The Law of Comparative Advantage (A)

The mercantilists views on trade

During the seventeenth and eighteenth centuries, a group of bankers, merchants,
government officials and philosophers) wrote essays about their thoughts of
international trade.
 A nation should export more than its imports.
 The resulting export surplus will be stored as bullion of precious metal basically
gold and silver.
 A government should do its best to encourage exports and restrict imports.
 All nations cannot simultaneously have an export surplus and the amount of gold
and silver is fixed at any point of time, one nation can only gain from trade at the
expense of other nations (Zero-Sum Game)
 Having exports surplus means more money in circulation and higher business
activity which lead to raise national output and increase employment.
 These days, as nations suffer from higher levels of unemployment, they attempt to
limit imports to stimulate domestic production and employment.
 The mercantilists measured the wealth of a nation by the stock of precious metals it
owned. This can be understood because the mercantilists were writing primarily for
rulers and to enhance national power.
 With more gold, rulers could maintain larger and better armies and strengthen their
power at home and get more colonies. In addition, more gold meant more money in
circulation and greater business activity.
 By encouraging exports and restricting imports, the government would increase
national output and raise employment.
 Today, we measure the wealth of nations by its stock of human, man-made, and
natural resources available for producing goods and services. The greater the
stock of useful resources, the greater the flow of goods and services to satisfy
human wants and the higher the standard level of living in the nation.
Limitations of The mercantilists views on trade:
 Trade surplus could be achieved in the short-run only and vanishes in the long run.
As the exported surplus will increase the money in circulation, this should result in:
o Increasing spending  increasing production  increasing national income
increasing imports (as the imports is positively related to national income)
o Increasing demands for goods and services  increasing prices of locally
produced goods and services  decreasing exports.
Increasing imports +decreasing exports = cancellation of the export surplus
 It is not necessary that the gains of any country should be at the expense of other
countries. International trade encourage specialization and division of labour, then
these benefits could be shared between trade partners.

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 Trade based on Absolute Advantage: Adam Smith
 Trade between two countries is based on absolute advantage. When any country is
more efficient in the production of one commodity, and the other country is more
efficient in the production of the other commodity, then both countries can gain
from specialization and trade. Thus, each of them will specialise in producing the
good with absolute advantage and then they exchange part of the output with other
nations with absolute disadvantage in producing these goods.
 In contrast with mercantilists views, all nations would gain from free trade
(advocates laissez-faire policy excluding the protection of industries important to
national defense)
Assumptions:
 For a variety of reasons, including difference in technology and climate, countries
differ in their ability to produce various commodities.
 There are only two countries A and B and only two commodities wheat and cloth.
 Perfect competition.
 The theory depends on the labour theory of value (i.e., factor is the only factor of
production or is used in the same proportion in the production of all commodities,
and labour units are homogenous.
 Labour is mobile inside the country and immobile between countries.
 No barriers to trade between countries.
 Constant return to scale between labour and output.
 Each country could produce one commodity at a lower real cost than the other
country.
Example:
Cost of production (labour hours)
Country USA UK
Wheat 6 1
Cloth 4 5
Wheat is produced in terms of bushels and cloth in terms of yards.
USA has an absolute advantage in wheat while UK has absolute advantage in
producing cloth.
Each country will benefit from specializing in the commodity in which it has an
absolute advantage and obtain the other through trading with the other country.
In the absence of trade:
 In USA, in 6 working hour
The quantity of wheat = 18 W, The quantity of cloth = 12 C
 In UK, in 6 working hour
The quantity of wheat = 3W, The quantity of cloth = 15C

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World production in the absence of trade (6 HOURs):
Country USA UK World
Wheat 18 3 21 W
Cloth 12 15 18 C

In the presence of trade:

Each country will specialize in the production of one commodity that it has an
absolute advantage at.
 USA produces wheat as its real cost (1/6 HOUR) is cheaper than UK
In USA, in 6 working hour
The quantity of wheat = 36 W, The quantity of cloth = zero
 UK produces cloth as its real cost (1/5 HOUR) is cheaper than USA.
In UK, in 6 working hour
The quantity of cloth = 30C, The quantity of wheat = zero

World production in the presence of trade (6 HOURs):

Country USA UK World
Wheat 36 --- 36 W
Cloth --- 30 30 C

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