Neoclassical Theories of
International Trade & Growth
Reach Cambridge, July 2016
Vasiliki Mavroeidi
Ph.D Candidate
Development Studies Centre, University of Cambridge
Some Rules
 No talking in class while I am talking or while a student
that has been asked a question is talking and/or thinking
 No looking at your phones or going online on your
computers during class. Each hour we will have a ten
minute break and you can check your devices then
 I will be asking you lots of questions – don’t be shy! Active
participation makes learning a lot easier.
 Note down your questions. I will be asking you quite
regularly of you have any! Don’t hesitate to ask if you do
not understand something.
Today’s class
 First we look at the concept of the production possibility
frontier
 Then we will talk about the concepts of comparative and
absolute advantage to see how neoclassical theory
explains that countries are better off trading
 In the last session we will talk about how economies grow.
Section 1: Production Possibility
Frontier (PPF)
Definition
 A curve showing the maximum possible combinations of
two goods (or services) that an economy can produce
when all resources are fully and efficiently employed.
The Production Possibility Frontier
Jeans
Shirts
1000
0
800
250
600
500
400
750
200
1000
0
1250
Production Possibility Frontier
1400
1200
1000
800
Shirts
600
400
200
0
0
200
400
600
Jeans
800
1000
1200
The Production Possibility Frontier –
Quiz! Take 5 minutes 
 Another example. You have 5 hours (300 minutes) in the
afternoon to study for school and your teachers have given
you endless optional homework; you have 60 mathematics
problem sets taking 10 minutes each and 20 history
questions taking 20 minutes each. Clearly you do not have
enough time in the day to do all of them!
 What is the maximum number of mathematics problems you
can solve without doing any history questions?
 What is the maximum number of history problems you can
do without any mathematical problems?
 What is the opportunity cost of a history question in terms of
mathematical problems?
 Can you draw the PPF curve?
Section 2: International Trade
Definitions
 Tariff: a tax or duty to be paid on a particular class of
imports or exports.
Ad Valorem: A fixed proportion of value of good. For
example, you are importing a pair of sunglasses that cost
$100 and the tariff is 20% then you pay $20 to Customs. The
price that the good now cost you is $120
Fixed tax: A fixed tax independent of the value of good. For
example, let’s say that the country levies a $1 tax on all
sunglasses, no matter how expensive
Autarky vs Trade
 When a country is not trading, we say that it is in
“autarky” it consumes all the goods it can produce (so
either on the PPF or inside it)
 When a country trades what happens?
 If trade happens and there is a country that has cheap
labour, does it mean that it will produce everything?
Comparative vs Absolute Advantage
-
Let’s look at another example:
CHINA
-
GERMANY
Plastics (1
ton) ($000)
Car ($000)
Plastics (1
ton) ($000)
Car ($000)
1
5
4
7
So China is cheaper at producing BOTH goods. This is an
ABSOLUTE advantage. Does this mean everything will be
produced there?
Comparative Advantage
 If a country A can produce a good at a lower
opportunity cost than another country B, then a has a
comparative advantage in the production of that good.
 This might sound complicated, but it really is not!
Why do we have these gaps in
opportunity costs?
 Differences in productivity (the Ricardian model of
