Classical theory of International trade

2.1 Introduction

Historical Approach to Examine the

Development of International Trade

Theory (Mercantilism, Absolute

Advantage, Comparative Advantage)

Three Basic Questions Basis for Trade

Gains from Trade

Patterns of Trade

2.3 Trade Based on Absolute Advantage: Adam Smith

Absolute Advantage Illustration of Absolute Advantage Main Views on Trade Comments Conclusion

Absolute Advantage Adam Smith(1723-90) Absolute advantage theory was proposed by Adam

Smith (1723-90) . With The Wealth of Nations Adam

Smith installed himself as the fountainhead of

contemporary economic thought . Adam Smith was born

in a small village in Kirkcaldy, Scotland. There his widowed mother raised him until he entered the University of Glasgow at age fourteen, as was the usual practice, on scholarship. He later attended Balliol College at Oxford, graduating with an extensive knowledge of European literature and an enduring contempt for English schools. He returned home, and after delivering a series of well-received lectures, was made first chair of logic (1751), then chair of moral philosophy (1752), at Glasgow University.

Absolute Advantage IntroductionAdam Smith coined (创新 ) the term "mercantile system" to describe the system of political economy that sought to enrich the country by restraining imports and encouraging exports. This system dominated western European economic thought and policies from the sixteenth to

the late eighteenth century. The goal of these policies was, supposedly, to achieve a "favorable" balance of trade that would bring gold and silver into the country. In contrast to the agricultural system of the physiocrats(自然拥护者 ), or the laissez-faire of the nineteenth and early twentieth

centuries, the mercantile system served the interests of merchants and producers such as the British East India Company, whose activities were protected

or encouraged by the state.

Illustration of Absolute Advantage No Trade

U.S. U.K.

Wheat (bushels/man-hour) 6 1

Cloth (yards/man-hour) 4 5

With Trade U.S. U.K.Wheat (bushels/man-hour) 12 0Cloth (yards/man-hour) 0 10 After Trade Output wheat increases 5 units(12-7,before trade)Output cloth increases 1 unit (10-9, before trade);The world output increases 5 units wheat and 1 unit cloth. U.S. gains 2 units wheat while U.K. gains 4 units cloth.

Main Views on TradeUnder the heavy pressure of high smuggling and created variety of products during the industrial revolution, by 1860 England had removed the last vestiges of the mercantile era .Adam Smith's insight that free trade leads to international specialization of labor and, usually, to greater economic well-being for all nations. What do nations trade? (two-win games)What the gains from trade? ( the greater economic well-being)What is the pattern of trade? (import and export)(supposing with two nations, two products and one factor “labor” world. One nation should export the more efficient product and import the less efficient product compared with the other nation. In other words, the nation should export the less cost product and import the higher cost product)

2.4 Trade Based on Comparative Advantage: David Ricardo

The Law of Comparative Advantage The Gains from Trade Exception to the Law of Comparative

Advantage Comparative Advantage with Money Comments Conclusion

The Law of Comparative Advantage

Introduction Countries engage in international trade for two basic

reasons:

• They are different from each other in terms of climate, land, capital, labor, and technology.

• They try to achieve scale economies in production. The Ricardian model is based on technological differences

across countries.

• These technological differences are reflected in differences in the productivity of labor.

The Law of Comparative Advantage David Recardo (1772-1823)

David Ricardo was one of those rare people who achieved tremendous success and lasting fame. After his family disinherited him for marrying outside his Jewish faith, Ricardo made a fortune as a stockbroker and a loan broker. When he died, his estate was worth over $100 million in today's dollars. At age twenty-seven, after reading Adam Smith's The Wealth of Nations, Ricardo got excited about economics. He wrote his first economics article at age thirty-seven and then spent only fourteen years—his last ones—as a professional economist. His Principles of Political Economy and Taxation was published in 1817, in which he presented the law of comparative advantage, one of the most important and still unchallenged laws of economics, with many practical applications.

