1. International Economics
Lecture 3 | Lucía Rodríguez| Why do countries trade? Some early answers

2. Classical theory: adam smith
How to measure Absolute Advantage?
Real costs of production.
How to measure real costs of production?
Labor Theory of Value
i) Labor is the only factor of production.
ii) It determines goods' relative price.
iii) No reference to money or gold.
iv) It moves freely from one industry to another.
Within a single country, competition ensures exchange in proportion to L costs.
v) Internationally immobile
If L requirements differ, prices will differ as well
Table 1. Absolute Advantage
Source: International Economics (2009). Eicher et al.
Inserte un mapa del país.
Days of L
Italy
Scotland
Wine
Cloth 20
100
120 30

3. Classical theory: adam smith
Table 1. Absolute Advantage
Source: International Economics (2009). Eicher et al.
Different national prices ensure gains from trade at an intermediate ratio
Table 2. Efficiency Gains
Empirical Evidence: it accounts for important segments of trade
Days of L required
Italy
Scotland
Wine (barrels)
Cloth (bolts) 20
100
120 30
Italy
Scotland
Total
Wine (barrels) 30 -5 25
Cloth (bolts) -6 20 14
Inserte un mapa del país.

4. Classical theory: david ricardo
David Ricardo Principles of Political Economy and Taxation (1817)
Trade Pattern: Comparative Advantage (CA)
Definition: Low relative cost of a good compared to other countries in autarky. Every country will have a CA in some good.
Intuition:
Terms of Trade.
Differences in Technology (output per unit of labor) as the source of CA.
Inserte un mapa del país.

5. Classical theory: david ricardo
Trade Benefits:
Broader markets, greater supply, higher welfare.
Overcomes Smith’s limitations: There is scope for mutually beneficial trade between the two countries, if both specialize according to their pattern of CA, even when one of them has an AA in every commodity.
Table 3. Comparative Advantage
Source: International Economics (2009). Eicher et al.
Days of Labor
Portugal
England
Wine (1 barrel) 3 2
Cloth (1 bolt) 10 4
Inserte un mapa del país.

6. Classical theory: david ricardo
Table 1. Comparative Advantage
Source: International Economics (2009). Eicher et al.
Table 2. Efficiency Gains
Portugal must shift more days than England because of less efficiency in absolute terms
Price ratios will converge (unless there are additional costs) Intermediate Equilibrium ToT
Days of L required
Portugal
England
Wine (barrels)
Cloth (bolts) 3 10 2 4
Portugal
England
Total
Wine (barrels) 20
-18 2
Cloth (bolts) -6 9 3
Inserte un mapa del país.

7. Classical theory: david ricardo
Trade Benefits:
Broader markets, greater supply, higher welfare.
Real Income increases because of specialization
Overcomes Smith’s limitations: There is scope for mutually beneficial trade between the two countries, if both specialize according to their pattern of CA, even when one of them has an AA in every commodity.
Economic Policy: Laissez-faire. Any intermediate ToT is mutually beneficial (No zero-sum game)
Limitations:
What if relative costs are equal?
ToT indetermination (Barone)
Inserte un mapa del país.

8. Classical theory: J. Stuart mill
J.S. Mill
Amount of output produced by a given amount of labor
Boradcloth
Linen
England 10 15
Germany 20

9. Classical theory: J.Stuart mill
Reciprocal Demand Theory:Cloth Market
Definition: Equilibrium barter ToT (ratio of exchange) will equate Exports Supply with Imports Demand internationally.
Demand elasticity is crucial due to the shape of the Supply curve (L Theory of Value+constant productivity of Labour).
World curves as differences. Walras’ law.
England World Trade Germany
Se Sx,e Sg 2
1.7
De Dm.g Dg
1.5
C* C* C*
Inserte un mapa del país.

10. Classical theory: limitations
Only two goods: What happens in a more realistic set-up?
Consider a rank ordering: relative marginal costs will predict the trade pattern
Compare Cloth with other goods and export the one with the lower ratio.
MC will depend on wages and the inverse of productivity
As long as there is a single wage rate in each country, relative labour productivities will determine the ranking.
Countries should tend to export those goods in which their productivity is relatively high.
Relative productivity must be high compared with other sector's relative productivity.
Chinese surge as an export powerhouse
Inserte un mapa del país.

11. Classical theory: limitations
Strong assumptions
No trade barriers: transportation costs, information costs,…
If they fall relative to the value of the good being transported, more goods are likely to become available.
Just one Input: L. Labor Theory of Value.
Labor is internationally immobile.
Constant costs of production, Leontieff production function.
Fixed amount of inputs: Vertical Aggregate Supply .
Inserte un mapa del país.

12. Classical theory: Empirical evidence
It predicts an extreme degree of specialization.
It assumes away effects of International Trade on the distribution of income within countries.
Allows no role for differences in resources among countries as a cause of trade.
Neglects the possible role of economies of scale as a cause of trade.
Inserte un mapa del país.

13. Classical theory: misconceptions
Free trade is beneficial only if your country is strong enough to stand up to foreign competition.
Foreign Competition is unfair and hurts other countries when it's based on low wages.
Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations