Chapter 2: TRADE THEORIES AND THE GAINS FROM TRADE

Contents

The Mercantilist period

The Ricardian Model

The HO model

Adam Smith – The Wealth of Nations

The Gains from Trade

Readings

• Required:

– International Economics (RC): Chapter 3, 4

– International Economics (KO): Chapter 2, 3

History of economic thought on trade policy

Other Trade Theories

The HO model

The Ricardian Model – Principles of

Political Economy and Taxation -

1817

Adam Smith – The wealth of

nations - 1776

The Mercantilist period

1500 - 1800

1

2

3

5

4

The Mercantilist Period

The Mercantilist Period

• History:

– Prevailed in Europe from the early XVI – late XVIII century

– Its exponents live in different countries

– Represents the view of national wealth and the policies best suited to promote it

The Mercantilist Period

The Mercantilist Period

The Mercantilist Period

The Mercantilist Period

• Factors driving Mercantilism:

– Consolidation of regional power centers by large, competitive nations

– Establishment of colonies outside Europe

– Growth of European commerce and industry

– Increase in volume and breadth of trade

– Increase in the use of metallic monetary systems

The Mercantilist Period

• Economic thought:

– Nation’s wealth:

•Promote a favorable ‘balance of trade’

•Accumulate the different in the form of precious metals

– Foreign trade: Emphasize the importance of foreign trade

– Profit: Trade is zero – sum game

– Government’s role: Focus on the power of government to control the economy

The Mercantilist Period

• Trade Policies:

– Domestic trade policies:

•Economic and non – economic goals are complementary

•Protect certain infant industries with export bounties and import duties

•Excise taxes are levied on domestic consumption

•Allowing monopolies in certain foreign markets

•Develop strong merchant marines

The Mercantilist Period

• Trade Policies:

– Foreign trade policies:

• Import duties, trade prohibitions

•Encourage export of…… and import of…….

•Discourage export of ….. and import of ……..

•Required all goods imported to be carried in either English or colonial vessels

The Mercantilist Period

Mercantil-ism

- Confuse wealth with money

- Incoherent, clumsy means - Cannot explain the pattern

of trade

- First development economists

- Policies consistent with nation’s priorities

- Aim to maximize national wealth by trade

Advantages

Disadvantages

Adam Smith – The Wealth of Nations

Adam Smith – The Wealth of Nations

• The beginning of classical school of economics

• Economic growth depended upon specialization and the division of labor

• Advocate free trade

• Do not oppose to restrictions imposed by small states, or exceptions

Adam Smith – The Wealth of Nations

• Productivities of labor inputs:

– Natural advantages: Climate, soil, mineral wealth

– Acquired advantages: Special skills and techniques

Adam Smith – Absolute Advantage

• Assumptions:

– Factor of production: Labor

– Homogeneous goods, prices depend on labor required

– 2 goods, 2 countries

Adam Smith – Absolute Advantage

• The Wealth of Nations and economic thought:

– Absolute advantage:

•Principle:

– When one nation has an absolute cost advantage that is, uses less labor to produce a unit of output) in one good and the other nation has an absolute cost advantage in the other good, international specialization and trade will be beneficial

Adam Smith – Absolute Advantage

Vietnam Thailand

Rice (tons) 100 200

Coffee (tons) 300 200

Adam Smith – Absolute Advantage

Vietnam Thailand

Units of labor/ A ton of rice 2 1

Units of labor/ A ton of coffee 0.5 1

Adam Smith – Absolute Advantage

Vietnam Thailand

Rice (tone) 100 200

Coffee (tone) 150 200

Adam Smith – Absolute Advantage

Absolute advantage

- Unreal assumptions - Cannot explain the pattern

of trade in some cases

- Explain the pattern of

international specialization and trade

- A basic for modern trade theories

Advantages

Disadvantages

The Ricardian Model

David Ricardo’s economic thought

• Reinforce the case for free trade

• International trade was first applied in the field of political economy

• Explain the pattern of international specialization and trade based on comparative advantage

The Ricardian Model

• Assumptions:

– 2 nations, 2 commodities

– Labor is the only input that can move freely among industries, technology is fixed

– Costs do not vary and are proportional to the amount of labor used

– Perfect competition in all markets

The Ricardian Model

• Comparative advantage:

– A country has a comparative advantage in producing a good if the opportunity cost of producing that good in terms of other goods is lower in that country than it is in other countries

– The opportunity cost of As in terms of Bs is the number of Bs that could have been produced with the resources used to produce a given number of As

– Depend on relative costs

The Ricardian Model

Vietnam Thailand

Rice (tons) 100 200

Coffee (tons) 300 200

David Ricardo – Absolute Advantage

Comparative advantage

- Cannot explain the terms of trade

- Unreal assumptions - Based only on supply side - …

- A supplement for Adam Smith’s theory

- Political economies are mentioned

Advantages

Disadvantages

The Ricardian Model

United States Canada

Wheat 60 160

Autos 120 80

The Ricardian Model

• The Gains from Trade:

The Ricardian Model

• The Gains from Trade:

The Heckscher – Ohlin Theory

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– Two countries: Home and Foreign

– Two goods: Cloth and Food

– Two factors of production: Land and Labor

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– Two countries: Home and Foreign

– Two goods: Cloth and Food

– Two factors of production: Land and Labor

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– Assumptions:

• 𝑎𝐿𝑎𝑇 : The ratio of labor to land used in production

• 𝑎𝐿𝐶𝑎𝑇𝐶 > 𝑎𝐿𝐹

𝑎𝑇𝐹

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– PPF (without factor substitution)

•aTFQF + aTCQC ≤ T

•aLFQF + aLCQC ≤ L

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– PPF (without factor substitution)

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– PPF (with factor substitution)

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– Price and Production:

•V = PCQC + PFQF

•QF = V/PF – (PC /PF)QC

•The slope of an isovalue line is – (PC /PF)

The HO Theory

• Two – factor economy model: 2 x 2 x 2

– Price and Production:

The HO Theory

The HO Theory

• Resources and Production Possibilities:

– Biased expansion of production possibilities:

The HO Theory

• Resources and Production Possibilities:

– Biased expansion of production possibilities:

•An economy will tend to be relatively effective at producing goods that are intensive in the factors with which the country is relatively well endowed

The HO Theory

• Assumptions:

– Two countries: Home and Foreign

– Same technology

– Home has a higher ratio of labor to land than Foreign does

•Home is labor – abundant

•Foreign is land – abundant

The HO Theory

• Factor’s endowment:

– Home is labor – abundant

– Foreign is land – abundant

• At any given price ratio of cloth to that of food:

– Home has a larger relative supply of cloth

– Foreign has a larger relative supply of food

The HO Theory

• Effects of International Trade:

PCDC + PFDF = PCQC + PFQF

(DF – QF) = (PC /PF)(QC – DC)

• This equation is the budget constraint for an economy, and it has a slope of – (PC /PF)

(DF – QF) – (PC /PF)(QC – DC) = 0

The HO Theory

• Relative prices and Pattern of Trade

The HO Theory

• Relative prices and Pattern of Trade

The HO Theory

• Relative prices and Pattern of Trade:

– Countries tend to export goods whose production is intensive in factors with which they are abundantly endowed

The HO Theory

• The Gains from Trade

The Gains from Trade

The Gains from Trade

The Gains from Trade

The Gains from Trade

End – of – chapter questions

• How can trade theories explain the pattern of international trade?

• What are gains from trade?