History of Economic Doctrines

Lecture 9

David Ricardo (1772-1823)

Trade and Comparative Advantage

David Ricardo replaced the “absolute advantage” approach of Adam Smith as a foundation for trade with the “law of comparative advantage.” Ricardo also argued that trade facilitates focusing on more and better specialization and divisions of labor.

law of comparative advantage:

The law of comparative advantage is an assertion that mutually beneficial trade can always take place between two countries (or individuals) whose pretrade cost and price structures differ.

No Trade

Ex: Suppose that, initially, without trade, the exchange rate is 10 coffees for one acrylic bearskin rug in Brazil, and one coffee for 10 acrylic rugs in Brazil. The absolute value of the slope of the PPF = relative prices of goods. The interior straight lines in this figure are the initial production possibilities frontiers and the consumption possibilities frontiers as well.

Free Trade with Complete Specialization

When trade commences, both nations’ consumption possibility curves shift outward so that more consumption of both goods occurs in both countries. With trade, the slope of the consumption possibilities frontier (CPF) equals the relative prices (terms of trade) given by the red line above. Why? Trade allows for one to focus on the thing that you are best at à you sell the things that you are relatively good at producing, in exchange for purchases of the things that you are relatively less efficient in producing.

Thus trade in accord with comparative advantage ultimately allows both Brazilians and Alaskans to consume more of both goods.

FOUR CATEGORIES OF GAINS FROM TRADE

Mercantilists are often viewed as vehement opponents of imports. They were not. Most mercantilists recognized the gains derived from trading domestic production for goods that could not be produced domestically – the uniqueness gains from trade. The gains from trade described by David Ricardo [above] can be thought of as static gains from specialization and exchange in accord with comparative advantage. In addition to the gains recognized by these early theorists, more modern economists have identified numerous dynamic gains and political gains from trade.

1. Comparative Advantage: Static Gains from trade.

David Ricardo’s “Law of Comparative Advantage”

2. Uniqueness Gains:

Some goods are almost impossible to produce domestically: ex: chrome or diamonds.

3. Dynamic Gains: Trade as a Foundation for Economic Growth

i. Technology transfers and inventions.

ii. Investment: MPC<1 and Y=C+S, then what you do not consume is S which is used for investment. More capital/investment will expand the PPF curve outwards and thus; benefit society by being able to produce more.

iii. Competition: Monopoly power in one country is significantly reduced by foreign competition. The globalization of competition induces more rapid innovation of efficient technologies.

iv. Economies of scale and scope: Domestic markets may be inadequate to permit full exploitation of economies of scale and scope. Economies of scale and scope may be more completely exploited because globalization expands the sizes of markets.

4. Political Gains:

If trade fosters interdependence among nations, then the cost of having conflicts/war will go up. [It can be very costly and unwise to fight with your customers or suppliers.] This results in more peaceful international relations.

economies of scale:

Economies of scale exist when increases in inputs result in more than proportional increases in output so that long-run average costs fall as output rises.

economies of scope:

Economies of scope are cost savings realized because certain types of production are complementary. For example, it may be less costly for one firm to produce two or more products than it would be for different firms to separately produce each product. Economies of scope may also be present in the form of positive externalities between industries within a country as it develops. For example, workers who become accustomed to punching a clock in one industry may already have the discipline necessary to work in another industry, and their examples may help their friends and relatives adapt to changes in the working environment.

Example of technology transfers: Overall, the U.S. has the best educational system in the world, and attracts many foreign students. Many educated foreign students return to their home countries and help develop their own countries.

Aside: Saving and investment: The paradox of US growth. Official US saving rates are incredibly low compared to many other countries. US saving = 2-3% of GDP, while the industrialized countries of Europe and Asia commonly have saving rates estimated at from 12% to 25% of GDP. Why is the US prosperous? Possible partial answer: In the National Income Accounts, spending on education is treated as consumption, not saving. If expenditures of education were treated as saving and investment, the picture might be much more accurate. Note: Another partial answer is that foreign investors have invested heavily in the US, especially during 1976-1993, and 2001-2004. [Federal budget deficits have been roughly paralleled by US trade deficits, which provided foreigners with investable US dollars.]

Issue: Should we eliminate barriers against trade with Cuba?

Huge Issue: OUTSOURCING: The Costs and Benefits

outsourcing:

The term outsourcing refers to attempts by a firm to reduce costs by contracting with another firm to do work previously done internally, within the firm. Outsourcing across international borders is currently increasing dramatically, and has become a thorny political issue.

Early in 2004, Greg Mankiw, the Chairman of President Bush’s Council of Economic Advisors, said that outsourcing across international borders is probably good for the US economy. Most economists would agree with him, but his comments aroused a negative reaction from the public.

Aside: Lower prices always benefit buyers and harm sellers. However, as Adam Smith noted in the Wealth of Nations, the ultimate purpose of economic activity is to resolve scarcity so that we can consume. Production is valuable only to the extent that it furthers the normative economic goal of higher standards of living.

Outsourcing (a synonym for “importing services”?) creates gains from trade, but imposes losses due to costs of transition. Thus, losses are incurred by some people any time relative prices and costs change when, for example, a society adopts new technology or international trade expands. [“Globalization.”]

