Classical Theories of International Trade International Economics Chapter 1 Classical Theories of International Trade

Chapter 1 Classical Theories of International Trade 1.1 Mercantilism 1.2 Trade Based on Absolute Advantage: Adam Smith 1.3 Trade Based on Comparative Advantage: David Ricardo 1.4 Comparative Advantage and Opportunity Cost 1.5 Comparative Advantage with More Than Two Commodities and Countries 1.6 Theory of Reciprocal Demand 1.7 Offer Curve and Terms of Trade

1.1 Mercantilism The mercantilists advocated government regulation of trade to promote a favorable trade balance. If a country could achieve a favorable trade balance, it would receive payments from the rest of the world in the form of gold and silver. Such revenues would contribute to an increase in spending and thus a rise in domestic output and employment. Critics Possible only for short term Assuming static world economy

Chapter 1 Classical Theories of International Trade 1.1 Mercantilism 1.2 Trade Based on Absolute Advantage: Adam Smith 1.3 Trade Based on Comparative Advantage: David Ricardo 1.4 Comparative Advantage and Opportunity Cost 1.5 Comparative Advantage with More Than Two Commodities and Countries 1.6 Theory of Reciprocal Demand 1.7 Offer Curve and Terms of Trade

1.2 Trade Based on Absolute Advantage: Adam Smith With free trade, countries could concentrate their production on the goods they could produce most cheaply and enjoy all the consequent benefits from the labor division. Cost differences govern the international movement of goods. The concept of cost is founded upon the labor theory of value.

1.2 Trade Based on Absolute Advantage: Adam Smith Two assumptions, within each country: Labor is the only factor of production and is homogeneous (i.e. of one quality). The cost or price of a good depends exclusively upon the amount of labor required to produce it.

1.2 Trade Based on Absolute Advantage: Adam Smith An arithmetic example A Case of Absolute Advantage Country Output per Labor Hour iPad Cloth U.K. U.S. 5 sets 15 sets 20 yards 10 yards The U.S. has an absolute advantage in iPad production; its iPad workers' productivity (output per worker hour) is higher than that of the U.K, which leads to lower costs (less labor required to produce a set of iPad). In like manner, the U.K has an absolute advantage in cloth production.

Chapter 1 Classical Theories of International Trade 1.1 Mercantilism 1.2 Trade Based on Absolute Advantage: Adam Smith 1.3 Trade Based on Comparative Advantage: David Ricardo 1.4 Comparative Advantage and Opportunity Cost 1.5 Comparative Advantage with More Than Two Commodities and Countries 1.6 Theory of Reciprocal Demand 1.7 Offer Curve and Terms of Trade

1.3 Trade Based on Comparative Advantage: David Ricardo Mutually beneficial trade can occur even when one country is absolutely more efficient in the production of all goods. The more efficient country should specialize in and export that good in which it is relatively more efficient (where its absolute advantage is bigger). The less efficient country should specialize in and export the good in which it is relatively less inefficient (where its absolute disadvantage is smaller).

1.3 Trade Based on Comparative Advantage: David Ricardo Assumptions of a simplified model There are only two countries with a fixed level of technology in the world; Each country owns only one input – labor, which is fixed endowed and homogenous and can move across industries but cannot flow across countries; Each country produces two commodities; Perfect competition and free trade prevail in markets.

1.3 Trade Based on Comparative Advantage: David Ricardo An Example of Comparative Advantage A Case of Comparative Advantage Country Output per labor hour iPads Cloth Relative cost U.S. 5 sets 15 yards 1 iPad=3 yards of cloth China 1 set 5 yards 1 iPad=5 yards of cloth The U.S. labor has a 5-to-1 absolute advantage in the production of iPads. The U.S. labor also has a 3-to-1 absolute advantage in the production of cloth. The U.S. has a greater absolute advantage in producing iPads than in producing cloth. China has an absolute disadvantage in the production of iPads and cloth. However, China’s absolute disadvantage is smaller in producing cloth than in producing iPads.

1.3 Trade Based on Comparative Advantage: David Ricardo Gains from Specialization and Trade with Comparative Advantage The Change in the World Output Resulting from Specialization Country Change in the production of iPads Cloth U.S. +5 sets -15 yards China -3 sets +15 yards Change in the World Output +2 sets As the U.S. transfers 1 worker from cloth production to iPad production, its output of iPads increases by 5 and cloth production falls by 15 yards. As China transfers 3 workers from iPad production to cloth production, its cloth production increases by 15 yards and iPad production falls by 3. The gain from production and trade is the increase in the world output that results from each country specializing in its production according to its comparative advantage.

