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CHAPTER 2 THE LAW OF COMPARATIVE ADVANTAGE - Coggle Diagram
CHAPTER 2 THE LAW OF COMPARATIVE ADVANTAGE
INTERNATIONAL TRADE THEORIES
International trade theory is a sub-field of economics which analyzes the patterns of international trade, its origins, and its welfare implications. International trade policy has been highly controversial since the 18th century. International trade theory and economics itself have developed as means to evaluate the effects of trade policies.
MERCANTILISM
Mercantilism is a political economy system aims at generating wealth by limiting imports & encouraging exports
The policy aims to reduce a possible current account deficit or reach a current account surplus, and it includes measures aimed at accumulating monetary reserves by a positive balance of trade, especially of finished goods
Trade policy was to encourage exports & restrict imports
Belief that nation could become rich & powerful only by exporting more than import
Mercantilism was an economic system of trade that spanned from the 16th century to the 18th century. Mercantilism is based on the principle that the world's wealth was static
ADAM SMITH THEORY OF ABSOLUTE ADVANTAGE
Attack the mercantilists view
In economics, the principle of absolute advantage refers to the ability of a party to produce a good or service more efficiently than its competitors.
Adam Smith’s theory of absolute cost advantage in international trade was evolved as a strong reaction of the restrictive and protectionist mercantilist views on international trade
He upheld in this theory the necessity of free trade as the only sound guarantee for progressive expansion of trade and increased prosperity of nations.
Suggest both nation could enjoy higher level of production & consumption with trade.
ASSUMPTION OF ABSOLUTE ADVANTAGE
1. Lack of Mobility for Factors of Production
Adam Smith assumes that factors of production cannot move between countries. This assumption also implies that the Production Possibility Frontier of each country will not change after the trade.
2. Trade Barriers
There are no barriers to trade for the exchange of goods. Governments implement trade barriers to restrict or discourage the importation or exportation of a particular good.
3. Trade Balance
Smith assumes that exports must be equal to imports. This assumption means that we cannot have trade imbalances, trade deficits, or surpluses. A trade imbalance occurs when exports are higher than imports or vice versa
4. Constant Returns to Scale
Adam Smith assumes that we will get constant returns as production scales, meaning there are no economies of scale. For example, if it takes 2 hours to make one loaf of bread in country A, then it should take 4 hours to produce two loaves of bread. Consequently, it would take 8 hours to produce four loaves of bread.
Only 2 countries (eg: M’sia & Thailand)
Only 2 products (eg: rice & car)
Full employment of factors of production.
All resources in both countries are homogenous
Perfect mobility of resources (labor move freely among industries)
One nation has an absolute cost advantage in one
good while the other nation has an absolute advantage in the other good
THEORY OF COMPARATIVE ADVANTAGE
Ricardo considered the limitations of Smith’s absolute adv theory
The theory of comparative advantage introduces opportunity cost as a factor for analysis in choosing between different options for production.
Comparative advantage suggests that countries will engage in trade with one another, exporting the goods that they have a relative advantage in.
Absolute advantage refers to the uncontested superiority of a country to produce a particular good better.
ASSUMPTIONS OF COMPARATIVE ADVANTAGE
1. Factors of Production
A major factor that affects comparative advantage is the country’s quality and quantity of the factors of production. For example, the natural availability of mineral resources like iron, gold, and copper is not something a country can change.
2. Exchange Rate
Movements in exchange rates affect the prices of imported and exported goods. For example, if your home currency depreciates which means foreign currency can buy more of your home currency, then your exports will increase as your goods are cheaper relative to others.
3. Inflation
An increase in the rate of inflation would make exported goods more expensive and imported goods cheaper.
4. Trade Barriers
Subsidies and taxes are examples of trade barriers that can be implemented by the government to create an artificial comparative advantage. A subsidy would make exports more competitive and a tariff would discourage imports.
Only 2 countries (eg: M’sia & Thailand)
Only 2 products (eg: rice & car)
Full employment of factors of production.
All resources in both countries are homogenous
Perfect mobility of resources (labor can move
freely among industries but only within a nation and not capable of moving between nations)