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Foundations of Modern Trade Theory: Comparative Advantage

9 important questions on Foundations of Modern Trade Theory: Comparative Advantage

Adam Smith founded the concept of cost on the labour theory of value:

Labour is the only factor of production and is homogeneous (of one quality) and the cost or price of a good depends exclusively on the amount of labour required to produce it.

The trading principle of Adam Smith: Principle of absolute advantage:

In a two – nation, two – product world, international specialization and trade will be beneficial when one nation has an absolute cost advantage (uses less labour to produce a unit of output) in one good and the other nation has an absolute cost advantage in the other good. Each nation must have a good that is absolutely more efficient in producing than its trading partner. A nation will import goods in which it has an absolute cost disadvantage and export those goods in which it has an absolute cost advantage.

The principle of comparative advantage by David Ricardo:

A principle to show that mutually beneficial trade can occur whether or not countries have an absolute advantage, which applies to a nation that is more efficient than its trading partner in the production of all goods. It does not necessarily mean that a nation only export products that will cost them the least and create a surplus.
The same counts in case a nation has a cost disadvantage in production of both goods.
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Marginal rate of transformation (MRT):

The MRT shows the amount of one product a nation must sacrifice to get one additional unit of the other product. For example:
MRT = Wheat
            Autos.
Plus, the rate of this sacrifice is called the opportunity cost of a product.

Consumption gains from trade:

When 2 nations that trade achieve post – trade consumption outside their domestic production possibilities frontiers; They can consume more products than they could consume in the absence of trade.

Trading possibilities line:

When the ratio of the trade term allows both trading partners to consume at some point outside their respective production possibilities frontiers. Plus, the international terms of trade for both countries.

The region of mutually beneficial trade:

Any acceptable international terms of trade have to be more favourable than or equal to the rate defined by the domestic price line. As such, the region of mutually beneficial trade is bounded by the cost ratios of the two countries.

The commodity terms of trade (also referred to as the barter terms of trade):

Is a frequently used measure of the international exchange ratio. It measured the relationship between the prices a nation gets for its exports and the prices it pays for its imports.

Dynamic gains from international trade:

Gains that were dwarfed (verkleind) by the effect of trade on the country’s growth rate and the volume of additional resources made available to, or utilized by, the trading country. Dynamic gains from trade can arise from increased investment in equipment and manufacturing plants, economies of large – scale production, internet, and increased competition that occurs over a period of time.

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International Economics and Businesses.

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