Ricardo first gained notice among economists over the "bullion controversy." In 1809 he wrote that England's inflation was theresult of the Bank of England's propensity to issue excess bank notes. In short, Ricardo was an early believer in the quantity theory of money, or what is known today as monetarism. In his Essay on the Influence of a Low Price of Corn on the Profits of Stock (1815), Ricardo articulated what came to be known as the law of diminishing returns. One of the most famous laws of economics, it holds that as more and more resources are combined in production with a fixed resource—for example, as more labor and machinery are used on a fixed amount of land—the additions to output will diminish. Ricardo also opposed the protectionist Corn Laws(谷物法 ), which restricted imports of wheat. In arguing for free trade, Ricardo formulated the idea of comparative costs, today called comparative advantage (LTV: Labor Theory of Value). Comparative advantage—a very subtle idea—is the main basis for most economists' belief in free trade today. The idea is this: a country that trades for products that it can get at lower cost from another country is better off than if it had made the products athome.

The Law of Comparative Advantage The Concept of Law of Comparative Advantage In a two-nation and two-commodity world economy, even if one nation is less efficient than the other nation in the production of both commodities, there is still a basis for mutually beneficial trade. The first nation should specialize in the production of and export the commodity in which its absolute disadvantage is smaller (the commodity of its comparative advantage) and import the commodity in which its absolute disadvantage is greater (the commodity of its comparative disadvantage).Note that in a two-nation, two-commodity world, once it is determined that one nation has a comparative advantage in one commodity, then the other nation must necessarily have a comparative advantage in the other commodity.

The Law of Comparative Advantage Assumptions of the model:

• Only two countries and two commodities in the world (Home and Foreign)

• Free Trade

• Perfect mobility of labor within each nation but immobility between the two nations

• Constant costs of production

• No transportation cost

• No technical change

• The labor theory of value

The Law of Comparative Advantage The Illustration of Comparative Advantage

Without Trade

U.S. U.K.

Wheat (bushels/man-hour) 6 1

Cloth (yards/man-hour) 4 2

Explanation: US has an absolute advantage of both wheat and

cloth with respect to UK, but the absolute advantage is greater in

wheat(6:1) than cloth (4:2), US has a comparative advantage in

wheat. On the contrary , UK’s comparative advantage in cloth

( smaller absolute disadvantage).

The Gains from TradeIf the trade exchange rate is equal to the domestic exchange

rate , no trade happens. Only trading partners can gains by

each specializing in the production and exporting the

commodity of its comparative advantage, international trade

happens.

E.G. (page table 2.2)

With Trade (specialization) U.S. U.K.Wheat (bushels/man-hour) 12 0Cloth (yards/man-hour) 0 4Explanation: If US exports 6w for 4c from UK, and UK exports 2c for 1w from US, no trade happens since it is the same with domestic exchange without trade .

Comparative Advantage with Money The comparative advantage can be expressed in terms of

currency of either nation (Price difference)E.G. See table 2.2 U.S. U.K.Wheat (bushels/man-hour) 6 ($1) 1($2)Cloth (yards/man-hour) 4 ($1.5) 2 ($1)Suppose that the wage rate in US is $6 dollar per hour, since one man-hour produces 6w in US, the price of a bushel of wheat is Pw = $1, Pc=$1.5; Suppose UK 1pound per hour, Pw=1pound, Pc=0.5pound. If the exchange rate 1pound =$2, Pw=$2, Pc=$1Business people would buy the lower price of wheat in US and sell them in UK; on the contrary buying the lower price of cloth in UK and sell them in US.

Comparative Advantage with Money The exchange rate influences the international tradeE.G. If 1 pound = $1, in UK Pw=$1 and Pc=$0.5No trade happens in Wheat from US to UK, and UK would export more cloth to US. Trade would be unbalanced in favor of theUK, and the exchange rate between the dollar and the pound would have to rise.E.G. If 1 pound =$3, in UK Pw=$3 and Pc=$1.5( the same with US)No trade happens in Cloth from UK to US, and US would export more wheat to UK. Trade surplus in UK would decrease while US trade deficit would decrease, and imbalance trade between the two countries would decrease.Therefore , each country need pay attention to its own currencyexchange rate to other nation’s.

