Pugel_14_SG_CH03 - CHAPTER 3 WHY EVERYBODY TRADES...

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CHAPTER 3 WHY EVERYBODY TRADES: COMPARATIVE ADVANTAGE Objectives of the Chapter Chapter 3 looks at trade in a hypothetical world of two countries and two commodities. This simple trade model is based on barter, where countries exchange only goods, without any money being used. The price of each good is, therefore, what each unit of the good is worth in units of the other good. Countries trade because their prices would differ if something prevented international trade. In this chapter we focus on production-side differences between countries as a source of price differentials. Adam Smith proposed that “absolute advantage” was the basis for international trade: countries would export those goods that they made better than anyone else in the world. Later, David Ricardo pointed out that some countries are absolutely awful at producing everything and so, according to Smith, those countries would have no reason to engage in trade. Instead, Ricardo proposed the notion of “comparative advantage,” in which even a relatively unproductive country can benefit from trade (as can its trade partners), as long as the country produces at least one good whose opportunity cost is lower than in the partner country. After studying Chapter 3, you should be able to 1. relate opportunity cost and price. 2. understand trade and arbitrage profits. 3. show how countries can gain from trade on the basis of absolute advantage. 4. explain the development of the theory of comparative advantage using Ricardo's labor theory of value. Important Concepts Absolute advantage: A nation has an absolute advantage in a commodity it produces with higher productivity than the rest of the world.
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