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Free Trade and Absolute and Comparative Advantage

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Free Trade and Absolute and Comparative Advantage Universität Potsdam This thesis deals with two theories of international trade: the theory of comparative advantage, which is connected to the name David Ricardo and is dominating current trade theory, and Adam Smith’s theory of ab- solute advantage. Both theories are compared and their assumptions are scrutinised. The former theory is rejected on theoretical and empirical grounds in favour of the latter. On the basis of the theory of absolute ad- vantage, developments of free international trade are examined, whereby the focus is on trade between industrial and underdeveloped countries. Reinhard Schumacher The main conclusions are that trade patterns are determined by absolute production cost advantages and that the gap between developed and poor countries is not reduced but rather increased by free trade. Free Trade and Absolute and Comparative Advantage ISSN 1866-0738 ISBN 978-3-86956-195-0 and Comparative Advantage and Absolute Reinhard Schumacher | Trade Free WeltTrends Thesis | 16 Reinhard Schumacher Free Trade and Absolute and Comparative Advantage WeltTrends Thesis | 16 Reinhard Schumacher Free Trade and Absolute and Comparative Advantage A Critical Comparison of Two Major Theories of International Trade Universitätsverlag Potsdam Bibliografische Information der Deutschen Nationalbibliothek Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im Internet über http://dnb.de abrufbar. Universitätsverlag Potsdam 2012 http://verlag.ub.uni-potsdam.de Am Neuen Palais 10, 14469 Potsdam Tel.: +49 (0)331 977 2533, Fax: -2292 E-Mail: [email protected] Die Schriftenreihe WeltTrends Thesis wird herausgegeben von Prof. Dr. habil. Jochen Franzke, Universität Potsdam, im Auftrag von WeltTrends e. V. Band 16 (2012) Reinhard Schumacher: Free Trade and Absolute and Comparative Advantage A Critical Comparison of Two Major Theories of International Trade Zugl.: Potsdam, Univ., Diplomarbeit, 2012 Produktionsleitung: Tim Haberstroh Satz: André Kadanik Druck: docupoint GmbH Magdeburg Das Manuskript ist urheberrechtlich geschützt. © WeltTrends, Potsdam 2012 ISSN (print) 1866-0738 ISSN (online) 2191-1673 ISBN 978-3-86956-195-0 Zugleich online veröffentlicht auf dem Publikationsserver der Universität Potsdam URL http://pub.ub.uni-potsdam.de/volltexte/2012/6023/ URN urn:nbn:de:kobv:517-opus-60237 [http://nbn-resolving.org/urn:nbn:de:kobv:517-opus-60237] Contents List of Tables and Figures 6 List of Abbreviations 6 Author's Short Biography 6 1 Introduction 9 2 The Theory of Absolute Advantage 13 2.1 Adam Smith, the Division of Labour, and the Labour Theory of Value 13 2.2 Adam Smith and Gains from International Trade 15 2.3 Adam Smith and the Pattern of Trade 19 2.4 Absolute Advantage after Adam Smith 22 3 The Theory of Comparative Advantage 25 3.1 David Ricardo and Comparative Advantage 25 3.1.1 The England-Portugal Example: Gains from International Trade 26 3.1.2 The Role of David Hume’s Price-Specie-Flow Mechanism 31 3.2 Modern Presentation of the Theory of Comparative Advantage 35 3.2.1 The Ricardian Model 35 3.2.2 The Standard Trade Model 40 3.3 Conclusion 45 4 Comparison of the Theories of Absolute and Comparative Advantage 49 4.1 International and Domestic Trade 50 4.2 Balanced Trade and Adjustment Mechanism 54 4.3 Full Employment of Capital and Labour 57 4.4 Specialisation and Gains from International Trade 61 4.5 Harmony vs. Struggle 64 4.6 Who is right? A Short Evaluation of the Differences 67 5 Smith’s Theory of Absolute Advantage and Trade between Developed and Underdeveloped Countries 77 5.1 The England-Portugal Example Re-Examined 78 5.2 Effects of Free Trade on Rich and on Poor Countries 81 6 Concluding Remarks 91 7 Reference List 95 Tables and Figures TABLES Table 2.1 A Textbook Example of Absolute Advantages 23 Table 3.1 Initial Situation of Ricardo’s England-Portugal Example 27 Table 3.2 An Example of the Ricardian model 37 FIGURES Figure 3.1 Production Possibility Frontier (PPF) and Social Indifference Curve 38 Figure 3.2 Gains from Trade in the Ricardian Model 39 Figure 4.1 Dynamic Gains from Trade 62 Abbreviations EU European Union GATT General Agreement on Tariffs and Trade GDP Gross Domestic Product HOM Heckscher-Ohlin Model PPF Production Possibility Frontier WN An Inquiry into the Nature and Causes of the Wealth of Nations, book by Adam Smith, published 1776 WTO World Trade Organisation Reinhard Schumacher, born in 1984, graduated 2010 with a Diploma Degree in Political Science and Public Administration (Verwaltungswis- senschaft) after having studied at the University of Potsdam and the Uni- versity of Limerick. He currently works as a research assistant at the Chair of Economic