Chapter 2.

Questions for review

No Question Answer
.

1 What are the basic questions that we seek to Three basic questions that seek to answer in chapter 2:
answer in this chapter? In what way is the model
presented in this chapter an abstraction or a (a) What is the basis for trade?
simplification of the real world? Can the model
(b) What are the gains from trade?
be generalized?
(c) What is the pattern of trade?

Besides, we examine the development of trade theory from the

17th century to the first part of the 20th century through a
simplification model of the real world. (Like the mercantilist’s
views on trade, absolute advantage theory by Adam Smith,
and comparative advantage theory by Ricardo)

The model presented in this chapter can be generalized

through several theories such as opportunity cost, production
possibility frontier and empirical test of the Ricardian model.

2 What were the mercantilists’ views on trade? Mercantilists views on trade were that:
How does their concept of national wealth differ
from today’s view? - The way for a nation to become rich and powerful was
to export more than it imported, as well as gain a trade
surplus.

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 - The wealth of the nation could be measured by an
inflow of bullion, or precious metals, primarily gold and
silver.

- The more gold and silver a nation had, the richer and
more powerful it was.

Modern trade views are way different than mercantilist’s trade

view that:

- The wealth of a nation is measured by its stock of

human (human capital, labor), man-made, capital
(direct& indirect), investment (public & private), and
natural resources available for producing goods and
services.

- The greater this stock of useful resources, the greater is

the flow of goods and services to satisfy human wants,
and the higher standard of living of the nation.

3 Why is it important to study the mercantilists’ - It is crucial to study the mercantilist’s views on trade
views on trade? How were their views different because of:
from those of Adam Smith? What is the relevance
of all this today? + The ideas of classical economists can best be
understood if they are regarded as reactions to
the mercantilists’ views on trade and on the role
of government.

+ In today’s world, there seems to be a resurgence

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 of neo-mercantilism, as nations plagued by high
levels of unemployment seek to restrict imports
to stimulate domestic production and
employment.

- Smith’s views about trade are different from the

mercantilist’s views that:

+ Trade between two nations is based on absolute

advantage.

+ While the mercantilists believed that one nation

could gain only at the expense of another nation
and advocated strict government control of all
economic activity and trade, Adam Smith (and
the other classical economists who followed him)
believed that all nations would gain from free
trade and strongly advocated a policy of laissez-
faire (i.e., as little government interference with
the economic system as possible).

+ Free trade would cause world resources to be

utilized most efficiently and would maximize
world welfare. There were to be only a few
exceptions to this policy of laissez-faire and free
trade.

- Absolute advantage is still relevant in today’s world that:

+ Most nations impose many restrictions on the

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 free flow of international trade. Trade restrictions
are invariably rationalized in terms of national
welfare. Trade restrictions are advocated by the
few industries and their workers who are hurt by
imports. As such, trade restrictions benefit the
few at the expense of the many (who will have to
pay higher prices for competing domestic
goods).

+ Smith’s theory served the interest of factory

owners (who were able to pay lower wages
because of cheaper food imports) and harmed
landowners in England (because food became
less scarce due to cheaper imports), and it shows
the link between social pressures and the
development of new economic theories to
support them.

4 What was the basis for and the pattern of trade - According to A. Smith’s theory, trade between two
according to Adam Smith? How were gains from nations is based on absolute advantage. Smith started
trade generated? What policies did Smith with the simple truth that for two nations to trade with
advocate in international trade? What did he each other voluntarily, both nations must gain. If one
think was the proper function of government in nation gained nothing or lost, it would simply refuse to
the economic life of the nation? trade.

- Adam Smith’s theory:

+ When one nation is more efficient than (or has

an absolute advantage over) another in the

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 production of one commodity but is less efficient
than (or has an absolute disadvantage with
respect to) the other nation in producing a
second commodity, then both nations can gain
by each specializing in the production of the
commodity of its absolute advantage and
exchanging part of its output with the other
nation for the commodity of its absolute
disadvantage.

