1. Classic Theories of International Trade
Dianna DaSilva- Glasgow

2. outline Introduction Mercantilism Absolute advantage: Adam Smith
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Introduction
Mercantilism
Absolute advantage: Adam Smith
Comparative advantage: David Ricardo
Comparative advantage and opportunity cost
Exception to the law of comparative advantage
Comparative advantage with money
Comparative advantage and the ppf
International Trade Theory- ECN 422, 2010/2011

3. Introduction Historical development of trade theory
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Historical development of trade theory
Answer the questions:
Basis for trade/ gains from trade- as countries will only voluntarily trade if there are gains to be had.
Pattern of trade
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4. Mercantilism Dominant thinking during the 17th-18th centuries
Group of merchants, bankers, government officers etc.
Trade is a zero-sum game because bullion is fixed at any one time
Bullion was gold and silver and was the primary means of exchange.
Trade surplus to become rich and powerful
Export surplus would lead to an inflow of bullion (receipt of payments from abroad) while imports would lead to an outflow (payments abroad) of bullion.
More bullion more power, economic and military (doctrine of economic nationalism).
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5. Mercantilism
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Thomas Munn, ‘England’s Treasure by Foreign Trade’ (1928):
“the ordinary means therefore to increase our wealth and treasure is by foreign trade, wherein we must ever observe this rule; to sell more to strangers yearly than we consume of theirs in value. For ... that part of our stock [exports] which is not returned to us in wares [imports] must necessarily be brought home in treasure [bullion]....”
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6. Mercantilism
Policy implication: Governments should restrict imports and stimulate exports.
Mercantilism is still somewhat evident in contemporary trade relations with the imposition of trade barriers by some countries, particularly aimed at protecting labour- intensive industries such as; textiles and other agri commodities.
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International Trade Theory- ECN 422, 2010/2011

7. Absolute advantage: Adam Smith
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The theory of absolute advantage is a direct response to mercantilism. Adam smith challenged mercantilists views that trade is a zero-sum game. Smith noted that trade can be mutually beneficial and in fact will only take place if both countries can benefit.
Smith noted that trade is based on absolute advantage- the greater efficiency (economic strength) that one nation may have over another in the production of a commodity.
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8. Absolute advantage: Adam Smith
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Alternatively, a country enjoys an absolute advantage over another country in the production of a product if it uses fewer resources to produce that product than the other country does.
International Trade Theory- ECN 422, 2010/2011

9. Absolute advantage: Adam Smith
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When nations specialize and trade based on productive efficiency output of both commodities will increase and resources will be more efficiently utilized so that both nations will gain from trade.
Policy implication: Policy of laissez- faire.
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10. Absolute advantage: Adam Smith
Illustration
US UK
Wheat (bushels/hr) 6 1
Cloth (yards/hr) 4 5
The US has the absolute advantage in the production of wheat since it can produce more bushels of wheat in one hour than the UK.
The UK has the absolute advantage in the production of cloth since it can produce more yards of cloth in one hour than the US.
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International Trade Theory- ECN 422, 2010/2011

11. Absolute advantage: Adam Smith
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Assume the countries specialize and exchange commodities at an exchange rate of 6W for 6C how will they benefit from trade in terms of cloth?
US gains 2C – or saves 30 minutes since it already produces 4 cloth. With the 30 minutes the US can produce 3 additional bushels of wheat (1 wheat= 10 minutes).
International Trade Theory- ECN 422, 2010/2011

12. Absolute advantage: Adam Smith
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UK gains 24C as the 6hrs that would have been spent on wheat can now produce cloth (6*5 = 30C)
Therefore, both countries can more efficiently utilize resources and thereby increase the amount of both commodities available.
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13. Absolute advantage: Adam Smith
Exercise:
Which country has the absolute advantage in each commodity?
Nation 1 Nation 2
Commodity X (hr)
Commodity Y (hr)
Assume the countries specialize and exchange commodities at an exchange rate of 10X for 15Y how will they benefit from trade in terms of Y?
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14. Absolute advantage: Adam Smith
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The productivity of labour is greater in nation 1 in the production of commodity X, hence nation 1 has the absolute advantage in the production of commodity X.
The productivity of labour is greater in nation 2 in the production of commodity Y, hence nation 2 has the absolute advantage in the production of commodity Y.
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15. Absolute advantage: Adam Smith
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Assume the countries specialize and exchange commodities at an exchange rate of 10X for 15Y how will they benefit from trade in terms of Y for nation 1?
Nation 1 will gain 7Y or save 53 minutes (1Y=7.5 minutes)
Nation 2 will gain 5Y or save 1:40 (it will take 100 minutes to produce 10X) minutes from not having to produce commodity X (1X=10 minutes) and will produce 20Y (1Y=5 minutes, 100/5=20Y).
International Trade Theory- ECN 422, 2010/2011
Nation 2 produces 6X in 1hr (1X= 10mins) to produce an additional 4X, nation 2 will need 40 minutes. Nation 2 will save 1:40 (100) minutes from not having to produce 10X.
In 1:40 minutes nation 2 will produce 20Y (1Y=5 minutes) (100/5 = 20Y).
By exchanging 15Y for 10X nation 2 will gain 5Y.

