The Classical Theory of International Trade ……
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The Classical Theory of International Trade
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The Classical Theory of International Trade
Adam Smith; John Stuart Mills; James Torrens; David Ricardo (Ricardian Theory)
•Why do nations trade?
•What determines in which good(s) they trade?
Key Questions…
Model Assumptions
Factors are immobile between countries No barriers to trade Exports pay for importsLabor is the only factor of production Constant return to scale in production
Absolute Advantage
Adam Smith (1776) For various reasons, including differences in technology and climate, countries differ in their abilities to produce different goods
Some are more productive than others
Definition:A country is said to have Absolute Advantage in the production of one good if it produces that good using smaller (lower) amount of productive inputs than is possible anywhere else in the world
Implication1. World output would expand if countries
specialize in the production of a good in which they have Absolute Advantage (highest relative productivity)
Implication2. Each good will be cheaper if produced in the
country that has Absolute Advantage
The above two are possible only if there is free international trade
Absolute Advantage
______________________________________2 countries : USA and France2 Goods : Beer and Wine1 Factor : Labor Each country has 2 units of labor
Suppose One-Person Day of Labor ProducesBeer Wine
USA
France
20
40
60
20
Which Country has AA to Produce Beer?
Beer Wine
USA
France
20
40
60
20
Which Country has AA to Produce Wine?
Beer Wine
USA
France
20
40
60
20
Specialization (Complete)
Beer Wine
80
120
Why Nations Trade? Some AnswersNations trade because trade allows them to specialize in the production of the good in which they have absolute advantage
Specialization increases world output
Why Nations Trade? Answer
Nations trade because trade allows them to get a product at a lower cost than if it is produced at home….
Free international trade allows nations to consume at a point outside their PPF
What determines which goods …
The relative amount of productive factors that a nation uses to produce a good
Productivity (efficiency) of factors…
Direction of Trade….
A country should specialize in the production of a good in which it has AA.
EXPORT the surplus output (of the good in which it has AA) in exchange for the IMPORT of the good in which it has Absolute disadvantage
However, the world is not…
Suppose One-Person Day of Labor Produces
Beer Wine
USA
France
20
10
60
20
Puzzles …….
Which country has AA?Which good should the U.S. Produce and Export?Which good should France Produce and Export?Is there a possibility for international trade between the US and France?
If so, on what basis?
Comparative Advantage
A country has comparative advantage in the production of a good if it has a lower pre-trade relative price than is found elsewhere
In other words….
Comparative Advantage
A country has comparative advantage in the production of a good in which it has the lowest opportunity cost than is found elsewhere
The Opportunity Cost of Beer and Wine
Beer Wine
USA
France
1W:3B
1W:1/2B
1B:1/3W
1B:2W
Where is it Cheaper to Produce…
Beer Wine
USA
France
1W:3B
1W:1/2B
1B:1/3W
1B:2W
Puzzles Solved
Which country has AA? US has AA in both Goods
Which good should the US Produce?US has CA in the production of Beer…
Puzzles Solved
Which good should France Produce?France has CA in the production of Wine
Is there a possibility for international trade between the US and France? If so, on what basis?
Yes, on the basis of CA.
Direction of Trade…
Each country should specialize in the production of a good in which it has comparative advantage and then EXPORT the excess of the production of that good in exchange for the IMPORT of the other good (in which it has comparative disadvantage)
Implications…
It is NOT necessary for a country to have absolute advantage in the production of any good for that country to be able to participate in international trade…
Implications…
The basis for international trade (specialization and export) is comparative advantage not absolute advantage….
Differences in the comparative cost of production (Opportunity cost)
Implications…
Complete specialization is possible
in the production of a good in which each country has comparative advantage…
Implications…
The volume of trade flow between countries that have different productivity or opportunity cost will be large.
Large volume of trade flows between the North (developed countries) and the South ( developing countries will take place)….
Implications…
With specialization and international trade, world output would increase and the trading partners will benefit.
…The actual benefit of each trading partner, however, will depend on their respective Terms of Trade (TOT)….the ratio of the price of exports to the price of imports.
Implications…
With international trade, there will be one world price (price equalization)…
….the world price of an internationally traded good will lie some where between the autarky prices of the two countries (trading partners).
Does the classical theory of international trade explain the current world trade pattern very well?
What are the limitations of the Classical theory of International Trade?
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