Chapter 3 In this chapter we are going to study, using Classical theory of international trade, how and why nations trade.

Chapter 3 Classical Theory is useful because: 1-- The theory is applicable to today's world in the sense that it explains why and how trade is beneficial to all

Chapter 3 Classical Theory is useful because: 1-- The theory is applicable to today's world in the sense that it explains why and how trade is beneficial to all 2-- The theory explains why and how a high cost (wage) country like U.S. could export to a low cost (wage) country like Mexico.

Chapter 3 Classical Theory is useful because: 1-- The theory is applicable to today's world in the sense that it explains why and how trade is beneficial to all 2-- The theory explains why and how a high cost (wage) country like U.S. could export to a low cost (wage) country like Mexico. 3-- The theory shows why specialization in necessary.

Chapter 3 Classical theory of international trade covers: Absolute advantage theory of Adam Smith Comparative advantage theory of David Ricardo. Some argue that Robert Thorrens had first discovered the Comparative Advantage theory in 1808

Chapter 3 New Assumptions 8-- Factors of production are not mobile among countries.

Chapter 3 New Assumptions 8-- Factors of production are not mobile among countries. 9-- There are no barriers to trade.

Chapter 3 New Assumptions 8-- Factors of production are not mobile among countries. 9-- There are no barriers to trade. 10- Imports are paid by exports. Balance of trade and no borrowing.

Chapter 3 New Assumptions 8-- Factors of production are not mobile among countries. 9-- There are no barriers to trade. 10- Imports are paid by exports. Balance of trade and no borrowing. 11- Labor is the only factor of production in terms of productivity analysis and cost of production.

Chapter 3 New Assumptions 8-- Factors of production are not mobile among countries. 9-- There are no barriers to trade. 10- Imports are paid by exports. Balance of trade and no borrowing. 11- Labor is the only factor of production in terms of productivity analysis and cost of production. 12- Production exhibits constant return to scale. This Assumption means a technological relationship which shows a change in inputs will lead to a proportional change in output.

His theory of international trade was very simple and was based on the principle of: -- self interest Absolute Advantage : Adam Smith Wealth of Nations, 1776

His theory of international trade was very simple and was based on the principle of: -- self interest -- specialization Absolute Advantage : Adam Smith Wealth of Nations, 1776

His theory of international trade was very simple and was based on the principle of: -- self interest -- specialization -- competition Absolute Advantage : Adam Smith Wealth of Nations, 1776

His theory of international trade was very simple and was based on the principle of: -- self interest -- specialization -- competition Absolute Advantage : Adam Smith Wealth of Nations, 1776

all of the three principles lead to one thing, the absolute advantage. Absolute Advantage : Adam Smith Wealth of Nations, 1776

all of the three principles lead to one thing, the absolute advantage. Even though he started with the example of a pin factory in which workers cooperate and specialize to make pins, he argued that this is applicable to international trade as well. Absolute Advantage : Adam Smith Wealth of Nations, 1776

all of the three principles lead to one thing, the absolute advantage. Even though he started with the example of a pin factory in which workers cooperate and specialize to make pins, he argued that this is applicable to international trade as well. He argued that if all countries specialize, they can increase production of whatever they were producing, and sell the extra to other countries. Absolute Advantage : Adam Smith Wealth of Nations, 1776