1.3 Trade Based on Comparative Advantage: David Ricardo Comparative Advantage in Money Terms Comparative Advantage in Money Prices Country Labor Input Hourly Wage Rate iPad (sets) Cloth (yards) Quantity Price U.S. 1 $20 5 $4 15 $1.33 China $5 $1 At this wage rate, China’s average cost in dollars of producing cloth is less than the U.S. average cost. With perfectly competitive markets, China’s selling price of cloth is lower than its U.S. selling price, and China exports cloth to the U.S.. Even though China is not as efficient as the U.S. in the production of cloth, its lower wage rate in terms of dollars more than compensates for its inefficiency.

Chapter 1 Classical Theories of International Trade 1.1 Mercantilism 1.2 Trade Based on Absolute Advantage: Adam Smith 1.3 Trade Based on Comparative Advantage: David Ricardo 1.4 Comparative Advantage and Opportunity Cost 1.5 Comparative Advantage with More Than Two Commodities and Countries 1.6 Theory of Reciprocal Demand 1.7 Offer Curve and Terms of Trade

1.4 Comparative Advantage and Opportunity Cost Opportunity cost is the quantity of one good that must be given up to release enough resources to produce one more unit of another good. The marginal rate of transformation (MRT) is the quantity of one good that it must abandon to produce each additional unit of another good.

1.4 Comparative Advantage and Opportunity Cost Gains from Specialization and Trade with Opportunity Costs Production and Consumption with and without Trade Based on an exchange ratio of 1 iPad=4 yards of cloth Item Country U.S. China Production at Full Employment 100 iPads 0 yard of cloth 0 iPad 300 yards of cloth Consumption with Trade 50 iPads 200 yards of cloth 100 yards of cloth Domestic Production and Consumption without Trade 150 yards of cloth 40 iPads Gains from Specialization and Trade 50 yards of cloth 10 iPads Both countries are better off when they specialize and trade .

1.4 Comparative Advantage and Opportunity Cost Production Possibilities Frontier and Constant Opportunity Costs A production possibilities frontier (PPF) shows the different combinations of two goods that can be produced when all of a country’s factors of production are fully employed in their most efficient way. The slope of PPF is referred to as the marginal rate of transformation (MRT), which shows the amount of one product a country must sacrifice to get one additional unit of the other product. Without specialization and trade, the U.S. and China can produce and consume at any point along their respective production possibilities frontiers.

1.4 Comparative Advantage and Opportunity Cost PPF for the U.S. and China at Full Employment U.S. China Numbers of iPads Yards of Cloth 100 60 90 30 50 80 40 70 150 120 20 200 10 250 180 300 210 240 270

1.4 Comparative Advantage and Opportunity Cost Points below the PPF, say, Point B or B', represent possible production combinations that can be produced but are inefficient because there would be some unemployed resources. Points above the PPF, say, Point C or C', represent production combinations that are not possible for a country to produce with available resources and technology.

1.4 Comparative Advantage and Opportunity Cost With each country specializing in the production of the good in which it has a comparative advantage, 10 more iPads and 50 more yards of cloth are produced in the world. With trade, the set of consumption points that a country can achieve is determined by the terms of trade – the relative price of trading iPads for cloth, and vice versa. Both countries are better off by specializing and trade than they would be without trade.

1.4 Comparative Advantage and Opportunity Cost Changes in the Gains from Specialization and Trade Production and Consumption with and without Trade Based on an exchange ratio of 1 iPad=3.5 yards of cloth Item Country U.S. China Production at Full Employment 100 iPads 0 yard of cloth 0 iPad 300 yards of cloth Consumption with Trade 50 iPads 175 yards of cloth 50 iPad 125 yards of cloth Domestic Production and Consumption without Trade 150 yards of cloth 40 iPads 100 yards of cloth Gains from Specialization and Trade 25 yards of cloth 10 iPads

1.4 Comparative Advantage and Opportunity Cost As the international exchange ratio (terms of trade) changes from 1 iPad for 4 yards of cloth to 1 iPad for 3.5 yards of cloth, the trading possibilities curve moves for each country. Changes in the Terms of Trade for the U.S. and China

1.4 Comparative Advantage and Opportunity Cost Distribution of the Gains from Trade Changes in a country’s terms of trade over time indicate whether a country can obtain more or less quantity of imports per unit of exports. A change in a country’s terms of trade may reflect a change in either international or domestic economic conditions. When the terms of trade change as a result of a change in domestic economic conditions, the effect on the country’s welfare is uncertain.

