Adam smith and devid recaro


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Adam smith and devid recaro

  1. 1. ABSOLUTE AND COMPARATIVE ADVANTAGEMERCANTILISM Mercantilism is a theory developed by the merchants; hence thename. It rests on the role of a strong state in supporting (state-granted)monopolies and protecting shipping and trading lanes. Mercantilismencourages exports and discourages imports. Gold and silver are used tokeep score of the game played between nation-states, and represent thewealth of the nation.ABSOLUTE ADVANTAGE THEORYAdam Smith, 1776 Adam Smith, The Wealth of Nations, London, 1776. The theory ofabsolute advantage was advanced to buttress Smiths argument that ifthere was no government involvement in trade, and if each individual wasleft to do what in his or her own best interest, then there would be moregoods and services available, prices would be reduced, and the wealth ofeach nation, measured as the welfare of the citizens, would increase.Smiths theory was offered to replace mercantilism. The Theory of Absolute Advantage and the Theory of ComparativeAdvantage rest on very strong assumptions, as follows: (1) Two countries, two commodities - assumed in boththeories. The theories are obvious for this case. The three-by-three case(and those beyond) cannot be established analytically, and it is not evenclear how the principle should be formalized. (See p. 3 of Ronald Jones,"The Positive Theory of International Trade," Handbook of InternationalEconomics, R. Jones and P. Kenen (eds.), 1984.) (2) Efficiency objective - The Absolute and ComparativeAdvantage theories assume that total world production, and thereforeefficiency, is the objective. Efficiency is not always a country goal. (3) Zero Transportation Costs - both theories presume thattransportation costs between and within countries are zero. (4) Factor Mobility/Immobility - both theories presume thatresources are absolutely mobile within a country and absolutely immobilebetween countries. (5) Full employment - Both theories assume full employment ineach country.These are very strong assumptions.
  2. 2. The USUAL EXAMPLE - PART 1 Suppose we have a two country world composed of Sweden andColombia. Suppose, as per the text, there are two goods in this world,engines and coffee. The production rate table is as follows:(hrs./unit) Sweden ColombiaEngines 10 200Coffee 300 50Suppose, further, that each country has 6,000 hours of labor. Finally,suppose that each country follows a crude form of mercantilism anddevotes half of its labor resource to each good. Then the production ineach 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 coffeeThus, world production is 315 engines and 70 kg. of coffee. Now, suppose that each country is enlightened by Smith and pursuesits absolute advantage. Clearly, Sweden has an absolute advantage inengines and Colombia has an absolute advantage in coffee. Then Swedenwould devote all of its labor resource to engines and Colombia all of itslabor 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 coffeeThus, world production is increased form 315 to 600 engines and from 70kg. to 120 kg. of coffee. Clearly, world production has increased and eachcountry can be made better off if trade is free. This example is arbitrary in that the division of the labor resourceinto halves was arbitrary. Here is an exercise. Show that if Swedenallocates s% of its labor to engines and (1-s)% to coffee, and if Colombiaallocates (1-c)% of its labor to engines and c% to coffee, then total world
  3. 3. production is maximized at s = 1 and c = 1, i.e., at the Absolute Advantagesolution. (Hint: Use linear programming.) Smith is correct. If government got out of the business ofsupporting inefficient production (e.g., coffee in Sweden and engines inColombia) and left each decision maker to his or her own devices, thenworld production would increase. Indeed, in our example, it nearly doublesin each good. Sources of absolute (and comparative) advantage Natural - climatic, resource endowment, etc. The Britishimport tea for this reason; Idaho has a natural (absolute) advantage inproducing Idaho trout, Idaho white pine, and Idaho potatoes. Acquired - a technique or process technology. The Swiss havean acquired (absolute) advantage in mechanical watches, the Belgians inchocolate and beer, the Japanese in electronic watches, the Germans inmachine tools, the Americans and Europeans in airplanes, etc.)COMPARATIVE ADVANTAGE THEORYDavid Ricardo, 1817 See David Ricardo, The Principles of Political Economy and Taxation,London, 1817. The theory of comparative advantage advances and refinesSmiths theory of absolute advantage. Ricardo agreed with Smiths viewthat if there was no government involvement in trade, and if eachindividual was left to do what is in his or her own best interest, thenthere would be more goods and services available, prices would bereduced, and the wealth of each nation would increase. Ricardoscomparative advantage theory extends Smiths view to the case where oneof the two countries has an absolute advantage in both commodities, andshows that even here trade is good for both countries. As noted above, Ricardos Comparative Advantage Theory rests onthe same very strong assumptions that underlie Smiths AbsoluteAdvantage 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 andTaxation, London: J. M. Dent & Sons, Ltd., date not listed, p. 82.) Suppose
  4. 4. England and Portugal each have 6,000 hours of labor available, and theproduction possibilities are as follows:(hrs./unit) England PortugalCloth 100 90Wine 120 80Notice 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. Thenwe 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 wineThus, 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 ofboth cloth and wine. Note, however, that Portugals greater efficiency isnot the same in both commodities. Rudely put, one English laborer isworth 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 workersin the production of both goods, the English workers are less worse in theproduction of cloth than they are in the production of wine. (Putdifferently, the degree of efficiency of the Portuguese workers is greaterin the production of wine than in the production of cloth.) Thus, Englandhas a comparative advantage in the production of cloth, and Portugal has acomparative (and absolute) advantage in the production of wine. This issummarized as follows: England has a comparative advantage in theproduction of cloth because 90/80 > 100/120, i.e., because hrs. hrs. unit of cloth Portugal unit of cloth England hrs. > hrs. unit of wine Portugal unit of wine England
  5. 5. This can also be stated as follows: England has a comparative advantagein the production of cloth because 90/100 > 80/120, i.e., because hrs. hrs. unit of cloth Portugal unit of wine Portugal hrs. > hrs. unit of cloth England unit of wine England(Note that the second inequality is simply a restatement of the first. Notealso that the first inequality compares ratios taken within the countries,whereas the second compares ratios taken across the countries. See AkiraTakayama, 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 ofcloth, then we would have 6000 hrs./(100 hrs./cloth) = 60 units of clothfrom England. In order to maintain the previous level of world productionof cloth (i.e., 63 1/3 units of cloth), it is necessary for Portugal toproduce at least 3 1/3 units. Thus, Portugal must allocate at least 300hours of labor (300 = 3 1/3 times 90) to the production of cloth. IfPortugal allocates the remaining 2700 hours of labor to the production ofwine, 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, aswe had before, and 71 1/4 units of wine, which is an increase of 8 3/4units of wine. Clearly, if we allocate slightly more than 300 hours of labor inPortugal to the production of cloth and the remaining hours to theproduction of wine, then we can increase the total world production ofboth cloth and wine by having England produce to its comparativeadvantage. Therefore, Ricardos extension of Smiths analysis holds. Thatis, even if one country is dominated in the production of both goods by theother country, both countries can be made better off if they engage in freetrade and the dominated country produces to its comparative advantage.
  6. 6. This example, like the absolute advantage example, is arbitrary inthat the division of the labor resource into halves was arbitrary. Here isanother exercise. Show that if Portugal allocates p% of its labor to clothand (1-p)% to wine, and if England allocates (1-e)% of its labor to clothand e% to wine, then total world production is maximized at e = 1, i.e., atthe comparative advantage solution. (Hint: Use linear programming.)