comparative advantage)
 From David Ricardo (1772-1823)
 Differences in the endowment of resources (the
Heckscher-Ohlin (HO) model of comparative
advantage)
Ricardian Comparative Advantage Assumptions
 Two countries
 Two goods
 Labour is the only source needed
 Labour productivity is constant
 Labour productivity varies across countries
 Workers can move between sectors but not between countries
 Labour markets are competitive
 Countries will specialise in the good they are relatively more productive
in!
A note on how to express these
differences
 We can compare total output of these countries assuming
they are using the same resources, meaning labour (e.g.
how many tons of cotton could countries A and B produce
if they used all their labour in cotton production?)
 We can compare inputs. How much labour does it take in
each country to produce the same amount of goods? (e.g.
how much labour does it take to produce a ton of cotton in
country A and how much in country B)
 We can compared output per worker. So it is the first
measure divided by the total amount of workers. (e.g. how
many tons of cotton does a worker produce in country A
and country B within some specified time?)
The Ricardian model Example 1
 China vs Germany
CHINA
US
CHINA
GERMANY
Shirts (millions)
Cars
Shirts (millions)
Cars
0
6
0
10
9
3
5
5
18
0
10
0
(continued)
 China:
 Opportunity cost of 1 million shirts is 1/3 car
 Opportunity cost of car is 3 million shirts
 Germany:
 Opportunity cost of 1 million shirts is 1 car
 Opportunity cost of 1 car is 1 million shirts
 Opportunity cost of shirts is LOWER in China. Opportunity
cost of cars is LOWER in Germany
 China should specialise in the production of shirts and
Germany should specialise in the production of cars.
What happens with trade?
 With specialization China can produce 0 cars and
produce all shirts. Then it can trade some of these shirts
for cars from Germany. In China the opportunity cost of a
million shirts is 1/3 car and in Germany it is 1 car. Trade will
happen after negotiations at an exchange rate
somewhere in between – let’s say at ½ car.
 Similarly, Germany can produce 0 shirts and produce
only cars. Then it can trade some of these cars from shirts
from China
China and Germany PPFs in Autarky
China&PPF&in&Autarky
Germany&&PPF&in&Autarky
Cars
Cars
10
6
18
10
Shirts&(millions)
Shirts&(millions)
China PPF after trade
China PPF after Trade
Cars
9
6
6 cars
imported
from Germ.
B
6
18
Shirts (millions)
12 million shirts
cars
exported to Germany
Germany PPF after trade
Germany PPF after Trade
Cars
10
6
cars
exp.
to China
4
A
12
12 million shirts
imported from China
20
Shirts (millions)
So we have gained from trade!
CHINA
GERMANY
World
Shirts
(millions)
Cars
Shirts
(millions)
Cars
Shirts Cars
0
6
0
10
9
3
5
5
14
18
0
10
0
28
4
18
16
8
AFTER TRADE
6
6
12
10
Example 2
Output per worker
Good
Flip Flops
Produced Wool (kg)
Country
Australia
Brazil
300
200
2
1
a. Which country has a comparative advantage in flip flops
production and why?
b. Which country has a comparative advantage in wool
production and why?
Group Exercise!
GHANA
Italy
Cocoa (tons)
Machines
Cocoa (tons)
Machines
0
5
0
22.5
5
2.5
10
7.5
10
0
15
0
1. Which country has the comparative advantage in Cocoa and which
country has the comparative advantage in Machines? Why?
2. Draw the PPFs in autarky.
3. Choose a relative price these countries could trade at. What would
be a new consumption point for Ghana after trade?
The Heckscher – Ohlin Model (H-O)
assumptions

