The Principle of Absolute Advantage

1
International Trade Models

• Mercantilism
• The Classical Theories
• The Principle of Absolute Advantage
• The Principle of Comparative Advantage
• The Heckscher-Ohlin-Samuelson Model
• Alternative Trade Theories

2
Mercantilism

• A school of thought dominant before the 19th
  century, which advocated restrictive trade
  policies, so as to maximize exports and minimize
  imports for the sake of accumulating gold and
  foreign exchange

3
The Principle of Absolute 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
  product of our own industry, employed in a way in
  which we have some advantage Wealth of
  Nations, Adam Smith

4
The Principle of Comparative Advantage

• A nation, like a person, gains from trade by
  exporting the goods or services in which it has
  its greatest comparative advantage in
  productivity and importing those in which it has
  the least comparative advantage.
• David Ricardo

5
The Law of Comparative Advantage

• Mutually beneficial trade is possible whenever
  relative prices (opportunity costs) between two
  goods differ in two countries.

6
Pre-Trade Equilibrium in Country A

• Production 25X 12.5Y
• Consumption 25X 12.5Y
• Relative Price of X 1/2 Y
• Relative Price of Y 2 X
• A has a comparative advantage over B in
  producing X, because the relative price of X in A
  is lower than the relative price of X in B.

7
Pre-Trade Equilibrium in Country B

• Production 10X 12.5Y
• Consumption 10X 12.5Y
• Relative Price of X 5/4 Y
• Relative Price of Y 4/5 X
• B has a comparative advantage over A in
  producing Y, because the relative price of Y in B
  is lower than the relative price of Y in A.

8
Free-Trade Equilibria

• Country A
• Production 50X 0Y Exports 20X
• Consumption 30X 20Y Imports 20Y
• Relative Price of X 1 Y
• Country B
• Production 0X 25Y Exports 20Y
• Consumption 20X 5Y Imports 20X
• Relative Price of X 1 Y

9
The Gains From Trade

• A nations gains from trade consists of two
  components
• the gain from the reallocation of consumption
  and
• the gain from specialization in production.

• The fact that a nation unequivocally gains from
  international trade does not mean that all groups
  within the nation necessarily gain in fact some
  groups will lose.

10
Who Gains?

• Producers and workers in the export industry gain
  as a result of higher world prices and a larger
  volume of trade
• Consumers of the import competing good gain as a
  result of lower world prices and a larger supply
  and
• Firms which use imported components and materials
  in their production process gain as a result of
  lower import prices.

11
Who Loses?

• Producers and workers in the import-competing
  industry lose due to increased competition from
  imports
• Consumers of the export good lose due to the
  smaller supply available to the local market and
  higher world prices and
• Firms which use exportable components and
  materials in their production process lose due to
  increased prices.