Comparative Advantage (Ricardo's Model
of Trade)
Mercantilists: - ANS-Were an influential school of economic thought that flourished
between 1500 and 1800. The Mercantilists believed that it was desirable four countries
to accumulate gold from having current account surpluses and that this would lead to an
increase in the wealth of the country. For this reason, the Mercantilists were against the
principles of free trade.
David Hume - ANS-lived in Scotland is well known for his work as both a philosopher
and economist. Hume pointed out the fallacy of the Mercantilists arguments
-Hume developed the specie flow argument that a country accumulating gold will
increase its monetary base, and hence its rate of inflation and this will remove its
competitiveness, so that its prices will rise relative to the rest of the world.
-Hence over time, the country will export less and import more and hence its trade
surplus, or wealth, will be eroded. Hume showed that the Mercantilists had ignored the
dynamic adjustment that would be expected to occur in this situation
Adam Smith (1723-1790) - ANS-also lived and worked in Edinburgh, Scotland and
published the "Wealth of Nations" in 1776 and discussed the division of labor, the free
market through the rational pursuit of self interest on part of the individual, which leads
to the invisible hand making the market economy efficient.
Smith emphasized the creation of wealth through free markets, including free trade.
These arguments used the important concept of Absolute Advantage.
Smith also developed the idea of efficient markets seeking to trade at the price which
maximizes the utility of an individual's situation eventually increases the welfare of all
the participants.
David Ricardo (1772-1823) - ANS-developed the theory of comparative advantage and
showed the mutual benefits arising from trade and advocated free trade
Comparative and Absolute Advantage for an Individual: - ANS-Consider the following
situation of a physician and a secretary. Clearly the physician has an absolute and also
comparative advantage over the secretary in terms of performing surgery. However,
, also suppose the physician is a better organizer, typist, and administrator than her
secretary. Hence the physician has an absolute advantage over the secretary in terms
of both surgery and secretarial services. However, due to physical and time constraints
the surgeon cannot do both jobs of being a surgeon and a secretary.
It is impossible for the secretary to perform the physician's job. Hence, the physician
has a COMPARATIVE ADVANTAGE in performing surgery, while the secretary has a
COMPARATIVE ADVANTAGE in being a secretary. Hence an individual may have an
absolute advantage in most things, but not a comparative advantage in most things.
The same analogy is true also for countries
Ricardian Model and Comparative Advantage - ANS-To understand why countries trade
we must consider how they can benefit from differences so that production can be
specialized. By trading they increase their consumer's choice set and the consumer's
utility in both countries.
The existence of Economies of scale in production implies that it is possible to produce
larger quantity more efficiently and at a lower cost.
[opportunity cost] the income lost, or amount of good foregone in the production of
another good, e.g the income lost from holding money rather than interest bearing
bonds
[absolute advantage] a country or an individual is absolutely more efficient at production
of a good than another country or an individual
[comparative advantage] is the idea that a country or an individual is relatively more
efficient at production of a good or service than another country or an individual
[autarky] is the state of self sufficiency, which implies no trade. this is similar to a siege
economy; or an economy where complete protectionist policies have been implemented
Ricardo's theory of comparative advantage - ANS-In order to understand the basic
concept of Comparative Advantage, it is simplest to start with a very simple model
which assumes:
a) a two country world
b) a two good world
c) no money illusion, therefore only RELATIVE PRICES matter
of Trade)
Mercantilists: - ANS-Were an influential school of economic thought that flourished
between 1500 and 1800. The Mercantilists believed that it was desirable four countries
to accumulate gold from having current account surpluses and that this would lead to an
increase in the wealth of the country. For this reason, the Mercantilists were against the
principles of free trade.
David Hume - ANS-lived in Scotland is well known for his work as both a philosopher
and economist. Hume pointed out the fallacy of the Mercantilists arguments
-Hume developed the specie flow argument that a country accumulating gold will
increase its monetary base, and hence its rate of inflation and this will remove its
competitiveness, so that its prices will rise relative to the rest of the world.
-Hence over time, the country will export less and import more and hence its trade
surplus, or wealth, will be eroded. Hume showed that the Mercantilists had ignored the
dynamic adjustment that would be expected to occur in this situation
Adam Smith (1723-1790) - ANS-also lived and worked in Edinburgh, Scotland and
published the "Wealth of Nations" in 1776 and discussed the division of labor, the free
market through the rational pursuit of self interest on part of the individual, which leads
to the invisible hand making the market economy efficient.
Smith emphasized the creation of wealth through free markets, including free trade.
These arguments used the important concept of Absolute Advantage.
Smith also developed the idea of efficient markets seeking to trade at the price which
maximizes the utility of an individual's situation eventually increases the welfare of all
the participants.
David Ricardo (1772-1823) - ANS-developed the theory of comparative advantage and
showed the mutual benefits arising from trade and advocated free trade
Comparative and Absolute Advantage for an Individual: - ANS-Consider the following
situation of a physician and a secretary. Clearly the physician has an absolute and also
comparative advantage over the secretary in terms of performing surgery. However,
, also suppose the physician is a better organizer, typist, and administrator than her
secretary. Hence the physician has an absolute advantage over the secretary in terms
of both surgery and secretarial services. However, due to physical and time constraints
the surgeon cannot do both jobs of being a surgeon and a secretary.
It is impossible for the secretary to perform the physician's job. Hence, the physician
has a COMPARATIVE ADVANTAGE in performing surgery, while the secretary has a
COMPARATIVE ADVANTAGE in being a secretary. Hence an individual may have an
absolute advantage in most things, but not a comparative advantage in most things.
The same analogy is true also for countries
Ricardian Model and Comparative Advantage - ANS-To understand why countries trade
we must consider how they can benefit from differences so that production can be
specialized. By trading they increase their consumer's choice set and the consumer's
utility in both countries.
The existence of Economies of scale in production implies that it is possible to produce
larger quantity more efficiently and at a lower cost.
[opportunity cost] the income lost, or amount of good foregone in the production of
another good, e.g the income lost from holding money rather than interest bearing
bonds
[absolute advantage] a country or an individual is absolutely more efficient at production
of a good than another country or an individual
[comparative advantage] is the idea that a country or an individual is relatively more
efficient at production of a good or service than another country or an individual
[autarky] is the state of self sufficiency, which implies no trade. this is similar to a siege
economy; or an economy where complete protectionist policies have been implemented
Ricardo's theory of comparative advantage - ANS-In order to understand the basic
concept of Comparative Advantage, it is simplest to start with a very simple model
which assumes:
a) a two country world
b) a two good world
c) no money illusion, therefore only RELATIVE PRICES matter