Two countries

Two goods

Two factors of production (land, capital or labour)

Different goods require different factor intensity (some require more capital than
labour etc)

Perfect competition

Factors of production cannot move between countries

Countries have identical technologies
- country that has the most abundant factor will specialise in the good that uses that
factor more intensively!
An example of H-O
The factor endowments of the two countries:
Italy
Spain
Capital
Labour
Capital
Labour
3,000
2,000
4,000
2,000
The technological requirements:
Food (1kg)
Textiles (one meter)
Capital
Labour
Capital
Labour
3
1
2
2
Group exercise on the H-O model
 Go to data.worldbank.org/country
 Choose two countries and in the search bar search for the
following indicators:
 Population density
 GDP per capita (current US$)
 Total natural resource rents (% of GDP)
 Then go to comtrade.un.org scroll down and click on country
profile and download the profile for the countries you checked.
Look at the top three export commodities in the most recent year
 First, compare them in terms of the indicators above listed here. Do
you think the top export commodities of these countries are
expected given the relative levels of these indicators?
Definitions:
 Gross Domestic Product (GDP): the monetary value of
final goods and services produced in a country in a given
period of time. It can be defined as a value-added
concept, counting only the sales less the value of
intermediate inputs. It does not include unpaid work.
 Resource Rents: Earnings coming from exploitation of
natural resources
Some thoughts on gains from trade
Price (P)
S
Price with tariff
A
B
Free Trade Price
C
D
D
Q1 Q2
Q3 Q4
Quantity (Q)
Section 2: Dynamic comparative
advantage – a way to grow
Efficiency and growth
 Comparative advantage is about efficiency – the
bedrock of neoclassical economics. By encouraging
perfect competition and free trade we saw that we can
increase total consumption in the economy by using the
same amount of resources.
 Does this lead to growth?
Dynamic Comparative Advantage
GROWTH
Dynamic comparative advantage
 Stage 1: poor country, no labour skills, no capital, but most
likely has land and resources so they can exploit that
 Stage 2: population grows and gains some skills,
manufacturing becomes possible but only simple processes
 Stage 3: wages rises and cannot sustain cheap industries,
but it has accumulated enough skills and capital to
specialize in heavy industries
 Stage 4: the economy now can focus on innovation as it
has comparatively very high skills and capital.
The story of China
However..
 It is not clear how these skills and capital accumulate at
each stage.
 The experience of past developed countries shows that
relying on free trade to develop has not been a strategy
so far.
Section 3: Macroeconomic
Growth
From the micro to the macro
 Before we looked at individual agents (consumers or
producers) or countries and looked at how resources
where allocated between different activities.
 Now we look at the macroeconomy, which looks at the
economy as a whole.
The Solow Model
 Assumptions
 The economy consists of one sector
 There are no international transactions and no government
 All output that is saved is invested
 We are looking at the long-run
 Technological progress, population growth are determined
exogenously (they are given to us and not explained by the
model)
The production function
 Y = A, F (K, L)
This simply states that the Income of a country (Y) is equal to
what is produced by the production function F, that has
inputs capital K and labour L, and some level of technology
A (exogenously determined).
F (K, L) is nothing more than our production possibility frontier
– everything we can produce with different combinations of
capital and labour.
This A has also been called a Total Factor Productivity
Graphic Illustration
Income
F (K, L)
Y2
Y1
K1, L1
K2 L2
Capital & Labour
Graphic Illustration
Income
A2
Y2
Y1
A1
K1, L1
Capital & Labour
Endogenous Growth Model
 Put forward by Paul Romer and Robert Lucas
 The key point is that “investments” in capital accumulation
and human capital generate increasing returns to scale. So
for each unit of investment we get a larger than unitary
effect on growth.
 One example is R&D – the more you invest in R&D the more
is the improvement in skills and innovation and that makes
growth faster.
 So we can respecify this as:
Y = F (K, L, A)
An increase in K, will also increase A (technical
efficiency), so growth is endogenous.
Institutions
 Put forward by Acemoglu and Robinson (in Why Nations
Fail)
 The crux of development is to be found in the political
institutions. These determine how efficient our economies
are and whether they will grow in the future!
 What is needed is low corruption, more democracy,
more property rights security etc.
Group exercise! Go to
data.worldbank.org/country
 Choose two developing countries and in the search bar search for
the following indicators for years 2000 and 2015:







Population (total)
GDP per capita (constant 2010 US$)
Gross capital formation (constant 2010 US$)
Manufacturing, value added (constant 2010 US$)
Ease of doing business index
Research and Development Expenditure (% of GDP)
Tariff rate, applied, simple mean, all products (%)
 Calculate the growth of the first four indicators between 2000 and
2015.
 Is this country doing well or not? Can you offer an explanation
based on this data? You can also supplement this with reading
about the countries from other sources.