L2 classical trade theory

Classical trade theory:

Classical theories assumptions: There're only two countries and two goods Zero transaction cost , so the price depend only on the cost of production ( labor cost) Goods' value determines according to the labor value theory Labor is fixed, homogeneous within a country, the only factor of production, and is fully utilized and mobilize Immobilization of labors between countries The perfect competition market The similarity of tastes The market depend on barter not money Constant return to scale Technology and production costs are constant

Absolute Advantage theories: Adam Smith ideas based on… The capability of one country to produce more of a product with the same amount of input than another country (same thing) The ability of a country to produce a good using fewer resources than another country (lower opportunity cost) As that's refer to the efficiency of country to produce that good So Adam Smith argued that : A country should produce only goods where it is most efficient …. and trade for those goods where it is not efficient Trade between countries is, therefore, beneficial, as the specialization of production will increase the efficiency of country and increase the whole production.

The EU has an absolute advantage in machine production Ex.: If we consider a case of 2 states EU and India, produce 2 goods machine and cloth, then to produce one unit of each good, they need the following hours of work: According to the previous table, we notice EU is more efficient in machine production as it needed for a lower hours of work comparing to India, while India is more efficient in cloth's production, as it needed for a lower time comparing to EU, so from Adam smith' point of view: The EU has an absolute advantage in machine production India has an absolute advantage in cloth production To produce one unit of product Country Machines Cloth EU 2 20 India 10 4

Increase the production of two good So according to absolute theory it's more beneficial for EU to specialize in machine production, and India In cloth then exchange with each other, assuming we have 40 hours of work so after specialization the situation , We notice that the specialization of production will lead to: Increase the production of two good Increase the production of two countries Increase the total production all over the world Country Machines Cloth Total production of country EU 20 units -2 units 18 India -4 unit 10 unit 6 Total producti on of goods 16 8 24 unit

Comparative Advantage theory: As the absolute theory didn't explain the situation when one country is more efficient in the production of the two goods comparing to the other country, then David Ricardo in his book Principles of Political Economy (1817), try to Extended the absolute trade theory through his theory about Comparative Advantage, as he showed that the country Should import even if it is more efficient in the product's production than country from which it is buying. As the comparative advantage is the ability of a country to produce a good at a lower opportunity cost than another country.

To show the benefit of specialization we will depend on the next example, As we notice U.S. has bigger Absolute Advantage in the production of two goods, but as we look to the comparative advantage we can notice that to produce one unit of machine in USA we sacrifice 0.5 unit of cloth, while to produce one more unit of cloth we sacrifice 2 unit of machine. No of work hour to produce one unit of goods Country Machines Cloth U.S. 2 4 India 40 10

While to produce one machine in India we sacrifice 4 units of cloth, and to produce one unit of cloth we sacrifice 0.25unit of machine, so the rate of sacrifice for machine is lower in USA comparing to India, and for the rate of sacrifice for cloth is lower in India comparing to USA, so it's beneficial to USA to specialize in machine production, then exchange the one unit of machine with 4 unit of cloth from India, while India specialize in cloth, and exchange the unit with 2units of machine from USA, so the situation after specialization will be like that:

If we assume USA work for 200 hours and India for 600 hours, as India must work more time than USA to cover the difference in efficiency Change in the Production of Country Machines Cloth U.S. +100 –50 50 India –15 +60 45 Change in World Output 85 10 95