1.4 Comparative Advantage and Opportunity Cost Complete Specialization Each country specializes completely in the production of the good in which it has a comparative advantage and imports the other good. Complete specialization occurs because as production expands in the industry with a comparative advantage, the domestic cost of producing the product does not rise. Constant costs are assumed to prevail over the entire range of production.

1.4 Comparative Advantage and Opportunity Cost The firm’s cost curves and the product’s supply curves are horizontal. Supply Curves of a Good and the PPF

1.4 Comparative Advantage and Opportunity Cost Trade under Increasing Opportunity Costs Increasing Costs and the PPF The PPF and Supply Curve under Increasing Cost Conditions

1.4 Comparative Advantage and Opportunity Cost The slope of the PPF at any point is represented graphically by the slope of a tangent to that point. A country has increasing opportunity costs. the tangent FG is steeper than DE. Two reasons: the factors of production used to produce the products are specialized in the production of a particular product. the premise that all resources are identical in the sense that all workers and capital have the same productivity in the production of both commodities is unrealistic.

1.4 Comparative Advantage and Opportunity Cost Production and Consumption without Specialization and Trade Without specialization and trade, the U.S. and China can produce and consume at any point on their PPF. Production and Consumption with Specialization and Trade Trade Triangle Trade Triangle Specialization and Trade under Increasing Cost Conditions

1.4 Comparative Advantage and Opportunity Cost Specializing in and exporting the good in which the country has a comparative advantage and trading for the other good enables both countries to become better off by consuming beyond their respective PPFs. Production under increasing cost conditions constitutes a mechanism that forces prices to converge and results in neither country specializing completely in the production of the good in which it has a comparative advantage. In the case of increasing costs, both countries continue to produce both goods after trade and it is called as partial specialization.

Chapter 1 Classical Theories of International Trade 1.1 Mercantilism 1.2 Trade Based on Absolute Advantage: Adam Smith 1.3 Trade Based on Comparative Advantage: David Ricardo 1.4 Comparative Advantage and Opportunity Cost 1.5 Comparative Advantage with More Than Two Commodities and Countries 1.6 Theory of Reciprocal Demand 1.7 Offer Curve and Terms of Trade

1.5 Comparative Advantage with More Than Two Commodities and Countries Comparative Advantage with More Than 2 Commodities Each country will then have a comparative advantage in the commodities that it exports at the particular equilibrium exchange rate established . Commodity Prices in the U.S. and U.K. Commodity Price in the U.S. ($) Price in the U.K. (￡) A B C D E 2 4 6 8 10 3 1

1.5 Comparative Advantage with More Than Two Commodities and Countries If the exchange rate is ￡1=$2, the dollar prices of the commodities in the U.K. would be: Commodity A B C D E Dollar price in the U.K 12 8 6 4 2 The U.S. will export Commodities A and B to the U.K. and import Commodities D and E from the U.K., leaving Commodity C not traded.

1.5 Comparative Advantage with More Than Two Commodities and Countries If the exchange rate becomes ￡1=$3. The dollar prices of the commodities in the U.K. would be: Commodity A B C D E Dollar price in the U.K 18 12 9 6 3 The U.S. will export Commodities A, B and C to the U.K. and import Commodities D and E from the U.K.

1.5 Comparative Advantage with More Than Two Commodities and Countries If the exchange rate turns to be ￡1=$1, the dollar prices of the commodities in the U.K. would be: Commodity A B C D E Dollar price in the U.K 6 4 3 2 1 The U.S. would export only Commodity A to the U.K. and import all other commodities, with the exception of Commodity B.

1.5 Comparative Advantage with More Than Two Commodities and Countries Comparative Advantage with More Than 2 Countries Ranking of Countries in Terms of International PW/PC Country A B C D E PW/PC 1 2 3 4 5 Given the equilibrium PW/PC=3 with trade, Countries A and B will export wheat to Countries D and E in exchange for cloth. Country C will not engage in international trade in this case because its pre-trade PW/PC equals the equilibrium PW/PC with trade. Given a trade equilibrium PW/PC=4, Countries A, B and C will export wheat to Country E in exchange for cloth, and Country D will not engage in the international trade. If the equilibrium turns to be PW/PC=2 with trade, Country A will export wheat to all the other countries except Country B, in exchange for cloth.

