Free Trade occurs when a government does not attempt to influence, through quotas or duties, what its citizens can buy from another country or what they can produce and sell to another country.
The Benefits of Trade allow a country to specialize in the manufacture and export of products that can be produced most efficiently in that country.
The Pattern of International Trade displays patterns that are easy to understand (Saudi Arabia/oil or China/crawfish). Others are not so easy to understand (Japan and cars).
The history of Trade Theory and Government Involvement presents a mixed case for the role of government in promoting exports and limiting imports. Later theories appear to make a case for limited involvement.
The Theory of Absolute Advantage Rice Cocoa Figure 4.1 G’ 0 5 10 15 20 5 10 15 20 A B K G K’
The Theory of Absolute Advantage and the Gains from Trade Production and Consumption without Trade S. Korea 2.5 10.0 Total production 20 20 S. Korea 6.0 14.0 Table 4.1 Resources Required to Produce 1 Ton of Cocoa and Rice Cocoa Rice Ghana 10 20 S. Korea 40 10 Ghana 10.0 5.0 Total production 12.5 15.0 Production with Specialization Ghana 20 0 S. Korea 0 20 Consumption after Ghana Trades 6T of Cocoa for 6TSouth Korean Rice Ghana 14.0 6.0 Increase in Consumption as a Result of Specialization and Trade Ghana 4.0 1.0 S. Korea 3.5 4.0
Theory of Comparative Advantage David Ricardo: Principles of Political Economy ( 1817).
Should trade even if country is more efficient in the production than its trading partner.
If both the countries use half of the resources to produce cocoa and half of the resources to produce rice:
Thus with 100 resources for each of the products, Ghana can produce 10 tons (100/10)of cocoa and 7.5 tons(100/13.33) of rice.
In the same way with 100 resources Korea would produce 2.5 tons(100/40) of cocoa and 5 tons(100/20) of rice.
So without trade the total production would be 12.5(10+2.5) tons of cocoa and 12.5(7.5+5) tons of rice.
The Theory of Comparative Advantage (Specialization) 3.75 7.5 2.5 G’ A’ (100 resources for each, 2.5 cocoa and 5 rice) 0 5 10 15 20 5 10 15 20 Cocoa Rice G A(100 resources for each (10 cocoa & 7.5 rice)) K K’
Theory of Comparative Advantage Scenario 3: International Trade takes Place: Cocoa to Rice Ratio in Ghana: 10: 7.5 or 4:3 or 1: 0.75 Cocoa to Rice ratio in Korea: 2.5:5 or 1:2 Cocoa is cheaper in Ghana. So Ghana can sell 1 unit of cocoa to Korea and get 2 units of Rice whereas she can only get 0.75 units of rice in exchange of giving up 1 unit of cocoa production in her own country. So, Ghana would export cocoa and import rice.
Theory of Comparative Advantage On the other hand, Rice to cocoa Ratio in korea:5:2.5 or 1:0.5 Rice to cocoa Ratio in Ghana:7.5:10 or 1: 1.33 Rice is cheaper in Korea because Korea can sell 1 unit of Rice to Ghana and get 1.33 units of cocoa whereas she can only get 0.5 units of cocoa by sacrificing the same amount of rice in her own country. SO Comparative Advantage comes into effect
Comparative Advantage and the Gains from Trade Table 4.2 S. Korea 40 20 S. Korea 2.5 5.0 S. Korea 0.0 10.0 S. Korea 4 6 Resources Required to Produce 1 Ton of Cocoa and Rice Ghana 10 13.33 Production and Consumption without Trade Ghana 10.0 7.5 Total production 12.5 12.5 Production with Specialization Ghana 15 3.75 Total production 15 13.75 Consumption after Ghana Trades 4T of Cocoa for 4TSouth Korean Rice Ghana 11 7.75 Increase in Consumption as a Result of Specialization and Trade Ghana 1.0 0.25 S. Korea 1.5 1.0 Cocoa Rice
The Theory of Comparative Advantage Figure 4.2 3.75 7.5 2.5 G’ 0 5 10 15 20 5 10 15 20 Cocoa Rice G C A K K’ B
The Basic Message of the Theory of Comparative Advantage
Potential world Production is higher greater with unrestricted free trade than it is with restricted trade.
Trade is a positive-sum game where all countries that participate realize economic gains.
Factor endowments: extent to which a country is endowed with such resources as land, labor, and capital.
Comparative Advantage arises out of national factor endowments. USA exports agricultural products because it has huge arable land . China excels in exporting labor-intensive manufactured goods like textile and footwear due to its abundance of low-cost labor.
Maybe because the US has advantages in innovative technologies which are less capital intensive but rather skill based (Computer Software)on the other hand she may import products that require heavy machinery and in turn large amounts of capital.
If Porter is right, we would expect his model to predict the pattern of international trade that we observe in the real world. Countries should be exporting products from those industries where all four components of the diamond are favorable, while importing in those areas where the components are not favorable.