Page 43 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

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

(vi) Why do people specialize and trade? Notes
(a) Because each person can consume more than they produce by specializing and trading.
(b) Because most people are not self sufficient.
(c) Because most people are good at producing only one thing.
(d) Because people have to have jobs in order to survive.
(e) To exploit their absolute advantages.
3.4 Summary

• 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 In 1846 Britain repealed the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.
• 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.
• Adam Smith attacked the mercantilist views on what constituted the wealth of nations, and
what contributed to ‘nation building’ or increasing the wealth and the welfare of nations. Smith
was the first economist to show that goods rather than gold (or treasure) were the true measure
of the wealth of a nation. He argued that the wealth of a nation would expand most rapidly if
the government would abandon mercantilistic controls over foreign trade. Smith also exploded
the mercantilistic myth that in international trade one country can gain only at the cost of other
countries. He showed how all countries would gain from international trade through
international division of labour.
• Adam Smith’s model of classical theory, like the rest of the classical theory of trade, emphasizes the
gains from trade i.e., the classical theory is a contribution to welfare economics; and welfare economics
is value-loaded. In the classical trade theory the welfare of every individual unequivocally improves
with trade; and in the limiting case where a large country trades with a small country, the small
country gains more from trade than does the large country. Because, the equilibrium terms of trade
nearly coincide with the large country’s pre-trade internal price ratio. Thus, in the classical theory
the introduction of trade does not make anybody or any country worse off. Not only do all countries
gain from trade, in the classical model, but also small countries gain more than the large countries
do, emphasizing greater equity inherent in international trade mechanism.
3.5 Key-Words

1. Absolute advantage : The ability of a country, individual, company or region to produce
a good or service at a lower cost per unit than the cost at which any
other entity produces that good or service.
2. Comparative advantage : In economics, the law of comparative advantage refers to the ability
of a party to produce a particular good or service at a lower marginal
and opportunity cost over another. Even if one country is more
efficient in the production of all goods absolute advantage in all
goods) than the other, both countries will still gain by trading with
each other, as long as they have different relative efficiencies

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