Moderntradetheoryseekstoanswerthefollowingquestions:

1.Whatconstitutesthebasisfortrade—thatis,whydonationsexportandimportcertainproducts?

2.Atwhattermsoftrade(relativeprices)areproductsexchangedintheworldmarket?

3.Whatarethegainsfrominternationaltradeintermsofproductionandconsumption?Mercantilists:Ifacountrycouldachieveafavorabletradebalance(asurplusofexportsoverimports),itwouldenjoypaymentsreceivedfromtherestoftheworldintheformofgoldandsilver.AdamSmith,aclassicaleconomist,wasaleadingadvocateoffreetrade(openmarkets)onthegroundsthatitpromotedtheinternationaldivisionoflabor.Withfreetrade,nationscouldconcentratetheirproductionongoodstheycouldmakemostcheaply,withalltheconsequentbenefitsofthedivisionoflabor.Acceptingtheideathatcostdifferencesgovernthemovementofgoodsamongnations,Smithsoughttoexplainwhycostsdifferamongnations.Smithmaintainedthatproductivitiesoffactorinputsrepresentthemajordeterminantofproductioncost.Suchproductivitiesarebasedonnaturalandacquiredadvantages.SmiththusviewedthedeterminationofcompetitiveadvantagefromthesupplysideofthemarketSmith’sconceptofcostwasfoundeduponthelabortheoryofvalue,whichassumesthatwithineachnation(1)laboristheonlyfactorofproductionandishomogeneous(ofonequality)and(2)thecostorpriceofagooddependsexclusivelyupontheamountoflaborrequiredtoproduceit.Anationwillimportthosegoodsinwhichithasanabsolutecostdisadvantage;itwillexportthosegoodsinwhichithasanabsolutecostadvantage.Thelessefficientnationshouldspecializeinandexportthegoodinwhichitisrelativelylessinefficient(whereitsabsolutedisadvantageisleast).Themoreefficientnationshouldspecializeinandexportthatgoodinwhichitisrelativelymoreefficient(whereitsabsoluteadvantageisgreatest).Todemonstratetheprincipleofcomparativeadvantage,Ricardoformulatedasimplifiedmodelbasedonthefollowingassumptions，1.Theworldconsistsoftwonations,eachusingasingleinputtoproducetwocommodities.2.Ineachnation,laboristheonlyinput(thelabortheoryofvalue).3.Laborcanmovefreelyamongindustrieswithinanationbutisincapableofmovingbetweennations.4.Theleveloftechnologyisfixedforbothnations.5.Costsdonotvarywiththelevelofproductionandareproportionaltotheamountoflaborused.6.Perfectcompetitionprevailsinallmarkets.7.Freetradeoccursbetweennations;8.Transportationcostsarezero,9.Firmsmakeproductiondecisionsinanattempttomaximizeprofits,whereasconsumersmaximizesatisfactionthroughtheirconsumptiondecisions.10.Thereisnomoneyillusion;11.Tradeisbalanced(exportsmustpayforimports).Absolute&ComparativeAdvantage

Absoluteadvantage:eachnationismoreefficientinproducingonegood OutputperlaborhourNation Wine

ClothUnitedStates 5bottles 20yardsUnitedKingdom 15bottles 10yardsComparativeadvantage:theUShasanabsoluteadvantageinbothgoods OutputperlaborhourNation Wine

ClothUnitedStates 40bottles 40yardsUnitedKingdom 20bottles 10yardsRicardo’sComparativeAdvantageinmoneyprices

Cloth (yards) Wine (bottles)Nation Labor

Wage Quant. Price Quant. PriceUS 1hr $20/hr 40 $0.50 40 $0.50UK 1hr ￡5/hr 10 ￡0.50 20 ￡0.25UK 1hr $8 10 $0.80 20 $0.40(at$1.6=￡1)Itispossibleforanationnottoh