all of the three principles lead to one thing, the absolute advantage. Even though he started with the example of a pin factory in which workers cooperate and specialize to make pins, he argued that this is applicable to international trade as well. He argued that if all countries specialize, they can increase production of whatever they were producing and sell the extra to other countries. This is a result of the generalization of the division of labor which he explained for the domestic production; the pin factory. ABSOLUTE ADVANTAGE THEORY NUMBER OF LABOR HOURS NEEDED TO PRODUCE ONE UNIT OF SOYBEANS TEXTILES U.S.5 15 ENGLAND20 5 relative prices (domestic TOT before international Trade) U.S.[5/15] or 1 T= 3 S England[20/5] or 4 T = I S Production Before International Trade Soybeans TextilesTotal U.S.1 12 England In this case it is obvious that the U.S. must specialize in the production of soybeans and England in the production of textiles. This is because each can produce it cheaper. Allocation of Labor after specialization SOYBEANS TEXTILES US20 0 ENGLAND0 25 Production After Specialization Soybeans Textiles US4 0 England0 5 Assume that term of trade is established to be one to one Consumption After International Trade Soybeans TextilesTotal US3 1 4 England In other words, both countries could specialize and produce more and trade some and consume more. Assuming international terms of trade (TOT) is one to one, US could exchange one unit of Soybeans for one unit of Textile and keep the rest of the soybeans for domestic use. Comparative Advantage What if one country has absolute advantage in the production of both commodities ? NUMBER OF LABOR HOURS NEEDED TO PRODUCE ONE UNIT OF SOYBEANS TEXTILES USa ls = 5 a lt = 15 ENGLANDa' ls =10 a' lt = 20 relative prices Before international Trade U.S. 1 T / 3 S England 1 T / 2 S Production Before International Trade Soybeans TextilesTotal U.S.1 12 England Comparative Advantage U.S. advantage over England are: Soybeans5/10 = 1/2 = 3/6 Textiles 15/20 = 3/4 U.S. has a higher advantage in both S and T. But US's advantage is higher in S. This is because there is a relatively smaller labor requirement for the production of S than for the production of T. So, even though the united States has an absolute advantage in the production of S and T, there is a higher advantage in the production of S. Therefore US must specialize in the production of S and England must specialize in the production of T in which she has a smaller disadvantage. Graphical Analysis of Comparative Advantage Assuming that the US has 1500 hours of labor endowment and England has 1000 hours of labor endowment available. Then the internal, pre-trade PPC, and consumption possibility frontier of each country could be represented as follows: Algebra of Comparative Advantage U.S. Let L = the country's labor supply a ls = labor needed for one unit of soybeans. a lt = " " " " " " textiles England L' = the country's labor supply a' ls = labor needed for one unit of soybeans. a' lt = " " " " " " textiles If a ls < a' ls (absolute advantage) means that home labor is more efficient in the production of soybeans than foreign labor. If a lt < a' lt (absolute advantage) means that home labor is more efficient in the production of textiles than foreign labor. So, the question becomes which commodity does the United States have a higher advantage or efficiency (least cost)? We have a higher efficiency in soybeans if (a ls / a lt ) < ( a' ls / a' lt ) Or: (a ls / a lt ) < (a' ls / a' lt ) This means that the United States has a comparative advantage in the soybean production and England has a smaller comparative disadvantage relative to the United States in the production of textiles. Trade Triangle Assume that the United States and England specialized in S and T respectively. Then the pattern of production and, consumption, exports, and imports would be: productionconsumption exportsimports USODOC CDBC BC UKO'D'O'C' C'D'B'C' B'C' It can be shown that the two triangles BCD and B'C'D' are similar and identical. They are similar because -- they are both right angle -- BD and B'D' are parallel; both represent the international TOT and therefore D and B' are equal angles. As a result, B and D' must be equal angles. Also we know that exports of US is imports of England and they must be equal. Since all three angles and at least one side of the two triangles are equal, the two triangles are identical. Both triangles are identical because of the assumption that countries must pay for their imports by exports. So, imports of the U.S. (England) must be Comparative Advantage NUMBER OF LABOR HOURS NEEDED TO PRODUCE ONE UNIT OF SOYBEANS TEXTILES US5 10 ENGLAND1515 relative prices Before international Trade U.S. 1 T = 2 Sor 1S=1/2T England 1 T =1 S Comparative Advantage Production Before International Trade SoybeansTextilesTotal U.S.112 England Comparative Advantage U.S. advantage over England are: Soybeans5/15 Textiles 10/15 Comparative Advantage Allocation of Labor after specialization SOYBEANS TEXTILES US150 ENGLAND 0 30Comparative Advantage Production After Specialization SoybeansTextiles Total U.S.30 3 England02 2 Total U.S. has a higher advantage in both S and T. But US's advantage is higher in S. This is because there is a relatively smaller labor requirement for the production of S than for the production of T. So, even though the united States has an absolute advantage in the production of S and T, there is a higher advantage in the production of S. Therefore US must specialize in the production of S and England must specialize in the production of T in which she has a smaller disadvantage. Absolute Advantage : Adam Smith Wealth of Nations, 1776