16. Absolute advantage: Adam Smith
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Gains to both countries and the world from the re- allocation of resources (complete specialization)
Nation Nation 2 World
Commodity X
Commodity Y
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17. Absolute advantage: Adam Smith
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Therefore specialization according to absolute advantage increases world production.
World production increases but each country produces less of one commodity.
However, by exchange each country can have an increase in the availability of both goods.
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18. Comparative advantage: David Ricardo
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David Ricardo, ‘Principles of Political Economy and Taxation’ (1817).
Address flaws in absolute advantage: what will happen if one country has the absolute advantage in both goods?
US UK
Wheat (bushels/hr)
Cloth (yards/hr)
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19. Comparative advantage: David Ricardo
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UK has an absolute disadvantage in both commodities and therefore should not be involved in trade based on the principle of absolute advantage.
Comparative advantage states that a nation should specialize in and export the commodity in which its absolute advantage is greater.
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20. Comparative advantage: David Ricardo
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Assumptions of law of comparative advantage:
Two dimensional model: 2 nations and 2 commodities
Free trade
Perfect mobility of labour within nation but immobility between two nations
Constant costs of production
No transportation costs
No technical change
Labour theory of value
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21. Comparative advantage: David Ricardo
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Comparative advantage was initially based on the labour theory of value which was rejected.
The cost or price of a commodity is determined by or can be inferred exclusively from its labour content.
Assumptions:
labour is the only factor of production or is used in the same fixed proportion in the production of all commodities
labour is homogenous
Since assumptions are not true comparative advantage cannot be based on the labour theory of value.
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22. Comparative advantage and opportunity cost
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Gottfried Haberler 1936 based the theory of comparative advantage on the opportunity cost theory-the law of comparative cost.
The nation with the lower opportunity cost (lower cost in terms of other goods) in the production of a commodity has a comparative advantage in that commodity (and a comparative disadvantage in the second commodity).
With opp. cost all inputs can be considered.
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23. Comparative advantage and opportunity cost
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What is opportunity cost?
the amount of one good given up for the production of one unit of another good.
Opportunity cost of X = ΔY/ΔX
Opportunity cost of Y = ΔX/ΔY
For example if 2 units of corn must be given up to release the resources necessary to produce 4 units of wheat, then the opp. cost of wheat is 2/4= ½.
With a two dimensional model oppc. of one commodity is the reciprocal of the other.
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24. Comparative advantage and opportunity cost
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Opp. Cost of nation 1 producing commodity X is (ΔY/ΔX)1
Opp. Cost of nation 2 producing commodity Y is (ΔX/ΔY)2
(ΔY/ΔX)1 < (ΔY/ΔX)2 indicates that the amount of Y that must be given up in production in nation 1 to produce an additional unit of x is less than in nation 2. Therefore nation 1 should produce X because fewer units of Y will have to be given up if X is produced in nation 1.
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25. Comparative advantage and opportunity cost
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Alternatively, (ΔX/ΔY)1 > (ΔX/ΔY)2 indicates that the amount of X that must be given up in production in nation 1 to produce an additional unit of Y is greater than in nation2. Therefore nation 2 has the comparative advantage in the production of Y.
Since opp. cost is inverse it is impossible for one nation to have a comparative advantage in both commodities.
International Trade Theory- ECN 422, 2010/2011

26. Comparative advantage and opportunity cost
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US UK
Wheat (bushels/hr)
Cloth (yards/hr)
Opportunity cost of W = ΔC/ΔW
US= 4/6 = 0.67
UK= 2/1= 2
Opportunity cost of C= ΔW/ΔC
US= 6/4 = 1.5
UK= 1/2= 0.5
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27. Comparative advantage and opportunity cost
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Since the US has the lower opp C. in the production of wheat it has the comparative advantage in wheat production.
Since the UK has the lower opp C. in the production of cloth it has the comparative advantage in cloth production.
International Trade Theory- ECN 422, 2010/2011

28. Gains from trade Gains from specialization: US UK World
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Gains from specialization:
US UK World
Wheat (bushels/hr)
Cloth (yards/hr)
Specialization increases production of the commodity of comparative advantage in each nation and reduces the production of the other commodity but exchange allows for the availability of both commodities in both nations to be increased.
International Trade Theory- ECN 422, 2010/2011

