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Dilfraz Singh, LPU Unit 3 : Free Trade Theory — Absolute Advantage, Comparative Advantage and Opportunity Cost

Unit 3 : Free Trade Theory — Absolute Advantage, Notes
Comparative Advantage and Opportunity Cost

CONTENTS
Objectives
Introduction
3.1 Absolute Advantage Model of Adam Smith
3.2 Comparative Advantage Model of David Ricardo
3.3 Opportunity Cost and the Pure Theory of Trade
3.4 Summary
3.5 Key-Words
3.6 Review Questions
3.7 Further Readings

Objectives

After reading this Unit students will be able to:
• Describe Absolute Advantage Model of Adam Smith.
• Explain Comparative Advantage Model of David Ricardo.
• Understand the Opportunity Cost and the Pure Theory of Trade.
Introduction

The theory of trade has a central place in economic analysis, and underpins the doctrine of free trade.
Free trade doctrines have a long and fascinating history in Europe. In 1846 Britain repealed the Corn
Laws, an historic event which marked the start of the era of free international trade, and lasted until
the great depression of the 1870s. The Corn Laws were the duties on imports of grain, which had
been in force in England since the middle of the fifteenth century. Other European countries had
similar taxes : France, Sweden, Bavaria, Belgium and Holland.
The reasoning behind the Corn Laws was as follows. Grain, chiefly wheat, is a staple foodstuff,
especially important in the diets of labouring people. But its price varies greatly from year to year,
depending on the size and quality of harvests. Duties on imports were levied on a sliding scale in
order to stabilise the price of wheat. When the domestic price was high because of a poor harvest,
duties were lowered to permit imports. When the domestic price was low because of a bumper harvest,
import duties were raised.
In the decades leading up to the repeal of the Corn Laws in Britain, the system had fallen into disrepute.
In fact the sliding scale of duties was tending to increase rather than reduce fluctuations in the price
of wheat. When the domestic price was high, traders tended to withhold supply to raise the price
even further. They anticipated that import duties would soon be lowered, which was in fact what
tended to happen. Then, when duties fell, traders began to import large quantities of grain. As supply
rapidly increased, and prices fell dramatically, import duties were quickly increased. The net effect
was to amplify market fluctuations through speculation, making a vulnerable market even more
unstable, much to the detriment of consumers.
The Corn Laws had another important effect. They benefited agricultural interests at the expense of
the newly emerging manufacturing sectors. High prices of grain, maintained through restricting
foreign supply, increased the value of land. Landowners, understandably, came to constitute an
important pressure group for the maintenance of the Corn Laws. Against these landed interests were

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