1. International Economics
Basics of International Trade Theory
Prof. D. Sunitha Raju

2. The International Economy : Introduction
Firm/Industry Competitiveness
• relative prices
A country’s international competitiveness
• relative productivities

3. Trade Theory : Discussion Issues
What is the basis for trade between countries?
How are gains from trade defined/ measured.
Can theory explain the pattern of global trade flows.

4. Developments in Trade Theory
Mercantilism
Wealth measured by stock of precious metals
When net exports rise, accumulation of wealth takes place
Gain for some nations at the cost of others
In the long run, not sustainable

5. Absolute Advantage (Adam Smith)
Unless all trading nations gain, trade will not take place
Cost differences determine the movement of goods between countries
Countries produce and exchange of commodity in which they have absolute advantage which leads to specialization
Nations gain from trade and policy of laissez-faire maximises
output and welfare

6. Absolute Advantage: Basic Assumptions
Labour is the only factor of production and is homogenous
Cost and price of good depends on the labour required to produce it

7. Absolute Advantage: Illustration 1UK
Wheat (bushels/man-hour) 6 1
Cloth (Yards/man-hour) 4 5
US will export wheat and import cloth from UK
→ export 6W & import 5C
(gain ¼ man-hour)
UK will export cloth and import wheat
→ export 5C and import 6W
→ gains from trade
6W = 30C
Supply 5C to USA & gains 25C or 5 man-hours

8. Absolute Advantage: Illustration 2UK
Wheat (bushels/man-hour) 6 1
Cloth (Yards/man-hour) 4 2
US has absolute advantage in both wheat & cloth
UK has absolute disadvantage in both wheat & cloth
Can trade take place?

9. Principle of Comparative Advantage (Ricardo)
Comparison of relative advantage or disadvantage between countries
US has 6 to 1 advantage in wheat and 2 to 1 advantage in textiles (over UK)
UK has greater disadvantage in wheat than in cloth.
Wheat : 1 to 6
Cloth : 1 to 2
Comparison of relative cost differences for Trade to take place

10. Comparative Advantage: Basic Assumptions
The world consists of two nations
Labor is the only input
Labor is fully employed and homogenous
Labor can move freely among industries within a nation, but is incapable of moving between nations
All firms within each nation utilize a common production method for each commodity
Costs do not vary with the level of production
Transportation costs are zero

11. Comparative Advantage: Resource CostUS
Domestically, 6W can be produced if 4C is given up (opportunity cost)
1C costs 1 W and 1W costs C UK
2C can be produced if 1W is given up
1C costs ½ W and 1W costs 2C
Therefore, cloth is relatively cheaper in UK and wheat in USA

12. Comparative Advantage: Gains from Trade
US (cloth)
Import of cloth takes place if 6W can be exchanged for greater than 4C
if 1C is less than 1½ W
UK (cloth)
Export of cloth takes place if 2C can be exchanged for greater than 1W
If 1C is greater than ½ W
Both US & UK gain if the price of cloth (in terms of wheat) is 1W

13. Translating comparative advantage into Costs
Assume
Wage rate in US = $20/hour
Wage rate in UK = £ 5/hour
Labour input
Wheat (Bushel)
Cloth (Yards)
Quantity
Price US
1 hr 6
$3.33 4 $5 UK 1 £5 2
£2.5
UK* $8 $4
* Exchange rate = 1£ = 1.60$

14. Trade with more than Two Commodities
Goods produced in each country ranked on the basis of their domestic cost
Production Costs in Two Countries with Five Goods
Commodity A B C D E
United States $1 $4 $9
$15
$20
United Kingdom £1 £2 £3 £4 £5
At an exchange rate of £1 = $3, the British costs converted
into dollars become: A B C D E
U.K. cost (£1=$3) $3 $6 $9
$12
$15

