Classical Theories of International Trade

Lecture 3
Evolution of Trade Theories
Mercantilism
Absolute Advantage
Comparative Advantage
Factor proportion Trade
International Product Cycle
New Trade Theory
National Competitive Advantage

Lecture 3
“If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the product of our own industry, employed in a way in which we have some advantage”
Wealth of Nations, Adam Smith

Adam Smith and the
Attack on Mercantilism and Economic Nationalism
In 1776, Adam Smith published the first modern statement of economic theory, An Inquiry into the Nature and Causes of the Wealth of Nations
The Wealth of Nations attacked mercantilism—the system of which dominated economic thought in the 1700s
Smith proved wrong the belief that trade was a zero sum game—that the gain of one nation from trade was the loss of another
On the other hand… Voluntary exchange (trade) is a positive sum game —both nations can gain

Theory of absolute advantage
Adam Smith ideas based on…
The capability of one country to produce more of a product with the same amount of input than another country
(same thing) The ability of a country to produce a good using fewer resources than another country (lower opportunity cost)

Theory of absolute advantage
Adam Smith argued:
A country should produce only goods where it is most efficient …. and trade for those goods where it is not efficient
Trade between countries is, therefore, beneficial

Theory of absolute advantage
… destroys the mercantilist idea since there are gains to be had by both countries party to an exchange
… questions the objective of national governments to acquire “wealth”: through restrictive trade policies
… also measures a nation’s wealth by the living standards of its people

Consider this “simple” example involving the EU and India
Only two products are produced, machines and cloth
Labor is fixed, homogeneous within a country, the only factor of production, and is fully utilized
Technology and production costs are constant
Transportation costs are zero and the countries barter (trade) for goods
TRADE BASED ON
ABSOLUTE ADVANTAGE

TRADE BASED ON
ABSOLUTE ADVANTAGE

The Production Possibilities Frontier (PPF) is a curve showing the various combinations of two goods that a country can produce when all of a country’s resources are fully employed and used in their most efficient manner
THE PRODUCTION POSSIBILITIES FRONTIER AND CONSTANT COSTS

Production Possibilities Curves for the United States and India
Machines
Cloth
2
15
10
5

India
Cloth Mach
15 0
7.5 1
0 2
EU
Cloth Mach
10 0
8 1
6 2
4 3
2 4
0 5
India - Opportunity Costs
Machine = 7.5 cloth
Cloth = 0.133 machine
EU - Opportunity Costs
Machine = 2 cloth
Cloth = 0.5 machine
“Opportunity Cost” also known as “Relative Price”

Machines
Cloth
2
15
10
5
What Determines the Slope of the PPC?
Slope = ∆Machines/∆Cloth = Opportunity Cost of Machines
Same graph, drawn more to scale!
EU: Slope = Opportunity Cost = -0.5
India: Slope = Opportunity Cost = -0.133

EU workers are more productive in producing machines
The EU has an absolute advantage in machine production
Indian workers are more productive in producing cloth
India has an absolute advantage in cloth production
Absolute Advantage: Production Conditions When Each Country Is More Efficient in the Production of One Commodity

TRADE BASED ON
ABSOLUTE ADVANTAGE …
What does this mean?

What ???
Theory of absolute advantage
Adam Smith: Wealth of Nations (again) argued:
A country should produce only goods where it is most efficient, and trade for those goods where it is not efficient

Assume TWO Persons per day, so that each product can be fully produced
(and)
(and)
(and)
This is a condition under Autarky: (The complete absence of trade)
Under Autarky all nations can only consume the goods they produce at home

Assume TWO Persons per day, so that each product can be fully produced
(and)
(and)
(and)
(and)
However, if each country produces to their absolute advantage …below…
.
.

TRADE BASED ON
ABSOLUTE ADVANTAGE
.
So there has obviously been an increase in World Output!!

Both countries can benefit if trade occurs
EU produces machines and exports them to India
India produces cloth and exports it to the EU
TRADE BASED ON
ABSOLUTE ADVANTAGE

(and)
(and)
(and)
(and)
.
.
Now, suppose that the EU trades … 3 machines to India … for 12 yards of cloth?

Introduction: The Gains from Trade
The improvement in national welfare (for both countries) is known as the gains from trade

One more quick example, just to be sure….
Output per Hour Worked
What are the EU’s relative prices (opp. cost) … Bread? Steel?
What are Canada’s relative prices (opp. cost) … Bread? Steel?
Who has absolute advantage in Bread?
Who has absolute advantage in Steel?
Given 2 working hours per country… what is the maximum world output?

Implications of Adam Smith’s Theory
Access to foreign markets helps create wealth
If no nation imports, every company will be limited by the size of its home country market
Imports enable a country to obtain goods that it cannot make itself or can make only at very high costs
Trade barriers decrease the size of the potential market, hampering the prospects of specialization, technological progress, mutually beneficial exchange, and, ultimately, wealth creation

Adam Smith and Trade Barriers
Smith was highly critical of trade barriers (Tariffs, Quotas, Subsidies…)
Trade barriers decrease
- Specialization
- Technological progress
- Wealth creation
The modern view of trade shares Smith’s dislike for trade barriers

Labor Theory of Value
Assumes that labor is the only relevant factor of production
This implies that the pre-trade price of a good is determined by the amount of labor it took to produce it.
TRADE BASED ON
ABSOLUTE ADVANTAGE

2-Country Scenario
U.S. has an Absolute Advantage in both goods.

Production Possibilities Curves for the United States and India
Machines
Cloth
1
5
15
5
Graphically obvious …
U.S. has an Absolute Advantage in both goods.

One country has Absolute Advantage in BOTH goods
In this scenario, there is obviously no opportunity to trade… especially not for U.S.
NO… No … No!!! This is not correct. We need to introduce the concept of:
Comparative Advantage Next lecture