Conclusion We examined the Ricardian model, the simplest model

that shows how differences between countries give rise to trade and gains from trade.

In this model, labor is the only factor of production and countries differ only in the productivity of labor in different industries.

In the Ricardian model, a country will export that commodity in which it has comparative (as opposed to absolute) labor productivity advantage.

Conclusion

The fact that trade benefits a country can be shown in either of two ways:

• We can think of trade as an indirect method of production.

• We can show that trade enlarges a country’s consumption possibilities.

The distribution of the gains from trade depends on the relative prices of the goods countries produce.

Conclusion

Extending the one-factor, two-good model to a world of many commodities makes it possible to illustrate that transportation costs can give rise to the existence of nontraded goods.

The basic prediction of the Ricardian model-that countries will tend to export goods in which they have relatively high productivity- has been confirmed by a number of studies.

2.5 Comparative Advantage and Opportunity Costs

Comparative Advantage and the Labor Theory of Value

The Opportunity Cost Theory The Production Possibility Frontier

under Constant Costs Opportunity Costs and Relative

Commodity Prices Comments Conclusion

The Production Possibility Frontier under Constant Costs

Production Possibility Frontier

It is a curve that shows the alternative combinations of the two

commodities that a nation can produce by fully utilizing all of its

resources with the best technology available to it.

See table 2.4 (page 42) to show:

1. US’s opportunity cost of wheat is two-thirds of a unit of cloth, while

the opportunity cost of cloth is one and one-second units of wheat;

2. UK’s opportunity cost of wheat is two units of cloth, while the opportunity cost of cloth is one-second of a unit of wheat;

The Production Possibility Frontier under Constant Costs

Illustration of PPF

FIGURE 2-1 The Production Possibility Frontiers of the United States and the United Kingdom.

Conclusion

To explain the basis for mutually beneficial trade

Labor theory of value (David Ricardo) →Opportunity cost theory (marginalism) → (absolute) slope of the production possibility frontier (Transformation Curve)→ the relative price of the commodity (price difference)→ trade basis

Opportunity cost of a commodity is equal to the relative price of that commodity and is given by the (absolute) slope of the production possibility frontier.

Conclusion

In the absence of trade, a nation’s production possibility

frontier is also its consumption frontier. With trade, each

nation can specialize in producing the commodity of its

comparative advantage and exchange part of its output with

the other nation for the commodity of its comparative

disadvantage. By so doing, both nations end up consuming

more of both commodities than without trade. With complete

specialization, the equilibrium-relative commodity prices will

be between the pretrade-relative commodity prices prevailing

in each nation.

2.7 Empirical Tests of the Ricardian Model

Examination of empirical tests of Ricardo Model

If we allow for different labor productivities in various industries in

different nations, Ricardo trade model does a reasonably good job at

explaining the patter of trade.

1. Mac Dougall in 1951 and 1952 using labor productivity and export data for 25 industries in US and UK for the year 1937

Relative Labor Productivities and Comparative Advantage–United

States and United Kingdom.

Conclusion: Positive relationship between labor productivity and

exports, higher productivity more exports.

(see figure 2-4)

2.7 Empirical Tests of the Ricardian Model

2. Golub study in 1995

The conclusion is that in general , relative unit labor costs( the ratio of

wages to unit labor productivity) and exports were inversely related.

That is to say, the lower labor costs more exports, and verse versa.

The color line shows a clear negative correlation between relative unit

labor costs and relative exports for the 33 industries . Supporting

Ricardo model.

(See figure 2-5)

Chapter Summary

This chapter examined the development of trade theory from the mercantilism to Smith, Ricardo, and Haberler and sought to answer three basic questions: (1) what is the basis for trade? (2) What are the gains from trade? (3) what is the pattern of trade?

Although Ricardo theory was confirmed by many empirical studies, the model explains neither the reason for the difference in labor productivity or costs across nations nor the effect of international trade on the earnings of factors.