Portugal hrs.

>

unit of cloth hrs. unit of wine

England England

This can also be stated as follows: England has a comparative advantage in the production of cloth because 90/100 > 80/120, i.e., because
hrs. unit of cloth hrs. unit of cloth England Portugal hrs.

>

unit of wine hrs. unit of wine

Portugal England

(Note that the second inequality is simply a restatement of the first. Note also that the first inequality compares ratios taken within the countries, whereas the second compares ratios taken across the countries. See Akira Takayama, International Trade, p. 111.) Now, suppose that the goal is to increase total world production (i.e., cloth and wine). If England put all of its labor into the production of cloth, then we would have 6000 hrs./(100 hrs./cloth) = 60 units of cloth from England. In order to maintain the previous level of world production of cloth (i.e., 63 1/3 units of cloth), it is necessary for Portugal to produce at least 3 1/3 units. Thus, Portugal must allocate at least 300 hours of labor (300 = 3 1/3 times 90) to the production of cloth. If Portugal allocates the remaining 2700 hours of labor to the production of wine, then we have 5700 hrs./(80 hrs./wine) = 71 1/4 units of wine from Portugal. Therefore, the world total of cloth and wine is 63 1/3 units of cloth, as we had before, and 71 1/4 units of wine, which is an increase of 8 3/4 units of wine. Clearly, if we allocate slightly more than 300 hours of labor in Portugal to the production of cloth and the remaining hours to the production of wine, then we can increase the total world production of both cloth and wine by having England produce to its comparative advantage. Therefore, Ricardo's extension of Smith's analysis holds. That is, even if one country is dominated in the production of both goods by the other country, both countries can be made better off if they engage in free trade and the dominated country produces to its comparative advantage.

This example, like the absolute advantage example, is arbitrary in that the division of the labor resource into halves was arbitrary. Here is another exercise. Show that if Portugal allocates p% of its labor to cloth and (1-p)% to wine, and if England allocates (1-e)% of its labor to cloth and e% to wine, then total world production is maximized at e = 1, i.e., at the comparative advantage solution. (Hint: Use linear programming.)