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UNIT III STUDY GUIDE International Trade Theories Reading Assignment Chapters 5: International Trade and Factor-Mobility Theory Course Learning Outcomes for Unit III Upon completion of this unit, students should be able to: 4. Differentiate between absolute advantage and comparative advantage trade theories. 4.1 Examine the theory of absolute advantage and factor mobility. 4.2 Examine the theory of comparative advantage. 4.3 Apply opportunity costs. Unit Lesson Theory of Mercantilism vs. Neomercantilism Mercantilism is the oldest form of economic theory. According to Daniels, Radebaugh, and Sullivan (2015), this economic thought was the foundation from about 1500 to 1800. The beliefs were that exports were good and imports were bad; in essence, countries should export more than they import. In 1776, economist Adam Smith attacked the mercantilism view by arguing that free trade does not come from stocks of precious metal but of factors of production (land, labor, and capital) (London, 2013). Absolute Advantage Adam Smith stated that countries produce some goods more efficiently than others and reasoned that unrestricted trade could lead a country to specialize in those products that give it a competitive advantage. In other words, the country that produces more of one product has absolute advantage in producing that product. To illustrate the concepts of absolute advantage and comparative advantage, we are going to use two countries and two products. See the Table 1 example below: Chairs United States Mexico Total 100 80 180 Desks 75 100 175 Table 1 In the example in Table 1, the United States has absolute advantage in chairs, and Mexico has absolute advantage in desks. The total represents world production. The sensible thing is to specialize, that is, take all of the resources (labor and capital) to produce that product they are good at producing. See Table 2: MBA 6601, International Business 1 United States Mexico Total Chairs 200 0 200 Desks 0 200 200 Table 2 Because all of the resources (labor and capital) were used to produce the one product that they were efficient in, world production increased by 20 in chairs and 25 in desks. Now, the two countries can trade with increased production. Comparative Advantage In the early 19th century, a British economist, David Ricardo, questioned Adam Smith’s theory on absolute advantage; what if a country is efficient at producing both products? In this case, trade would not take place because the United States is efficient at producing both goods. See Table 3 below: United States Chairs 100 Desks 85 Mexico Total 90 190 80 165 Table 3 In this case, the United States can produce more of each good than Mexico. However, Mexico can produce can only produce 90% of desks and 94% of chairs compared to the United States. In this case, Mexico has comparative advantage in desks, and the United States has comparative advantage in chairs. With this concept of comparative advantage, the United States should produce chairs and Mexico should produce desks, and then trade could take place. Opportunity Costs Let’s look at another concept called opportunity cost. As defined by Merriam-Webster dictionary (2014): the added cost of using resources (as for production) that is the difference between the actual value resulting from such use and that of an alternative (as another use of the same resources or an investment of equal risk but greater return). (para. 1) Therefore, the United States could produce either 200 units of chairs or 160 units of desks. Mexico could produce 180 units of chairs and 170 units of desks. If the United States produces only chairs, it gives up 80 units of desks to gain 100 units of chairs. If Mexico produces only chairs, it gives up 85 units of desks to gain 90 units of chairs. Therefore, the opportunity cost of producing desks is higher for the United States, and the opportunity cost of producing chairs is lower. The opportunity cost of producing chairs is higher for Mexico, and the opportunity cost of producing desks is lower. Again, the United States has comparative advantage in chairs, and Mexico has comparative advantage in desks. United States Mexico Total Chairs 200 0 200 Desks 0 170 170 Table 3 MBA 6601, International Business 2 By specializing, the United States has increased production of 10 units of chairs and Mexico has increased production of 5 units of desks, and now trade should take place with increased production. Note: You can have absolute advantage in both goods but only comparative advantage in one. References Daniels, J. D., Radebaugh, L. H., & Sullivan, D. P. (2015). International business: Environments and operations (15th ed.). Upper Saddle River, NJ: Pearson Education. London, C. W. (2013, August 23). What was mercantilism? [Web log message]. Retrieved from http://www.economist.com/blogs/freeexchange/2013/08/economic-history Opportunity cost. (2014). In Merriam-Webster’s online dictionary. Retrieved from http://www.merriam-webster.com/dictionary/opportunity%20cost MBA 6601, International Business 3