Lecture 3 Free trade - Smith and Ricardo
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Adam Smith and David Ricardo were influential 18th century economists who advocated for free trade and specialization based on comparative advantage. Smith argued that free markets and specialization driven by self-interest would maximize economic efficiency through an "invisible hand." Ricardo formalized the concept of comparative advantage, showing that countries and individuals benefit from specializing in and trading goods they have a relative rather than absolute cost advantage in producing. Examples are provided to illustrate absolute and comparative advantage between countries. Ricardo demonstrated that free trade according to comparative advantage allows all countries to gain.
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Lecture 3 Free trade - Smith and Ricardo
- 1. Free trade – Smith & Ricardo March,
- 2. Adam Smith (1723-1790) Scottish economist, philosopher & author
- 3. Adam Smith – Father of Capitalism The Wealth of Nations, 1776
- 4. Smith’s main points about free market Criticism of Mercantilism No government intervention Free trade (laissez-faire) “Invisible hand” of the market Specialization, self-interest Division of labor “It is not from the benevolence (kindness) of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”
- 5. David Ricardo(1772-1824) British economist & Member of Parliament
- 6. David Ricardo – British classical school The Principles of Political economy and Taxation, 1817
- 7. Ricardo’s main points about free market Industrial specialization No government intervention Free trade (laissez-faire) Comparative advantage
- 8. Absolute & Comparative advantage
- 9. Absolute advantage (Smith) Absolute advantage describes a situation in which an individual, business or country can produce MORE of a good/service than any other producer with the same quantity of resources (or same quantity of products with LESS resources)
- 10. Absolute advantage - Examples Which country has an Absolute advantage in producing each product? 1) The US can produce 20 toys France can produce 12 toys 2) The US can produce 20 toys for 4 hours France can produce 12 toys for 3 hours 3) The US can produce 20 toys or 7 chocolates France can produce 12 toys or 20 chocolates
- 11. Absolute advantage - Examples Which country has an Absolute advantage in producing each product? 1) The US can produce 20 toys France can produce 12 toys The US can produce 20 toys – AA, because can produce MORE! 2) The US can produce 20 toys for 4 hours France can produce 12 toys for 3 hours The US – AA, because can produce MORE in less time / 1 hour! 3) The US can produce 20 toys or 7 chocolates France can produce 12 toys or 20 chocolates The US – AA for toys, and France AA for chocolates!
- 12. Absolute advantage -Exercise Which country has an Absolute advantage in producing each product? 1) The US can produce 20 planes France can produce 12 planes 2) Korea can produce 3 cars or 9 motorcycles Germany can produce 4 cars or 8 motorcycles 3) Japan can produce 4 laptops or 12 phones Brazil can produce 1 laptop or 5 phones 4) Cuba takes 4 hrs to make a TV and 12 hrs to make salsa Mexico takes 1 hr to make a TV and 5 hrs to make
- 13. Absolute advantage -Exercise Which country has an Absolute advantage in producing each product? 1) The US can produce 20 planes - AA France can produce 12 planes 2) Korea can produce 3 cars or 9 motorcycles - AA Germany can produce 4 cars - AA or 8 motorcycles 3) Japan can produce 4 laptops or 12 phones - AA Brazil can produce 1 laptop or 5 phones 4) Cuba takes 4 hrs to make a TV and 12 hrs to make salsa Mexico takes 1 hr to make a TV and 5 hrs to make
- 14. Comparative advantage (Ricardo) Comparative advantage describes a situation in which an individual, business or country can produce goods/services at a LOWER OPPORTUNITY COST than another producer. Opportunity cost represents the potential benefit an individual, business or a country misses out on when choosing one alternative over another! EX: A farmer chooses to plant wheat; the opportunity cost is planting a different crop, or an alternate use of the resources (land and farm equipment).
- 15. Comparative advantage -Exercise A) What is the opportunity cost for producing one of each product? 1) The US can produce 20 planes or 2 cruise ships France can produce 12 planes or 2 cruise ships B) Who has a comparative advantage in planes? C) Who has a comparative advantage in cruise ships? D) What is a term of trade that benefits both countries? REMARK: For calculating comparative advantage, you must calculate the UNIT COST of each product for each country or PER UNIT OPPORTUNITY COST!
