1. International Economics
Classical and Neoclassical Trade Theory

2. Historical development of trade theory
Foundations of trade theory
Historical development of trade theory
Mercantilism
Regulation to ensure a positive trade balance
Critics: possible only for short term; assumes static world economy
Absolute advantage (Adam Smith)
Countries benefit from exporting what they make cheaper than anyone else
But: nations without absolute advantage do not gain from trade
Comparative advantage (David Ricardo)
Nations can gain from specialization, even if they lack an absolute advantage

3. Absolute & Comparative Advantage
Absolute advantage: each nation is more efficient in producing one good
Output per labor hour
Nation Wine Cloth
United States 5 bottles 20 yards
United Kingdom 15 bottles 10 yards
Comparative advantage: the US has an absolute advantage in both goods
United States 40 bottles 40 yards
United Kingdom 20 bottles 10 yards

4. Ricardo’s Comparative Advantage in money prices
Cloth (yards) Wine (bottles)
Nation Labor Wage Quant. Price Quant. Price
US 1 hr $20/hr 40 $ $0.50
UK 1 hr £5/hr 10 £ £0.25
UK 1 hr $8 10 $ $0.40
(at $1.6 = £1)

5. Production possibilities schedule
Comparative advantage
Production possibilities schedule
Generalizes theory to include all factors, not just labor
Shows combinations of products that can be made if all factors are used efficiently
Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another)

6. Marginal Rate of Transformation
Comparative advantage
Marginal Rate of Transformation

7. Production possibilities schedules: constant opportunity costs
Comparative advantage
Production possibilities schedules: constant opportunity costs

8. Trading under constant opportunity costs
Comparative advantage
Trading under constant opportunity costs

9. Production gains from specialization: constant opportunity costs
Comparative advantage
Production gains from specialization: constant opportunity costs
Before After Net Gain
Specialization Specialization (Loss)
Autos Wheat Autos Wheat Autos Wheat US
Canada
World

10. Consumption gains from trade: constant opportunity costs
Comparative advantage
Consumption gains from trade: constant opportunity costs
Before After Net Gain
Trade Trade (Loss)
Autos Wheat Autos Wheat Autos Wheat US
Canada
World

11. Production possibilities schedule under increasing costs
Increasing opportunity costs
Production possibilities schedule under increasing costs

12. Indifference curves and int'l. trade
Bringing demand into the model
Indifference curves and int'l. trade

13. Trading under increasing costs: US
Increasing opportunity costs
Trading under increasing costs: US

14. Trading under increasing costs: Canada
Increasing opportunity costs
Trading under increasing costs: Canada

15. trade pattern-”Trade triangle”
1. FT cons’n point
2. FT prod’n point
3. NB: Home consumes more food than it produces (i.e. imports food)
4. NB: Home produces more cloth than it consumes (i.e. exports cloth)

16. Production gains from specialization: increasing opportunity costs
Before After Net Gain
Specialization Specialization (Loss)
Autos Wheat Autos Wheat Autos Wheat US
Canada
World

17. Consumption gains from trade: increasing opportunity costs
Before After Net Gain
Trade Trade (Loss)
Autos Wheat Autos Wheat Autos Wheat US
Canada
World

18. Basis for trade, gains from trade
Bringing demand into the model
Basis for trade, gains from trade

19. Factor endowment theory (Heckscher-Ohlin)
Why relative price differentials?
Factor endowment theory (Heckscher-Ohlin)
Comparative advantage is explained entirely by different national supply conditions, especially resource endowments
Nations export products that use inputs which are relatively abundant (cheap) at home, and import products which need inputs which are relatively scarce (expensive) at home

20. Factor endowment theory: assumptions
Why relative price differentials?
Factor endowment theory: assumptions
Nations all have the same tastes and preferences (same indifference curves)
They use factor inputs which are of uniform quality
They all use the same technology

21. Comparative advantage according to factor endowment theory
Factor endowment model
Comparative advantage according to factor endowment theory
Autarky equilibrium

22. Comparative advantage according to factor endowment theory
Factor endowment model
Comparative advantage according to factor endowment theory
Post-trade equilibrium

23. Factor endowment theory: implications
Factor endowment model
Factor endowment theory: implications
Factor price equalization
The shift within each nation towards use of cheaper factors, and away from expensive ones, leads to more equal factor prices (if factors are mobile)
Distribution of income
Trade changes domestic distribution of income as demand for different factors changes
Tests of factor endowment theory
Emphasize the importance of varieties of different factors (such as human capital) and accounting for changes in resource endowment; other explanations are also important

24. Factor Price Equalisation Theorem
In Hecksher-Ohlin's world, by trade, each countries' factor price (W/r) will be eventually the same. (Remember that in the H-O world, commodities can freely move while factors cannot. However, as a result of free trade of commodities, factor prices will be the same as well as commodity prices).
The relation between factor price (W/r) and factor intensity (K/L)
Assumptions we sustain:
As wage is relatively higher (W/r ), producers use more K-intensive technology (k = K/L )
X is more labour intensive (kX = KX /LX < kY = KY /LY)
Both countries have the same production technologies.

25. Relazione tra prezzo relativo dei fattori e prezzo relativo dei beni-paese H
If H country's total endowment ratio is kh, the wage-rental ratio in H will range (W/r)U < (W/r) < (W/r)L

26. La relazione tra prezzo dei fattori (W/r) e prezzo dei beni (PX / PY)
As (W/r) increases, PX / PY increases, because X is more labour intensive.
Before trade, (PX / PY )F is greater than (PX / PY)H as H is labour abundant.
Therefore, from the corresponding factor prices, (W/r)F > (W/r)H before trade.

27. Relazione tra prezzo relativo dei fattori e prezzo relativo dei beni-paese F

28. Teorema del pareggiamento del prezzo dei fattori
By trade, the two countries' commodity prices will converge (1) to the one world price (PX / PY).W
Eventually, (PX / PY).F = (PX / PY).W = (PX / PY).H after trade.
When (PX / PY). = (PX / PY).W, the only corresponding factor price (1) is (W/r)W
With (W/r)W , both H and F use kX and kY for the two sectors' production.

29. Teorema del pareggiamento del prezzo dei fattori

30. Teorema del pareggiamento del prezzo dei fattori
We sustain the assumption that X is (always) more labour intensive. However, sometimes it is possible that two industries change the order of factor intensities. Suppose kY > kX when (W/r) is low, but kY < kX when (W/r) is high.
Then the graph we saw before changes:

31. Il caso della inversione dell’intensità fattoriale

32. Il caso della inversione dell’intensità fattoriale
The relation between (W/r) and (PX / PY) is not linear any more. When (W/r) is low, (1) as (W/r) increases, PX / PY increases because X is more labour intensive. Once (W/r) is higher (1) than (W/r)*, Y is more labour intensive. Therefore, as (W/r) increases, Py increases faster than Px, i.e. (PX / PY ) decreases.
In this case, even if there is one commodity price (PX / PY )w in the world by trade, two factor prices (1) (W/r)' and (W/r)" can exist. We cannot guarantee that H and F have the same (W/r).