Chapter 1 Classical Theories of International Trade 1.1 Mercantilism 1.2 Trade Based on Absolute Advantage: Adam Smith 1.3 Trade Based on Comparative Advantage: David Ricardo 1.4 Comparative Advantage and Opportunity Costs 1.5 Comparative Advantage with More Than Two Commodities and Countries 1.6 Theory of Reciprocal Demand 1.7 Offer Curve and Terms of Trade

1.6 Theory of Reciprocal Demand Theory of reciprocal demand suggests that the actual price at which trade takes place depends on the trading partners’ interacting demands. According to the theory of reciprocal demand, final terms of trade will be closer to the domestic price ratio of the country with stronger demand for the imported good. The reciprocal demand theory contends that the equilibrium terms of trade depend on the relative strength of each country’s demand for the other country’s product.

1.6 Theory of Reciprocal Demand The stronger Canadian demand for autos relative to U.S. demand for wheat, the closer the terms of trade will be to Canadian domestic price ratio, and vice versa. Equilibrium Terms-of-Trade Limits

1.6 Theory of Reciprocal Demand The reciprocal demand theory best applies when both countries are of equal economic size, so that the demand of each country has a noticeable effect on the market price. If one country is significantly larger than the other, the larger country attains fewer gains from trade while the smaller country attains most of the gains from trade. This situation is characterized as the importance of being unimportant.

Chapter 1 Classical Theories of International Trade 1.1 Mercantilism 1.2 Trade Based on Absolute Advantage: Adam Smith 1.3 Trade Based on Comparative Advantage: David Ricardo 1.4 Comparative Advantage and Opportunity Cost 1.5 Comparative Advantage with More Than Two Commodities and Countries 1.6 Theory of Reciprocal Demand 1.7 Offer Curve and Terms of Trade

1.7 Offer Curve and Terms of Trade The offer curve (or reciprocal demand curve) of a country indicates the quantity of imports and exports the country is willing to buy and sell on the world market at all possible relative prices. In short, the curve shows the country’s willingness to trade at various possible terms of trade. The offer curve really is a combination of a demand curve and a supply curve.

1.7 Offer Curve and Terms of Trade Deriving an offer curve: trade triangle approach Trade Triangles at Two Possible Terms of Trade

1.7 Offer Curve and Terms of Trade The construction of the offer curve is completed by connecting all possible points at which a country is willing to trade. Alternative Terms of Trade and Export-Import Combinations on the Offer Curve

1.7 Offer Curve and Terms of Trade Equilibrium Terms of Trade Point E is the trading equilibrium. TOTE is the market-clearing price ratio. Trading Equilibrium

1.7 Offer Curve and Terms of Trade Shifts of Offer Curves Reasons for Shifts: A change in tastes for the imported good; A rise in income that leads to an increased demand for imports; An improvement in productivity in Country I’s export industries. Shifts in Country I’s Offer Curve

1.7 Offer Curve and Terms of Trade When offer curves shift, the equilibrium terms of trade and volume of trade change. Increased Demand for Imports by Country I

1.7 Offer Curve and Terms of Trade Terms of Trade Estimates The relative price ratio PX/PY in the offer curve diagram is called as the commodity terms of trade, or net barter terms of trade . The economic interpretation of the terms of trade: As the price of exports rises relative to the price of imports, each unit of a country’s exports is able to purchase a larger quantity of imports. Thus, more imports, which like any other goods bring utility to consumers, can be obtained with a given volume of exports, and the country’s welfare on the basis of those price relations alone has improved.

1.7 Offer Curve and Terms of Trade In calculating the terms of trade for any given country, a price index must therefore be calculated for exports and imports. The price index is a weighted average of the prices of many goods, calculated for comparison with a base year. The base-year price indices are then set at values of 100, and other years can be compared with them. Over a long period, terms of trade illustrates how a country’s share of the world gains from trade changes and gives a rough measure of the fortunes of a country in the world market.

1.7 Offer Curve and Terms of Trade Other Concepts of the Terms of Trade Income Terms of Trade TOTY = (PX/PM)×QX or (PX×QX)/PM where QX is the quantity index of exports. Single Factoral Terms of Trade TOTSF = (PX/PM)×OX where OX is the productivity index. Double Factoral Terms of Trade TOTDF = (PX/PM)×(OX/OM) where OM represents the foreign productivity index for the home country’s imports.