Summary ITT Readings
Week 1
Ch.3: Why Everybody Trade: Comparative Advantage
Full analysis of international trade requires consideration of the entire economy. Yet the
entire economy is very complex. Thus, we consider an economy composed of just two
products. For international trade, one product can be exported and the other imported.
This captures an essential feature of international trade: A country tends to be a net
exporter of some products and a net importer of others.
Adam Smith’s Theory of Absolute Advantage
Adam Smith promoted free trade by comparing nations to households. Every household
finds it worthwhile to produce only some of the products it consumes, and to buy other
products using the proceeds from what the household can sell to others. The same should
apply to nations.
International trade can create benefits, because the US can focus on producing what it
does best (wheat) and export it, and the rest of the world can focus on producing what it
does best (cloth) and export it.
Better at producing means each country’s ability to produce each product in one of two
equivalent ways:
- Labor productivity: the numver of units of output that a worker can produce in one
hour
- The reciprocal of labor productivity: the number of hours that it takes a worker to
produce one unit of output
Absolute advantage: labor productivity in wheat (EG) is higher than the rest of the world’s
labor productivity in wheat. If there is no trade, then each country will have to produce
both products (wheat and cloth) to satisfy its demand for the products. If the countries
then open to free trade, each can shift its labor resources toward producing the good in
which it has the absolute advantage. The total world production increases. For each
product, production using labor that has high productivity replaces production using labor
that has low productivity.
Adam Smith showed the benefits of free trade by showing that global production
efficiency is enhanced because trade allows each country to exploit its absolute advantage
in producing some product(s). At least one country is better off with trade, and this
country’s gain is not at the expense of the other country.
Yet the argument fails to put to rest a fear that others had already expressed even before
he wrote: What if our country has no absolute advantage and foreigners are better at
everything? Would they want to trade?
Ricardo’s theory of comparative advantage
David Ricardo showed that there is a basis for beneficial trade whether or not countries
have any absolute advantage. The opportunity cost of producing more of a product in a
country is the amount of production of the other product that is given up. The opportunity
cost exists because production resources must be shifted from the other product to this
product.
Principle of comparative advantage: A country will export the goods and services that it
can produce at a low opportunity cost and import the goods and services that it would
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Week 1
Ch.3: Why Everybody Trade: Comparative Advantage
Full analysis of international trade requires consideration of the entire economy. Yet the
entire economy is very complex. Thus, we consider an economy composed of just two
products. For international trade, one product can be exported and the other imported.
This captures an essential feature of international trade: A country tends to be a net
exporter of some products and a net importer of others.
Adam Smith’s Theory of Absolute Advantage
Adam Smith promoted free trade by comparing nations to households. Every household
finds it worthwhile to produce only some of the products it consumes, and to buy other
products using the proceeds from what the household can sell to others. The same should
apply to nations.
International trade can create benefits, because the US can focus on producing what it
does best (wheat) and export it, and the rest of the world can focus on producing what it
does best (cloth) and export it.
Better at producing means each country’s ability to produce each product in one of two
equivalent ways:
- Labor productivity: the numver of units of output that a worker can produce in one
hour
- The reciprocal of labor productivity: the number of hours that it takes a worker to
produce one unit of output
Absolute advantage: labor productivity in wheat (EG) is higher than the rest of the world’s
labor productivity in wheat. If there is no trade, then each country will have to produce
both products (wheat and cloth) to satisfy its demand for the products. If the countries
then open to free trade, each can shift its labor resources toward producing the good in
which it has the absolute advantage. The total world production increases. For each
product, production using labor that has high productivity replaces production using labor
that has low productivity.
Adam Smith showed the benefits of free trade by showing that global production
efficiency is enhanced because trade allows each country to exploit its absolute advantage
in producing some product(s). At least one country is better off with trade, and this
country’s gain is not at the expense of the other country.
Yet the argument fails to put to rest a fear that others had already expressed even before
he wrote: What if our country has no absolute advantage and foreigners are better at
everything? Would they want to trade?
Ricardo’s theory of comparative advantage
David Ricardo showed that there is a basis for beneficial trade whether or not countries
have any absolute advantage. The opportunity cost of producing more of a product in a
country is the amount of production of the other product that is given up. The opportunity
cost exists because production resources must be shifted from the other product to this
product.
Principle of comparative advantage: A country will export the goods and services that it
can produce at a low opportunity cost and import the goods and services that it would
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