Classical Theory of International Trade Gipe 2

8/8/2019 Classical Theory of International Trade Gipe 2

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ADAM SMITH ABSOLUTE COST ADVANTAGE

DAVID RICARDO COMPARATIVE COST ADVANTAGE

JOHN STUART MILL RECIPROCAL DEMAND(offer curves)


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CLASSICAL THEORYAnswers three aspects:

y Gains from trade benefits and their division among

trading countriesy Structure of trade actual imports, exports and allocation

of resources and flow of trade

y Terms of trade rate at which imports and exports are

traded


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ADAM SMITH ABSOLUTE

COST ADVANTAGE

In his Wealth of the Nations (1776), Adam Smithpromoted free trade by comparing nations to

households, It is the maxim of every prudent master of a family,never to attempt to make at home what it will cost ...more to make than to buy. The tailor does not attempt tomake his own shoes, but buys them from the shoemaker

... If a foreign country can supply us with a commoditycheaper than we ourselves can make it, better buy it ofthem with some part of the product of our own industryemployed in a way in which we have some advantage.


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ADAM SMITH ABSOLUTE

COST ADVANTAGEyAdam Smith attacked the mercantilist assumptionthat trade is a zero-sum game (one country gains at

the cost of other one losing)yCountries differ in their ability to produce goodsefficiently, and that a country has an absoluteadvantage in the production of a product when it is

more efficient than any other country in producing ityCountries should specialize in the production ofgoods for which they have an absolute advantage andthen trade these goods for the goods produced byother countries


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ABSOLUTE ADVANTAGEy A country has an absoluteabsolute advantageadvantage over another in

the production of good X when an equal quantity of

resources can produce more X in the first country than

in the second = higher productivity!

production ofa unit of labour

Conclusion:

Country A will produce and export wine.

Country B will produce and export cloth.

product Country A Country B

Wine 25 barrels 10 barrels

Cloth 10 bales 15 bales


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ABSOLUTE ADVANTAGE

Before specialization, each country divides its ownproduction capacity between wine and cloth

Total wine production 35 bareels (25+10)

Total cloth production 25 bales(10+15)After specialization,

y With 2 units of labour, A produces 50 barrels of wineand B 30 bales of cloth

y Excess 15 bareels of wine and 5 bales of cloth withsame 2 units of labour put forth by each country

Gains from trade: higher productionandconsumption


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COMPARATIVE COST

ADVANTAGEy Clear-cut absolute cost advantage or one country has an

absolute advantage in the production of all goods as a

special and not a general case for trade as unexplainedby Adam Smith

y A country to specialize in the production of those goods

that it produces most efficiently and to buy the goods

that it produces less efficiently from other countriesy Country should specialize in the production of those

goods in which it is relatively more productive... even

if it has absolute advantage in all goods it produces


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COMPARATIVE

ADVANTAGEy A difference in comparative costs of production the necessarycondition for international exchange to occur does, in fact,reflect a difference in the techniques of production, the capitaland labor inputs, and productivity.

y The theory also aims at showing that trade is beneficial to allparticipating countries: win/win!

y Positive-sum game of international trade!

y The gains from specialisation and trade depend on the patternofcomparative, not absolute advantage.

y With no trade, each countrys consumption is limited by itsability to produce.

y With free trade, each country specializes in producing only onegood.. Each country can reach its desirable levels of

consumption by trading.


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TWO COUNTRY - TWO

COMMODITY MODELCountry Wine Clothing Domestic

terms of trade

Portugal 80 hrs per

barrel

90 hrs per

yard

80:90

1W=0.89C or

1C= 1.13C

England 120 hrs per

barrel

100 hrs per

yard

120:100

1W= 1.2 C or

1C=0.83 W

Comparative

cost ratios

80:120

0.67

90:100

0.90


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SPECIALIZATION AND

GAINS FROM TRADEy In the example England has absolute

disadvantage in both productions while

Portugal has absolute advantage

yHowever comparative disadvantage of England

is less in case of cloth and comparative

advantage is more for Portugal in case of

production of wine

yAccordingly England will produce and export

cloth and Portugal would produce and export

wine


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Portugals domestic exchange ratio

International terms of trade

Englands domestic exchange ratio

Portugals exchange

P1.13W

A 1C

T

1W

E

0.83W

P0.89C

WINE

CLOTH

COMPARATIVE COST ADVANTAGE


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COMPARATIVE ADVANTAGE

y International rate of exchange would be1W=1C

yTherefore gains of England would be 1.20 -1.00 = 0.20 while that of Portugal would be1.00 - 0.89 = 0.11

yThe total gains from trade with comparativecosts advantage would be 0.31(0.20+0.11)

yThe two selling limits would be 0.89 and 1.20for both. The terms of trade will fall withinthese limits

yResult: Both sides gain from trade.


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CRITICISMSy Lacks positive approach and explains normative approach(welfare

model and not trade model)y Unrealistic assumptions

y No explanation for differences in labour productivity between

countries

y

Restrictive in naturey Does not suit a trade between big and small sized countries

y Lack of universal application on defense and self-sufficiency

basis

y

One sided and ignores demand factory Leaves protection policies out of application of theory

y Not applicable to undeveloped economies

For Ohlin, it is clumsy and dangerous tool of analysis as

comparative costs is applicable to all types of trade and notonly to international trade.

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Classical Theory of International Trade Gipe 2

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