Policy and International Economics at the University of Pots- dam. Research interests: International Political Economy, Trade Theory and Policy, Development Economics, History of Economic Thought. Contact: [email protected] Publikation von Abschlussarbeiten Seit zwei Jahrzehnten betreuen wir akademische Veröffentlichungen. Seit fünf Jahren publizieren wir in der Reihe WeltTrends Thesis studentische Abschlussarbeiten (Magister-, Diplom- und Masterarbeiten) mit dem Schwerpunkt internationale Beziehungen und vergleichende Länderstudien in ansprechender Form. Unser Angebot: WeltTrends übernimmt Korrektorat, Satz und Werbung. Der Universitätsverlag Potsdam realisiert die Buchpublikation, die Online-Veröffentlichung auf dem zertifizierten Publikations- server der Universität Potsdam sowie den Nachweis in den relevanten bibliografischen Datenbanken und Bibliothekskatalogen. Sie erhalten zehn Autorenexemplare, weitere Exemplare gibt es zum Sonderpreis. Die Kosten liegen für Sie deutlich unter den üblichen Verlagsangeboten. Die konkreten Konditionen, z. B. mit Farbfotos oder in englischer Sprache, werden nach Vorlage des Manuskripts abgesprochen. Bisher erschienen: 1 | Kolleck: FTAA/ALCA – Von Alaska bis Feuerland? 2 | Die „dritte Generation“ – „Trzecie pokolenie“ 3 | Kube: Immigration und Arbeitskämpfe in den USA 4 | Krämer: Die Politik Deutschlands in der Kosovofrage 5 | Bar: Wasserkonflikte in Zentralasien 6 | Iro: UN Peacebuilding Commission in Sierra Leone 7 | Dittrich: Die FDP und die deutsche Außenpolitik 8 | Chinalski: Regional Governance in der Oder-Partnerschaft 9 | Kolanoski: Die Entsendung der Bundeswehr ins Ausland 10 | Kaltschew: Das politische System Kenias 11 | Wernert: Die Rolle der Afrikanischen Union 12 | Klein: Rechtspopulistische Parteien in Regierungsbildungsprozessen 13 | Vogt: Strategische Aspekte deutscher Weltraumsicherheitspolitik www.welttrends.de 14 | Wagener: Der EU-Verfassungsvertrag und die Positionen linker Parteien 15 | Kasper: EU-Nachbarschaftspolitik als Instrument der Demokratieförderung Ansprechpartner: Prof. Dr. Jochen Franzke 0331 977 3414 ([email protected]) Büro WeltTrends 0331 977 4540 ([email protected]) 1 Introduction Foreign trade is an old phenomenon. In modern times international trade has become more common than at any time before and it is hard to imagine our world without international trade. Each time we buy goods, parts of them or even the whole good was produced abroad. On the other hand, German cars, for example, are driven in nearly every country of the world. It is not a question whether a country should participate in international trade. Besides a few exceptions (e.g. North Korea), every country participates in international trade. The overall amount of international trade is constantly increasing. Even setbacks like “the Great recession” – the term that is used to label the latest eco- nomic crisis1 – have only a temporary negative effect on world trade. Between 1948 and 2004 the volume of world trade (in US dollars) in- creased about one hundred fifty fold.2 International trade has grown by 4 percent each year on average since 1920. In the same period, world- wide GDP grew “only” by 2.7 percent each year on average.3 The concept of free trade is not as old as international trade it- self, but it is not a new topic. Economists are engaged with it since more than two hundred years. Today it concerns big parts of the world population. Inside the European Union (EU), free trade is even di- rectly perceivable by ordinary citizens. Nowadays, every citizen cannot only travel unrestricted between the EU countries but going through customs is history as well. Everybody can freely buy goods in another EU country without restrictions. The development of the EU led to a European single market that contains four freedoms, namely the free movement of goods, the free movement of capital, the free movement of services, and the free movement of persons.4 Internationally, trade is not as free as inside the EU. However, after World War II, an international trade system was developed with the aim of introducing free trade worldwide. In the framework of the General Agreement on Tariffs and Trade (GATT) trade barriers were reduced. In the last decades, the world became more and more economically integrated.5 The World Trade Organisation (WTO) that succeeded the GATT provides a legal and institutional base for international trade and 1 See The Economist 2009c, 13. 2 See O'Brien/Williams 2008, 159. Exports rose from $58 billion to $8,907 billion and imports increased from $66 billion to $9,252 billion. 3 See Maddison 1991, 74. 4 See Dicke 2004. 5 See Krugman/Obstfeld 2009, 227–42. 10 Free Trade and Absolute and Comparative Advantage continues the reduction of trade barriers.6 The function of the WTO is
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