Ex: The transition of America’s society from agriculture to an industrial society. At the time of the American Revolution, 70-80% of Americans were involved in agriculture; today, less than 2% depend directly on agriculture for income. Overall society has gained with the shift from rural agriculture to urban industrial employment, and now, increasingly, to the service economy. However, but there are “negative pecuniary externalities” which in this case meant that small farmers were hurt by the changing structure of agriculture as the prices of food dropped because of technological change. The percentage of income that goes for food from typical family budgets has dropped tremendously over the centuries. Farmers continue to be driven out of agriculture because of declining relative prices for agricultural production.

Some people are hurt financially if their jobs are replaced by technological advances, or are “outsourced” through international trade. However there are many who gain from the lower prices resulting from outsourcing.

Ex: The US has completely stopped producing small electronics and instead imports them from other countries where they can be produced with cheaper and less skilled labor. And American consumers gain.

Losses from Barriers to Trade:

Every job saved by President Bush’s steel tariff cost other US producers and consumers more than $3 million per year. Roughly 5,000 jobs for steelworkers were “saved” by 30% tariffs from 2001-2003, but roughly 20,000 jobs in “downstream” industries [ex: automobile and construction industries] were lost because of these barriers to trade. People’s whose jobs are lost don’t consider the overall advantage of “outsourcing.”

Political Economy and Trade

In the United States, the losers from trade tend not to be at the top of the income pyramid. People who lose jobs and income because of expanded trade are far more intensely affected as individuals by changes in patterns of trade than are those who gain because of lower prices. Thus, the losers from trade are far more prone to vote as a bloc on this issue than are those who gain. Consequently, overcoming political resistance to “outsourcing” may require generous trade adjustment assistance in the form of extended [and increased?] unemployment compensation and job retraining programs, etc.

An Extension: The Heckscher- Ohlin- Samuelson Theory

Who gains and who loses?

[Eli Heckscher (1879-1952) and Bertil Ohlin (1899-1979) and Paul Samuelson (1915- )

Aside: Intuition on Diminishing Marginal Products: Note: Q/L [average labor productivity] is upward sloping because the higher is K/L [more machines per worker] the greater is the output per worker. Similarly, Q/K is downward sloping because the higher is K/L [fewer workers per machine] the lower is the output per machine.

Assumptions:

Consider two resources K and L. and two countries, A and B, and two goods, X and Y. Let w = the wage rate, and r equal the rate of return from economic capital.

1. Suppose A is relatively abundant in capital, and B is relatively abundant in labor, so that

(K,L)A>(K,L)B =capital labor ratio.

2. Suppose also that efficient production of X requires a greater K/L ratio than does Y. [X is a capital intensive good, and Y is a labor intensive good.]

Results: No Trade:

3. If there is no trade, then (w/r)A > (w/r)B. [w reflects the relative productivity of labor, and r reflects the relative productivity of capital.].
4. It follows that, with no trade, (Px/Py)A < (Px/Py)B because w/r is higher in America than in Brazil, and thus, r/w is higher in Brazil than America.

Results: With Trade:

5. Suppose the two countries begin to trade.
6. As America exports X and imports Y, price of Y goes down and price of X goes up because there are more consumers to compete for the product. In equilibrium, (Px/Py)A = (Px/Py)B.
7. It follows that resource prices will tend to equalize (w/r)A = (w/r)B. Thus, wages tend to fall in the US and rise in Brazil, while the rate of return to capital will rise in the US and fall in Brazil.
8. Thus, the static gain to trade goes to owners of capital in America, while in Brazil, workers gain.

Application of H-O-S Theory:

The education system of the United States is unmatched in embedding human capital in the work force. Consequently the U.S. export goods intensive in human capital. Result? Since 1976, the U.S. income distribution gap widened in part because rich and/or educated [human] capital owners gained tremendously from globalization. Unskilled workers [people with little capital, physical or human] gained the least from trade. [Note: The gap between US high school and college graduate incomes has grown enormously in the past 40 years.] However, in Brazil, trade leads to low skilled workers gaining the most due to their export of cheap labor.

Another example: In 1950 per capita Japanese income was roughly half of that in Mexico. Since then, Japan has become an industrial powerhouse, and Japanese wages are now roughly 80% of those in the United States. Reason: Japan has a very high saving rate and invested heavily in physical and human capital. This enable Japan to, ex: make better cars and sell them at low prices.

Summary:

1. The static gains from trade in accord with comparative advantage go exclusively to the owners of the resource that was relatively abundant in a country before trade; because the country will export goods intensive in the abundant resource, and import the goods intensive in the relatively scarce resource.

2. The owners of the resource that was relatively scarce in the country before trade lose from trade in accord with comparative advantage.

3. In the long run, it is highly likely that almost everyone gains because of:

a. uniqueness gains.

b. dynamic gains facilitating economic growth include: (i) technology transfers, (ii) faster capital accumulation, (iii) economies of scale and scope, and (iv) international competition.

4. political gains. International relations are calmer when we trade.

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These web pages are significantly edited and elaborated versions of student notes based on lectures by Ralph Byrns, 2002-2005.