- 16. Comparative advantage -Exercise A) What is the opportunity cost for producing one of each product? 1) The US can produce 20 planes or 2 cruise ships France can produce 12 planes or 2 cruise ships B) Who has a comparative advantage in planes? - US C) Who has a comparative advantage in cruise ships? - France D) What is a term of trade that benefits both countries? Planes Cruise ships US 20 (1P costs 1/10 C) 2 (1C costs 10 P) France 12 (1P costs 1/6 C) 2 (1C costs 6 C)
- 17. Comparative advantage –Exercise 2 A) What is the opportunity cost for producing one of each product? 2) Korea can produce 3 cars or 9 motorcycles Germany can produce 4 cars or 8 motorcycles B) Who has a comparative advantage in cars? C) Who has a comparative advantage in motorcycles? D) What is a term of trade that benefits both countries?
- 18. Comparative advantage –Exercise 2 A) What is the opportunity cost for producing one of each product? 2) Korea can produce 3 cars or 9 motorcycles Germany can produce 4 cars or 8 motorcycles B) Who has a comparative advantage in cars? - Germany C) Who has a comparative advantage in motorcycles? - Korea D) What is a term of trade that benefits both countries? Cars Motorcycles Korea 3 (1C costs 3 M) 9 (1M costs 3/9 or 1/3 C) Germany 4 (1C costs 2 M) 8 (1M costs 4/8 or ½ C)
- 19. Comparative advantage –Exercise 3 A) What is the opportunity cost for producing one of each product? 3) Japan can produce 4 laptops or 12 phones Brazil can produce 1 laptop or 5 phones B) Who has a comparative advantage in laptop? C) Who has a comparative advantage in phones? D) What is a term of trade that benefits both countries?
- 20. Comparative advantage –Exercise 3 A) What is the opportunity cost for producing one of each product? 3) Japan can produce 4 laptops or 12 phones Brazil can produce 1 laptop or 5 phones B) Who has a comparative advantage in laptops? - Japan C) Who has a comparative advantage in phones? - Brazil D) What is a term of trade that benefits both countries? Laptops Phones Japan 4 (1L costs 3 P) 12 (1P costs 1/3 L) Brazil 1 (1L costs 5 P) 5 (1P costs 1/5 L)
- 21. Comparative advantage –Exercise 4 A) What is the opportunity cost for producing one of each product? 4) Cuba takes 4hrs to make a TV and 12 hrs to make salsa Mexico takes 1hr to make a TV and 5 hrs to make salsa B) Who has a comparative advantage in TVs? C) Who has a comparative advantage in salsa? D) What is a term of trade that benefits both countries?
- 22. Comparative advantage –Exercise 4 A) What is the opportunity cost for producing one of each product? 4) Cuba takes 4hrs to make a TV and 12 hrs to make salsa Mexico takes 1hr to make a TV and 5 hrs to make salsa B) Who has a comparative advantage in TVs? - Mexico C) Who has a comparative advantage in salsa? - Cuba D) What is a term of trade that benefits both countries? TV Salsa Cuba 4hrs (1T costs 1/3 S) 12 hrs (1S costs 3 T) Mexico 1 hr (1T costs 1/5 S) 5 hrs (1S costs 5 T)
- 23. Homework The table below shows the production possibilities of two countries Tonju and Emria of two goods, smartphones and apples, given a fixed amount of resources: Smartphones Apples Tonju 39 13 Emria 48 24 A) What is the opportunity cost for producing one of each product? B) Which country has the absolute advantage in smartphones and which in apples? C) If the two countries were to specialize and trade with one another, which country would import smartphones?
Hinweis der Redaktion
- Adam Smith (1723– 1790) was a Scottish economist, philosopher as well as a moral philosopher, a pioneer of political economy, and a key figure during the Scottish Enlightenment, also known as ''The Father of Economics' or ''The Father of Capitalism''. Smith wrote two classic works, “The Theory of Moral Sentiments” (1759) and “An Inquiry into the Nature and Causes of the Wealth of Nations” (1776). The latter, often abbreviated as “The Wealth of Nations”, is considered his magnum opus and the first modern work of economics. In his work, Adam Smith introduced his theory of absolute advantage.
