ARGUMENTS FOR FREE TRADE

Absolute Advantage (Adam Smith 1776)

If one country is more efficient in the production of one good and

less efficient in the production of the other, then each country
should specialise in the production of the good where it has
comparative advantage.

If Ecuador and Argentina can both produce beef and bananas but
Argentina can produce beef more efficiently and Ecuador can
produce bananas more efficiently then Argentina should specialise
beef, export some of it to Ecuador and import bananas and Ecuador
should specialise in bananas, export some of the and import beef.

Comparative Advantage (David Ricardo 123)

Absolute advantage explains only a small part of trade and it is

obvious that in some cases where a country is more efficient in
producing two products than another, it often specialises in one
and imports the other.
Comparative advantage based on opportunity cost is observed in
everyday life (Justice Holmes and his secretary)

A country should specialise in producing the good in which its

comparative advantage is greatest and export that good and import
the other

Comparative |Advantage assumes that:

-labour is the only factor of production and homogeneous
-constant returns to scale (no economies of scale)
-ignores transport costs, differences in tastes and preferences
 USA EU
Wheat (tonnes per person hour) 6 1
Wine (litres per person hour) 4 2

In the USA 6 units of wheat can be exchanged for 4 unit of wine. If

by trading more than 4 units of wine can be obtained for 6 units of
wheat the USA will gain from trade.
In the EU 2 units of wine can be exchanged for 1 unit of wheat. If
by trade more wheat could be obtained trade would be to the
advantage of the EU.
Assume that it is possible to exchange 6 units of wine for 6 units of
wheat. Both the USA (which formerly got only 4 units of wine for
6 units of wheat) and the EU (which formerly had to give up 12
units of wine to get 6 units of wheat) will gain.
There is a saving of 3 person hours in the EU and of 30 minutes in
the USA.
If the EU is less efficient than the EU in both goods how can it
export to the USA?

If wages are lower in the EU, when the prices of both goods are
expressed in a common currency, wine will be cheaper in the EU
and grain will be cheaper in the US

Wage in USA is $6 per hour so 1 unit of grain will cost $1 to

produce and 1 unit of wine will cost $1.50
If wage in EU is €2 per hour then will wine will cost €1 and grain
will cost €2 to produce.
If the exchange rate is €1=$1 then the price in EU will be $1 for a
unit of wine and $2 for a unit of grain.
There will be an incentive for traders to buy wine in the EU and
trade it for grain with the USA
What would the situation be if the exchange rate were $0.5= €1or
$2=€1?
HECKSCHER-OHLIN THEOREM

What determines comparative advantage?

Hescksher and Ohlin proposed factor endowments and the basis of
comparative advantage.

A country with abundant capital will produce capital intensive

goods and export them to a country that has abundant labour and
which therefore exports labour intensive goods and vice versa.

This theory explains trade between the USA and China (computers
and clothing but is not convincing in explaining intra-EU trade as
countries (with exception of most recent entrants) have similar
factor endowments.

There are problems with quality of labour (skilled labour works

with a lot of capital) and the theory like Ricardo’s theory ignores
economies of scale and differences in tastes and preferences.