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
Output per Labor Hour
Country
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
Output per labor hour
Country
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
Change in the production of
Country
iPads
Cloth
U.S.
+5 sets
-15 yards
China
-3 sets
+15 yards
Change in the World Output
+2 sets
0
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
iPad (sets)
Cloth (yards)
Hourly Wage
Rate
Quantity
Price
Quantity
Price
U.S.
1
$20
5
$4
15
$1.33
China
1
$5
1
$5
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
• 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
100 iPads
0 yard of cloth
0 iPad
300 yards of cloth
Consumption with Trade
50 iPads
200 yards of cloth
50 iPads
100 yards of cloth
Domestic Production and
Consumption without Trade
50 iPads
150 yards of cloth
40 iPads
100 yards of cloth
Gains from Specialization and
Trade
50 yards of cloth
10 iPads
Production at Full
Employment
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
Numbers of iPads
Yards of Cloth
100
0
60
0
90
30
50
50
80
60
40
100
70
90
30
150
60
120
20
200
50
150
10
250
40
180
0
300
30
210
20
240
10
270
0
300
1.4 Comparative Advantage and Opportunity Cost
Cloth
Cloth
U.S.
300
China
300
C
C'
B
150
B'
A
MRT= −3
100
0
50
100
iPad
0
MRT= −5
A'
40
60
iPad
 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
Cloth
Cloth
U.S.
300
D'
300
E Trading possibilities line
export
(terms of trade:
1 ipad = 4 cloth)
A
200
150
import
Trading possibilities line
100
F
0
China
F'
A'
(terms of trade:
1 ipad = 4 cloth)
E'
import
D
50 export 100
iPad
0
40 50 60
iPad
 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
Production at Full Employment
Country
U.S.
China
100 iPads
0 yard of cloth
0 iPad
300 yards of cloth
Consumption with Trade
50 iPads
50 iPad
175 yards of cloth 125 yards of cloth
Domestic Production and
Consumption without Trade
50 iPads
40 iPads
150 yards of cloth 100 yards of cloth
Gains from Specialization and Trade
0 iPad
25 yards of cloth
10 iPads
25 yards of cloth
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.
Cloth
Cloth
U.S.
China
300 D'
300
E
200
G
175
150
A
G'
125
100
A'
E'
D
0
50
100
iPad
0
40 50 60
Changes in the Terms of Trade for the U.S. and China
iPad
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.
Yards of
Cloth per
iPad
Cloth
U.S.
300
SU.S.
3
0
150
100
iPad 0
A
MRT= −3
50
Supply Curves of a Good and the PPF
100
iPad
1.4 Comparative Advantage and Opportunity Cost
• Trade under Increasing Opportunity Costs
• Increasing Costs and the PPF
Yards of Cloth
per iPad
Cloth
D
300 A
B
E
F
C
C
B
G
0
H
100
iPad
0
100
The PPF and Supply Curve under Increasing Cost Conditions
iPad
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
Cloth
C
Cloth
F
F'
K
A
Trade Triangle
J
H'
C'
D
H
Trade Triangle
A'
G
J'
K'
D' G'
0
iPad 0
Specialization and Trade under Increasing Cost Conditions
iPad
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
A
B
C
D
E
Price in the U.S. ($) Price in the U.K. (￡)
2
4
6
8
10
6
4
3
2
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
be(2:1)
to Canadian domestic price ratio, and
Wheat
Canada will
Price Ratio
vice versa.
Improving U.S.
Terms of Trade
Terms of Trade
(1:1)
2
C
Improving Canadian
Terms of Trade
1
E
A
0.5
0
U.S. Price Ratio (0.5:1)
D
B
0.5
1
2
Autos
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
• Offer Curve
• 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 Yan offer curve: trade triangle approach
Y
C'
Y3
C
Y1
S1
Y2
R
S2
P
 PX 
 
 PY 1
R'
Y4
P'
V
O
X1
X2
(a)
X
 PX 
 
 PY  2
V'
O
X3
X4
(b)
Trade Triangles at Two Possible Terms of Trade
X
1.7 Offer Curve and Terms of Trade
• The constructionImports
of the
offer curve is completed
by connecting all possible
OCI
of
points at which a country
is willing to trade. (PX/PY)4
Good Y
(PX/PY)3
T"'
T"
(PX/PY)2
(PX/PY)1
T'
Y6
Y5
T
O
X5 X6
Exports of
Good X
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.
is the market-clearing price ratio.
I's Imports of Good Y TOTE OC
(PX/PY)E or TOTE
I
II's Exports of Good Y
(PX/PY)1 or TOT1
Y2
YE
Y1
O
B
E
OCII
A
X1 XE
X2
Trading Equilibrium
I's Eports of Good X
II's Imports of Good X
1.7 Offer Curve and Terms of Trade
Shifts of Offer Curves
I's Imports
of Good Y
OCI
OCI"
OCI'
Decreased
Willingness
to Trade
H
G
F'
F
O
Reasons for Shifts:
H'
A change in tastes for the
TOTE
imported good;
G'
A rise in income that leads to
TOT1 an increased demand for
imports;
An improvement in
Increased
productivity in Country I’s
Willingness
to Trade
export industries.
TOT2
I's Exports of Good X
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
I's Imports
of Good
Y
OCI
OCI'
II's Exports of Good Y
change.
TOTE
Y2
E''
E'
Y1
YE
TOT1
OCII
E
O
XE
X1 X2 I's Exports of Good X
II's Imports of Good X
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.