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Free Trade
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles
J Woelfel
(We recommend this as work of authority.)
Trade among
countries without policy restrictions, as opposed to PROTECTIONISM.
The January/February 1988 issue of the Federal Reserve Bank of
St. Louis's Review contained
a description of the economics of free trade and is quoted here:
The most
famous demonstration of the gains from trade appeared in 1817 in David
Ricardo's "Principles of Political Economy and Taxation."
We use his example involving trade between England and Portugal
to demonstrate how both countries can gain from trade. The two countries produce the same two goods, wine and cloth,
and the only production costs are labor costs.
The figures below list the amount of labor (e.g., worker-days)
required in each country to produce one bottle of wine or one bolt of
cloth.
Since both
goods are more costly to produce in England than in Portugal, England
is absolutely less efficient at producing both goods than its prospective
trading partner. Portugal
has an absolute advantage in both wine and cloth. At first glance, this appears to rule out mutual gains from
trade; however, as well demonstrate below absolute advantage is irrelevant
in discerning whether trade can benefit both countries.
The ratio
of the production costs for the two goods is different in the two countries.
In England, a bottle of wine will exchange for 3/7
of a bolt of cloth because the labor content of the wine is 3/7
of that for cloth. In Portugal,
a bottle of wine will exchange for 1/5 of a bolt
of cloth. Thus, wine is
relatively cheaper in Portugal than in England and, conversely, cloth
is relatively cheaper in England than in Portugal.
The example indicates that Portugal has a comparative advantage
in wine production and England has a comparative advantage in cloth
production.
The different
relative prices provide the basis for both countries to gain from international
trade. The gains arise
from both exchange and specialization.
The gains
from exchange can be highlighted in the following manner.
If a Portuguese wine producer sells five bottles of wine at home,
he receives one bolt of cloth.
If he trades in England, he receives more than two bolts of cloth.
Hence, he can gain by exporting his wine to England.
English cloth-producers are willing to trade in Portugal; for
every 3/7 of a bolt of cloth they sell there,
they receive just over two bottles of wine.
The English gain from exporting cloth to (and importing wine
from) Portugal, and the Portuguese gain from exporting wine to (and
importing cloth from) England. Each country gains by exporting the good in which it has a
comparative advantage and by importing the good in which it has a comparative
disadvantage.
Gains from
specialization can be demonstrated in the following manner.
Initially, each country is producing some of both goods.
Suppose that, as a result of trade, 21 units of labor are shifted
from wine to cloth production in England, while, in Portugal, 10 units
of labor are shifted from cloth to wine production.
This reallocation of labor does not alter the total amount of
labor used in the two countries; however, it causes the production changes
listed below.
The shift of 21 units
of labor to the English cloth industry raises cloth production by three
bolts, while reducing wine production by seven bottles.
In Portugal, the shift of 10 units of labor from cloth to wine
raises wine production by 10 bottles, while reducing cloth production
of both goods: wine by
three bottles and cloth by one bolt.
This increased output will be shared by the two countries.
Thus, the consumption of both goods and the wealth of both countries
are increased by the specialization brought about by trade based on
comparative advantage.
(Adapted from "Protectionist
Trade Policies: A survey
of Theory, Evidence and Rationale," Review,
Federal Reserve Bank of St. Louis, January/February 1988.)
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