15. Examples of Comparative Advantages in International Trade
Speciality Resulting from Natural Advantages
Speciality Resulting from Acquired Advantages
Canada
Lumber
Hong Kong
Textiles
Israel
Citrus fruit
Japan
Automobiles, consumer electronics
Italy
Wine
South Korea
Steel, ships
Jamaica
Aluminum ore
Switzerland
Watches
Mexico
Tomatoes
United States
Jetliners, computer software
Saudi Arabia
Oil
United Kingdom
Financial services
Wheat, corn

16. Where Does U.S. Comparative Advantage Lie?
Industry
Revealed Comparative Advantage Ratio
Agricultural products
+0.77
Greatest Comparative Advantage
Greatest Comparative Disadvantage
Chemicals
+0.21
Machinery
+0.02
Telecommunication equipment
-0.01
Medical equipment
-0.02
Industrial supplies
-0.28
Civilian aircraft
-0.29
Automotive
-0.42
Consumer goods
-0.51
Steel
Petroleum
-0.82

17. Competitiveness under Varying Production Condition
Production under Constant Cost
Production under Increasing Cost

18. Production Possibilities Schedule (PPS)
PPS shows various combinations of 2 goods that a country can produce when all inputs (land, labour capital & Entrepreneurship) are used most efficiently.
Under constant cost conditions, relative cost of producing one good in terms of other remains same
MRT =

19. Production Possibility Frontier
Production Possibility Schedules for Wheat and Cloth in the United States and the United Kingdom
United States
United Kingdom
Wheat
Cloth
180 60
150 20 50
120 40 90 30 80
100 10

21. Relative Commodity Price under Constant Cost
US:
30 W = 20 C
1 W = or 20 2 C C 30 3 20 C =
30 W
30 W or
1.5 W 1C = 20

22. UK:
10 W = 20 C
20 C
2 C or
1 W = 10
20 C = 10 W
10 W
1 W or
C = 20 2
Relative price of wheat lower in US than in UK
Relative price of cloth lower in UK than in US
Difference in relative prices reflects comparative advantage
(specialization)

23. Consumption/Demand Issues
Consumer demand is underlined by tastes/ preferences or utility
How much of the goods produced will be consumed depends on consumer preferences
Consumer Indifference Curve
Slope of the Indifference Curve represents consumers’ trade off between two goods, i.e. Marginal Rate of Substitution

24. Indifference Curves A Y
Slope = ∆ Y/∆ X = MRSA A U 2 A U 1 A U X A

25. Equilibrium in Autarky
Consumption utility maximized subject to the constraints of Production Possibility Frontier YB
Slope = -(bLX/bLY) = MRTB
Slope = MRSB
LB/ bLY B B YB U 2 B U 1 B U XB XB

26. Gains from Trade

27. What Would Country A Do Under Free Trade?
Slope = -(PX/PY)tt
Slope = -(aLX/aLY) = MRTA = -(Px/PY)A
LA /aLY ∙ AC ∙ U2 A A
Imports of Y A U1 ∙ ∙ XA A
LA /aLX
Exports of X

28. Trading under Constant Costs
Basis for Trade
Slopes of the production possibilities schedules give the relative cost of one product in terms of other
Differences in relative costs provide the basis for mutually favourable trade
Production gains from Specialisation
A country will specialise in the production of the good in which it has comparative advantage
A country will trade part of this production for the good in which it has comparative disadvantage
(b)

29. (c) (d) Consumption gains from Trade
Consumption alternatives limited by the domestic production possibilities schedules
The exact consumption will be determined by the tastes & preferences
Specialization & free trade care achieve post-trade consumption outside domestic production possibilities schedules
trade results in consumption gains for both countries
Terms of Trade
Domestic terms of trade represents the relative prices at which goods are exchanged at home
A country will exports/import goods internationally if the terms of trade are more favourable than domestic terms of trade
(d)

30. Changing Comparative Advantage
Technological improvements
Trade restrictions
High Transaction Costs