- Adam Smith was an 18th-century Scottish economist, philosopher, and author who is considered the father of modern economics. Smith argued against mercantilism and was a major proponent of laissez-faire economic policies. In his first book, "The Theory of Moral Sentiments," Smith proposed the idea of an invisible hand—the tendency of free markets to regulate themselves by means of competition, supply and demand, and self-interest
- The Philosophy of Free Markets The philosophy of free markets emphasizes minimizing the role of government intervention and taxation in the free markets. Although Smith advocated for a limited government, he did see the government as responsible for the education and defense sectors of a country. From Smith comes the idea of the "invisible hand" that guides the forces of supply and demand in an economy. Every person, by looking out for themselves, inadvertently helps to create the best outcome for all. By selling products that people want to buy, a hypothetical butcher, brewer, and baker in this economy hope to make money. If they are effective in meeting the needs of their customers, they will enjoy financial rewards, and while they are engaging in enterprise for the purpose of earning money, they are also providing products that people want. Smith argued that this kind of system creates wealth for the butcher, brewer, and baker, in addition to creating wealth for the entire nation. A wealthy nation is one that is populated with citizens working productively to better themselves and address their financial needs. In this kind of economy, according to Smith, a man would invest his wealth in the enterprise most likely to help him earn the highest return for a given risk level. The invisible-hand theory is often presented in terms of a natural phenomenon that guides free markets and capitalism in the direction of efficiency, through supply and demand and competition for scarce resources, rather than as something that results in the well-being of individuals. For Smith, an institutional framework is necessary to steer humans toward productive pursuits that are beneficial to society. This framework consists of institutions like a justice system designed to protect and promote free and fair competition. However, there must be competition undergirding this framework. For Smith, competition is the 'desire that comes with us from the womb, and never leaves us, until we go into the grave.
- David Ricardo (1772 – 1823) was a British political economist, one of the most influential of the classical economists along with Thomas Malthus, Adam Smith and James Mill. He was also a politician, and a member of the Parliament of Great Britain and Ireland. He wrote his first economics article at 37, firstly in The Morning Chronicle advocating reduction in the note-issuing of the Bank of England and then publishing The High Price of Bullion, a Proof of the Depreciation of Bank Notes in 1810. Ricardo's most famous work is his “Principles of Political Economy and Taxation” (1817).
- David Ricardo (1772–1823) was a classical economist best known for his theory on wages and profit, the labor theory of value, the theory of comparative advantage, and the theory of rents. David Ricardo and several other economists also simultaneously and independently discovered the law of diminishing marginal returns. His most well-known work is the "Principles of Political Economy and Taxation" (1817).
- Comparative Advantage Among the notable ideas that Ricardo introduced in "Principles of Political Economy and Taxation" was the theory of comparative advantage, which argued that countries can benefit from international trade by specializing in the production of goods for which they have a relatively lower opportunity cost in production even if they do not have an absolute advantage in the production of any particular good. Between 1500 and 1750 most economists advocated Mercantilism which promoted the idea of international trade for the purpose of earning bullion by running a trade surplus with other countries. Ricardo challenged the idea that the purpose of trade was merely to accumulate gold or silver. With "comparative advantage" Ricardo argued in favour of industry specialisation and free trade. He suggested that industry specialization combined with free international trade always produces positive results. This theory expanded on the concept of absolute advantage. Ricardo suggested that there is mutual national benefit from trade even if one country is more competitive in every area than its trading counterpart and that a nation should concentrate resources only in industries where it has a comparative advantage,[16] that is in those industries in which it has the greatest efficiency of production relative to its own alternative uses of resources, rather than industries where it holds a competitive edge compared to rival nations. Ricardo suggested that national industries which were, in fact, mildly profitable and marginally internationally competitive should be jettisoned in favour of the industries that made the best use of limited resources – the assumption being that subsequent economic growth due to better resource use would more than offset any short-run economic dislocation which would result from closing mildly profitable and marginally competitive national industries.
