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Classic Theories of International Trade

Classic Theories of International Trade. Dianna DaSilva- Glasgow. outline. Introduction Mercantilism Absolute advantage: Adam Smith Comparative advantage: David Ricardo Comparative advantage and opportunity cost Exception to the law of comparative advantage

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Classic Theories of International Trade

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  1. Classic Theories of International Trade Dianna DaSilva- Glasgow

  2. outline • 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 • 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 International Trade Theory- ECN 422, 2010/2011

  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). International Trade Theory- ECN 422, 2010/2011

  5. Mercantilism • 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]....” International Trade Theory- ECN 422, 2010/2011

  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. International Trade Theory- ECN 422, 2010/2011

  7. Absolute advantage: Adam Smith • 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. International Trade Theory- ECN 422, 2010/2011

  8. Absolute advantage: Adam Smith • 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 • 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. International Trade Theory- ECN 422, 2010/2011

  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. International Trade Theory- ECN 422, 2010/2011

  11. Absolute advantage: Adam Smith • 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 • 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. International Trade Theory- ECN 422, 2010/2011

  13. Absolute advantage: Adam Smith Exercise: • Which country has the absolute advantage in each commodity? Nation 1 Nation 2 • Commodity X (hr) 10 6 • Commodity Y (hr) 8 12 • 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? International Trade Theory- ECN 422, 2010/2011

  14. Absolute advantage: Adam Smith • 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. International Trade Theory- ECN 422, 2010/2011

  15. Absolute advantage: Adam Smith • 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

  16. Absolute advantage: Adam Smith • Gains to both countries and the world from the re-allocation of resources (complete specialization) Nation 1 Nation 2 World • Commodity X +10 -6 4 • Commodity Y -8 +12 -4 International Trade Theory- ECN 422, 2010/2011

  17. Absolute advantage: Adam Smith • 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. International Trade Theory- ECN 422, 2010/2011

  18. Comparative advantage: David Ricardo • 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) 6 1 • Cloth (yards/hr) 4 2 International Trade Theory- ECN 422, 2010/2011

  19. Comparative advantage: David Ricardo • 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. International Trade Theory- ECN 422, 2010/2011

  20. Comparative advantage: David Ricardo 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 International Trade Theory- ECN 422, 2010/2011

  21. Comparative advantage: David Ricardo • 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. International Trade Theory- ECN 422, 2010/2011

  22. Comparative advantage and opportunity cost • 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. International Trade Theory- ECN 422, 2010/2011

  23. Comparative advantage and opportunity cost • 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. International Trade Theory- ECN 422, 2010/2011

  24. Comparative advantage and opportunity cost • 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 additionalunit 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. International Trade Theory- ECN 422, 2010/2011

  25. Comparative advantage and opportunity cost • 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 additionalunit 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 US UK • Wheat (bushels/hr) 6 1 • Cloth (yards/hr) 4 2 • 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 International Trade Theory- ECN 422, 2010/2011

  27. Comparative advantage and opportunity cost • 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 • Wheat (bushels/hr) +6 -1 5 • Cloth (yards/hr) -4 +2 -2 • 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 •  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. International Trade Theory- ECN 422, 2010/2011

  30. Comparative advantage and opportunity cost • 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. International Trade Theory- ECN 422, 2010/2011

  31. Comparative advantage and opportunity cost • Nation 1 Nation 2 • Commodity X 6 3 • Commodity Y 4 2 • 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 International Trade Theory- ECN 422, 2010/2011

  32. Comparative advantage and opportunity cost • 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. International Trade Theory- ECN 422, 2010/2011

  33. Comparative advantage with money • 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)

  35. COMPARATIVE ADVANTAGE AND THE PPF • 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. International Trade Theory- ECN 422, 2010/2011

  36. Table 2.4. Production Possibility schedules for wheat and cloth in the united states and the united kingdom International Trade Theory- ECN 422, 2010/2011

  37. Constant cost PPF (US) for wheat oppc= 120/180= 2/3 (Y=cloth & X= wheat) (80-60)/(90-60) =20/30=2/3 or 0.67 International Trade Theory- ECN 422, 2010/2011

  38. Constant cost PPF (UK) for Wheatoppc= 120/60= 2 (Y=cloth & X= wheat) (60-40)/(40-30) =20/10=2 International Trade Theory- ECN 422, 2010/2011

  39. COMPARATIVE ADVANTAGE AND THE PPF •  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. International Trade Theory- ECN 422, 2010/2011

  40. Opportunity costs and relative commodity prices • 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 International Trade Theory- ECN 422, 2010/2011

  41. OPPORTUNITY COSTS AND RELATIVE COMMODITY PRICES • 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) International Trade Theory- ECN 422, 2010/2011

  42. EMPIRICAL TESTS OF THE RICARDIAN MODEL • 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 2000- 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. International Trade Theory- ECN 422, 2010/2011

  43. SHORTCOMING OF THE RICARDIAN MODEL • 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. International Trade Theory- ECN 422, 2010/2011

  44. Further reading • Salvatore (2007) , Chapters 1 and 2 • Krugman and Obstfeld (2009), Chapters 1 and 2 International Trade Theory- ECN 422, 2010/2011

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