+ By this process, resources are utilized in the most

efficient way, and the output of both
commodities will rise.

- Gains from trade can be generated by:

+ The increase in the output of both commodities

measures the gains from specialization in
production available to be divided between the
two nations through trade.

- The policies that A. Smith advocates:

+ All nations would gain from free trade and

strongly advocated a policy of laissez-faire (i.e.,
as little government interference with the
economic system as possible).

- The main function of the government in the economic

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 life of the nation that A. Smith thought about is:

+ The protection of industries important for

national defense.

5 In what way was Ricardo’s law of comparative

advantage superior to Smith’s theory of absolute
advantage? How do gains from trade arise with
comparative advantage? How can a nation that is
less efficient than another nation in the
production of all commodities export anything to
the second nation?

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Problems:

1. Table 2.5 shows bushels of wheat and yards of cloth that the United States and the United Kingdom can
produce with one hour of labor time under four different hypothetical situations. In each case, identify the
commodity in which the United States and the United Kingdom have an absolute advantage or
disadvantage.

Case A:

- The US has an absolute advantage over the UK in wheat production.

- The UK has an absolute advantage over the US in cloth production.

Case B:

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- The US has an absolute advantage over the UK in both commodities

- The UK has an absolute disadvantage in both commodities.

Case C:

- The US has an absolute advantage over the UK in wheat production.

- Neither of these nations has an absolute advantage in cloth production.

Case D:

- The US has an absolute advantage over the UK in both commodities.

- The UK has an absolute disadvantage in both commodities.

2. With respect to Table 2.5, indicate in each case the commodity in which each nation has a comparative
advantage or disadvantage.

Case A.

The US The UK

In 1 hour of production 4W=1C ->1W=1/4C 1W=2C

Comparative price of wheat PW/PC = 1/4 PW/PC = 2

Comparative price of cloth PC/PW= 4 PC/PW=1/2

- The US has a comparative advantage over the UK in wheat production

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- The UK has a comparative advantage over the US in cloth production.

-> The US should export wheat, import cloth

-> The UK should export cloth, import wheat.

Case B

The US The UK

In 1 hour of production 4W=3C ->1W=3/4C 1W=2C

Comparative price of wheat PW/PC = 3/4 PW/PC = 2

Comparative price of cloth PC/PW= 4/3 PC/PW=1/2

- The US has a comparative advantage over the UK in wheat production

- The UK has a comparative advantage over the US in cloth production

Case C

The US The UK

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 In 1 hour of production 4W=2C ->1W=1/2C 1W=2C

Comparative price of wheat PW/PC = 1/2 PW/PC = 2

Comparative price of cloth PC/PW= 2 PC/PW=1/2

- The US has a comparative advantage over the UK in wheat production

- The UK has a comparative advantage over the US in cloth production.

Case D

The US The UK

In 1 hour of production 4W=2C ->1W=1/2C 2W=1C -> 1W =1/2C

Comparative price of wheat PW/PC = 1/2 PW/PC = 1/2

Comparative price of cloth PC/PW= 2 PC/PW=2

- The US and the UK has a comparative advantage in neither commodity.

3. With respect to Table 2.5, indicate in each case whether or not trade is possible and the basis for trade.

Case A: Trade is based on absolute advantage.

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Case B: Trade is based on comparative advantage.

Case C: Trade is based on comparative advantage.

Case D: No trade is possible (both commodities have the same ratio in both absolute and comparative advantage)

4. Suppose that in Case B in Table 2.5 the United States exchanges 4W for 4C with the United Kingdom.

(a) How much does the United States gain in terms of cloth?

The US gains 1C

(b) How much does the United Kingdom gain in terms of cloth?

The UK gains

(c) What is the range for mutually beneficial trade?

(d) How much would each nation gain if they exchanged 4W for 6C instead?

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