- Absolute advantage is the ability of an individual, company, region, or country to produce a greater quantity of a good or service with the same quantity of inputs per unit of time, or to produce the same quantity of a good or service per unit of time using a lesser quantity of inputs, than another entity that produces the same good or service. An entity with an absolute advantage can produce a product or service at a lower absolute cost per unit using a smaller number of inputs or a more efficient process than another entity producing the same good or service. Absolute advantage is when a producer can produce a good or service in greater quantity for the same cost, or the same quantity at a lower cost, than other producers. Absolute advantage can be the basis for large gains from trade between producers of different goods with different absolute advantages. By specialization, division of labor, and trade, producers with different absolute advantages can always gain more than producing in isolation. Absolute advantage is related to comparative advantage, which can open up even more widespread opportunities for the division of labor and gains from trade. Understanding Absolute Advantage The concept of absolute advantage was developed by Adam Smith in his book "Wealth of Nations" to show how countries can gain from trade by specializing in producing and exporting the goods that they can produce more efficiently than other countries. Countries with an absolute advantage can decide to specialize in producing and selling a specific good or service and use the funds that good or service generates to purchase goods and services from other countries. By Smith’s argument, specializing in the products that they each have an absolute advantage in and then trading the products, can make all countries better off, as long as they each have at least one product for which they hold an absolute advantage over other nations.
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- Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors and realize stronger sales margins. The law of comparative advantage is popularly attributed to English political economist David Ricardo and his book “On the Principles of Political Economy and Taxation” written in 1817, although it is likely that Ricardo's mentor, James Mill, originated the analysis. Comparative advantage is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. 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. Understanding Comparative Advantage Comparative advantage is one of the most important concepts in economic theory and a fundamental tenet of the argument that all actors, at all times, can mutually benefit from cooperation and voluntary trade. It is also a foundational principle in the theory of international trade. The key to understanding comparative advantage is a solid grasp of opportunity cost. Put simply, an opportunity cost is a potential benefit that someone loses out on when selecting a particular option over another. In the case of comparative advantage, the opportunity cost (that is to say, the potential benefit which has been forfeited) for one company is lower than that of another. The company with the lower opportunity cost, and thus the smallest potential benefit which was lost, holds this type of advantage. Another way to think of comparative advantage is as the best option given a trade-off. If you're comparing two different options, each of which has a trade-off (some benefits as well as some disadvantages), the one with the best overall package is the one with the comparative advantage. Opportunity cost is the value of something when a particular course of action is chosen. Simply put, the opportunity cost is what you must forgo in order to get something. The benefit or value that was given up can refer to decisions in your personal life, in a company, in the economy, in the environment, or on a governmental level. EXAMPLES: - Someone gives up going to see a movie to study for a test in order to get a good grade. The opportunity cost is the cost of the movie and the enjoyment of seeing it. -A player attends baseball training to be a better player instead of taking a vacation. The opportunity cost was the vacation. When the government spends $15 billion on interest for the national debt, the opportunity cost is the programs the money might have been spent on, like education or healthcare. For a farmer choosing to plant corn, the opportunity cost would be any other crop he may have planted, like wheat or sorghum. As a consultant, you get $75 an hour. Instead of working one night, you go to a concert that costs $25 and lasts two hours. The opportunity cost of the concert is $150 for two hours of work. Mr. Brown makes $400 an hour as an attorney and is considering paying someone $1000 to paint his house. If he decides to do it himself, it will take four hours. His opportunity cost for doing it himself is the lost wages for four hours, or $1600.
- What is the opportunity cost for producing one of each product? First, you have to calculate the opportunity cost per 1 unit! Ex. If USA decides to produce 1 cruise ship than it will give up 10 planes. Or always you have to divide COST/ GAIN! In this case 20/2. The other cost per unit always is reciprocal to the one you have calculated, or 2/20. US, for 1 plane has to give up of 1/10 of cruise ship, or for producing 1 cruise ship has to give up of 10 planes. 1/10 is an opportunity cost for producing 1 plane in the US. France, for 1 plane has to give up of 1/6 of cruise ship, or for producing 1 cruise ship has to give up of 6 planes. B) Who has a comparative advantage in planes? The country with lower opportunity cost in planes = USA C) Who has a comparative advantage in cruise ships? The country with lower opportunity cost in cruise ships = France because it will give up only 6 planes for 1 cruise ship D) What is a term of trade that benefits both countries? 1 cruise ship for 6<x<10 If 1 cruise ship is 20 planes, it will be awesome for France, but USA will never go for It, because it can produce 10 planes for 1 cruise ship. If 1 cruise ship is 1 plane, France will not accept because it can produce 1/6 cruise ship for 1 plane even though it is good for the USA.