Free Trade TheoryWhy Nations Trade

Basics of Trade

• Defined: 2 Countries engage in economic activity

• Exports: goods/services leave country

• Imports: goods/services enter country

• Trade Surplus: Export more than import

• Trade Deficit: Import more than export

Why Trade?

Ways to Limit Trade

• Tariffs– taxes on imports

• Quotas- limits on quantity imported

• Protectionism: Gov’t policy which seeks to limit trade

• Globalization: the “global” movement towards free trade – Trade without Tariffs & Quotas – free market capitalism on a global scale

Adam Smith• In his 1776 book Wealth of Nations, Adam Smith

talked about specialization

When each worker madetheir own pins, they produced 20 pins per day each

Adam Smith on Specialization

Adam Smith noted that when each worker specialized in a production stage, the output by the factory increased to 4,800 pins per worker

(Page 11, Wealth of Nations)

Also known as Division of Labor

Specialization works!

Any illegal activity you can think of…

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Idaho

Nevada

Texas

Florida

David Ricardo• In his 1816 book David Ricardo developed the free

trade theory based on comparative advantage

• Absolute Advantage: when a country can produce a good more efficiently – produce a good using fewer resources

• Comparative Advantage: when a country can produce a good at a lower opportunity cost– country gives up less when they produce a good

Countries should produce (specialize) in goods where they have a comparative advantage

Trade benefits both parties (each country gets “more”)

Free Trade promotes a more “efficient” world economy

Absolute Advantage is not relevant in deciding which country should produce a good

Ricardo’s Trade TheoryHere is my

great theory!

Practice Problems