Class 3 - Comparative Advantage

Great Economists

Adam Smith - "An Inquiry into the Nature and Causes of the Wealth of Nations" 1776
David Ricardo - "Principles of Political Economy and Taxation" 1817
John Maynard Keynes (1883-1946) - "The General Theory of Employment, Interest and Money" 1936. 3 volume biography by Robert Skidelsky. Now compacted into a 1 volume summary. Ran British economic policy during WWII. One of the founders of the IMF.

Almost all economic worth knowing comes from these 3 economists. The rest is commentary. All were British. Smith was Scottish.

Adam Smith set up the idea that economic wealth is created by specialization, which requires trade. Human beings have a natural propensity to truck, barter and exchange. Therefore, they need to specialize. The desire to trade leads to the need to specialize. (Not the opposite.)

Now the question became: how do we facilitate trade. Smith: set up markets with incentives. People are primarily movitated by self love and the love/well-being of their close family and friends. (Marx's theory depended on the idea that people are just as concerned with everyone else as well.) To motivate the baker to bake bread, you need to appeal to his "self-love" and offer him something in return. Don't appeal to his altruistic side for the good of all mankind.

2002 book by Steven Pinker "The Blank Slate". Human psychology is not a blank slate. There are certain things in human nature that are a product of evolution and natural selection.

Adam Smith spent a long period of time as the tutor of a Scottish duke. He took him on a 2 year tour of Europe. During this tour, he was able to meet with many of the great minds of Europe of the time.

Ricardo's story is very different. Ricardo was a Jewish millionaire stock trader at a very young age. He got bored of that and became a politician. (Similar to the Kennedy story.) He was involved in the debate over the "Corn Laws". In Europe, they call cob corn "maize". When they refer to "corn", they mean any kind of grain. In those days in England, there were tariffs and quotas on grain, particularly French grain. It had to due with their dislike of Napolean. In 1815, Napolean was history. (In US today, we have quotas on sugar from Jamaica and West Indies. Also on Brazilian ethanol. Originally, they had a political motive, but in the end it expanded.) Motivation may be political, but the consequences are economic.

By limiting corn, land owners became richer, food prices went up, urban manufacturing wage rates went up, urban manufacturing profits went down.

Principle of Comparative Advantage

Paul Samuelson called the idea of comparative advantate one of the things that economists understand well, but most people don't.

Gains from Trade (to both trading countries):
1. Exports
2. Imports
3. Specialization
4. Opportunity costs

Pareto Optimal Transaction - voluntary trades will continue when both parties gain. When one party feels he's no longer benefitting, the voluntary trade will end. e. g. buying a Starbucks coffee.

Exports - some are invisible, such as education delivered to foreign students. Tourism is an Austrian export.

Specialization is based on opportunity costs (as defined by economists). See Mankiw's example in Ch 3 - based on Rogers and Hammerstein's play Oklahoma! The example has one country that has an absolute advantate in manufacturing both goods. And yet still they benefit from trade.

Slope of farmer's production frontier is -1/3.
Slope of rancher's production frontier is -1/2.