29. Comparative advantage and opportunity cost
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 Gains from exchange (6C for 6W)
The Gains to the US in terms of cloth=  2 C or 30 minutes saved from not having to produce the 2 additional units of cloth.
The gains to the UK in terms of cloth is 6C (6*2= 12C) after exchanging 6C for 6W or 6 hours that would have been spent to produce 6W.
The range of mutually beneficial trade for the two countries is: 4C > 6W> 12C
With the spread of gains being 8C, 2C for the US and 6C for the UK.
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30. Comparative advantage and opportunity cost
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Exception to the law of comparative advantage:
When the absolute disadvantage of one nation with respect to another nation is the same in both commodities mutually beneficial trade could not take place.
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31. Comparative advantage and opportunity cost
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Nation 1 Nation 2
Commodity X
Commodity Y
Nation 1
Opp C. of X = 4/6= 0.67
Opp C. of Y = 6/4= 1.5
Nation 2
Opp C. of X = 2/3= 0.67
Opp C. of Y = 3/2= 1.5
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32. Comparative advantage and opportunity cost
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The comparative disadvantage of nation 2 is in the same proportion for both commodities as is the comparative disadvantage of nation 1 for commodity X hence there is no basis for mutually beneficial trade as nation 1 would not benefit.
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33. Comparative advantage with money
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Countries can trade even if one is less efficient at producing both commodities where wages are lower in the less efficient country making the commodity cheaper in the low wage country.
International Trade Theory- ECN 422, 2010/2011

34. Comparative advantage with money
Wr US= $6 per hour
Wr UK= £1 per hour (2$)
Exchange rate US$2 = £1
Cost per unit= Total wage cost/total output
US UK
Price of one bushel of wheat $1.00 ($6/6)) $2.00 ($2/1)
Price of one yard of cloth $1.50 ($6/4) $1.00 ($2/2)
Price of cloth in the US = $6/ 4 = $1.5
Price of wheat in the UK= $2/ 1 = $2
Price of cloth in the UK - $2/ 2= $1

35. COMPARATIVE ADVANTAGE AND THE PPF
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Opportunity cost is reflected in the PPF which shows production possibilities when resources are fully employed.
The slope of the PPF shows the opportunity cost of producing two commodities in the country or the (marginal) rate of transformation of good X for good y.
With constant costs, as assumed by David Ricardo, the PPF is a straight line with a negative slope.
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36. Table 2.4. Production Possibility schedules for wheat and cloth in the united states and the united kingdom
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United States
United Kingdom
Wheat
Cloth
180 60
150 20 50
120 40 90 30 80
100 10
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37. Constant cost PPF (US) for wheat oppc= 120/180= 2/3 (Y=cloth & X= wheat)
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38. Constant cost PPF (UK) for Wheat oppc= 120/60= 2 (Y=cloth & X= wheat)
(60-40)/(40-30) =20/10=2
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39. COMPARATIVE ADVANTAGE AND THE PPF
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 Constant opportunity costs arise when:
Resources or factors of production are either perfect substitutes for each other or used in fixed proportion in the production of both commodities and
All units of the same factor are homogenous or of exactly the same quality.
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40. Opportunity costs and relative commodity prices
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Opportunity cost= MRT
Since price equals cost of production the opp cost of good x is equal to the relative price of good y, that is, Px=ΔY/ΔX = PX/PY
Opportunity cost (relative commodity prices) are constant in each nation but differ among nations, providing the basis for trade.
Pw/Pc= 2/3 in the US vs. Pw/Pc= 2 in the UK
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41. OPPORTUNITY COSTS AND RELATIVE COMMODITY PRICES
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Hence the difference in relative commodity prices (oppc.) reflects comparative advantage and provides the basis for trade.
However, for trade to take place, the equilibrium-relative commodity price of each commodity must fall between the pre-trade relative commodity price in each nation (see fig 2.3).
With trade, both production and consumption are higher (see Fig 2.2)
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42. EMPIRICAL TESTS OF THE RICARDIAN MODEL
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Empirical studies support the Ricardian theory of comparative advantage based on productivity of labour:
MacDougall 1951 to 1952 – positive relationship between labour productivity and exports in the UK and US.
Golub 1995 and negative relationship between unit labour costs and exports.
However, comparative advantage does not explain all patterns of trade.
MacDougall supported trade based on product differentiation.
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43. SHORTCOMING OF THE RICARDIAN MODEL
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Assumes rather than explains comparative advantage. In other words, the model does not explain the underlying source of differences in labour productivity among nations.
This is done by the Heckscher-Ohlin model.
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44. Further reading Salvatore (2007) , Chapters 1 and 2
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Salvatore (2007) , Chapters 1 and 2
Krugman and Obstfeld (2009), Chapters 1 and 2
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