Grp05 S01 - Pre-recardian Qn02

Seminar 1: International Trade Theory – A. Smith & D. Ricardo A) Pre-Ricardian views on trade 2. (a) How did Adam Smith explain his contention that all nations engaged in trade can benefit from trade? Adam Smith explained his contention based on the Theory of Absolute Advantage. Countries should specialize in the production of goods for which they have an absolute advantage and then trade these for goods produced by other countries. A country should never produce goods at home that it can buy at a lower cost from other countries. By specializing in the production of goods in which each has an absolute advantage, both countries benefit by engaging in trade. Also, resources will be efficiently utilized and total output and welfare will increase. For e.g UK & US Production Possibility Frontier

Wheat(bushels/manhour) Cloth(yards/manhour)

U.S. 6

U.K. 1

4

5

With the reference to data above, U.S has an absolute advantage over U.K. in the production of wheat, while the U.K has an absolute advantage over the U.S. in the production of cloth. With trade, the U.S would specialize in the production of wheat and exchange part of it for U.K Cloth. The opposite is true for the United Kingdom. If the U.S. exchange 6W for 6C of U.K, the U.S will gains 2C or gains 0.5 man hour. And for U.K, by exchanging 6C require 1.2 hours in U.K. for 6W with the U.S , the U.K gains 24C or saved almost 5 man hours.

Thus, as a result of specialization and trade, output of both wheat and cloth would be increased and consumers in both nations would be able to consume more. Trade is a positive sum game; produce net gains. (b) Why do nations usually impose restrictions on the free flow of trade? Free trade is stated as a political objective, in which trade of goods and services between countries flows unhindered by governmentimposed prices like quotas or duties. Free trade has become very politically based, and it is not uncommon for so-called "free trade agreements" to impose additional trade restrictions. Such restrictions on trade are often due to domestic political pressure by powerful corporate, environmental or labor interest groups seeking special protections of their perceived interests. Political arguments for government intervention cover a range of issues including preserving jobs, protecting industries deemed important for national security, retaliating against unfair foreign competition, protecting consumers from dangerous products (e.g military style assault weapons, genetically modified food-hormone treated beef), furthering the goals of foreign policy ( governments sometimes use trade policy to support their foreign policy objectives by granting preferential trade terms to a country it wants to build strong relations with. Trade policy has also been used several times to pressure or punish ‘rogue states’ that do not abide by international law or norms) and advancing the human rights of individuals in exporting countries. Economic arguments for government intervention are typically concerned with boosting the overall wealth of a nation to the benefit of all, both producers and consumers. Until the early 1980s, most economists saw little benefit in government intervention and strongly advocate a free trade policy. Other factors that also contribute to the economic arguments: • • • • • •

Free trade in raw materials retrogrades development International trade requires more resources to distribute Sheltering young industries may pay-off later Influence of Foreign Firms Usually benefits only the wealthy within countries Diversification and Economic Bubbles

B) Comparative Advantage

Wheat (bushels/labourhour) Cloth (yards/labourhour)

Case B (US) 4

Case B (UK) 1

3

2

6. Answer the following questions with reference to problem 5. (a) What is the dollar price of wheat and cloth in the UK if the exchange rate between the pound and the dollar is £1 = $2? Wage Rate (US) = $6 Wage Rate in UK = £1 = $2 Price of wheat in UK = Wage / Qty = $2 / 1 = $2 Price of cloth in UK = Wage / Qty = $2 / 2 = $1 i) Would the US be able to export wheat to the UK at this exchange rate? Wage Rate in US = $6 Price of wheat in US = Wage / Qty = $6 / 4 = $1.5 Price of cloth in US = Wage / Qty = $6 / 3 = $2 Yes. US would be able to export wheat to the UK at this exchange rate since the price of wheat in US is lower than UK.

ii) Would the UK be able to export cloth to the US at this exchange rate? Yes. The price of cloth in UK is lower than US at this exchange rate. (b) What if the exchange rate were £1 = $4? Wage Rate (US) = $6 Wage Rate in UK = £1 = $4 Price of wheat in US = Wage / Qty = $6 / 4 = $1.5 Price of cloth in US = Wage / Qty = $6 / 3 = $2 Price of wheat in UK = Wage / Qty = $4 / 1 = $4 Price of cloth in UK = Wage / Qty = $4 / 2 = $2 US would still be able to export wheat to UK at this exchange rate but UK would not be able to export cloth to US since the price of cloth at this exchange rate are the same for both country. (c) What if the exchange rate were £1 = $1? Wage Rate (US) = $6 Wage Rate in UK = £1 = $1 Price of wheat in US = Wage / Qty = $6 / 4 = $1.5 Price of cloth in US = Wage / Qty = $6 / 3 = $2

Price of wheat in UK = Wage / Qty = $1 / 1 = $1 Price of cloth in UK = Wage / Qty = $1 / 2 = $0.5 UK would now export to US instead since the price of wheat and cloth is now lower than US. (d) What is the range of exchange rates that will allow the US to export wheat to the UK and the UK to export cloth to the US? Between $2 to $3 Wage Rate (US) = $6 Wage Rate in UK = £1 = $3 Price of wheat in US = Wage / Qty = $6 / 4 = $1.5 Price of cloth in US = Wage / Qty = $6 / 3 = $2 Price of wheat in UK = Wage / Qty = $3 / 1 = $3 Price of cloth in UK = Wage / Qty = $3/ 2 = $1.5