Trade Theory

Trade Theory

Why is trade mutually beneficial?

Sources: Baumol, Blinder and Scarth 1988 Economics: Principles and PolicyDicken 1998 Global Shift: Transforming the World Economy

David Ricardo

• 1772-1823• The Principles of

Political Economy and Taxation (1817)

• Law of Comparative Advantage

Why trade?

• Global resources are not equally distributed: oil, water, forests

• Natural endowments are also uneven: climate, terrain

• Labour quality varies from place to place: skills, productivity, and wages

• Specialization permits greater output per unit of input

A Fallacy

• Nothing new is produced by trading therefore,if one party gains, the other must lose

• Zero-sum game: one nation’s gain must be another nation’s loss

• “Beggar thy neighbour,” Adam Smith’s term for mercantilist approach to trade policy

International vs Intranational Trade

• Why is international trade different?– Interprovincial trade takes place within a single

sovereign territory, one nation’s government– Currency is the same in intranational trade– Labour and capital are relatively mobile within

a nation and between regions

Absolute advantage Output from 1 Person-year of Labour

In Canada In Honduras

Bananas (kg) 10 500

Wheat (kg) 300 30

Canada has an absolute advantage in wheatHonduras has an absolute advantage in bananas

50 years of labour are required in Canada to produce 500 kg of bananas

10 years of labour are required in Honduras to produce 300 kg of wheat

Absolute Advantage

• It seems obvious that Canada and Honduras will both be better off if they specialize in wheat and bananas (respectively) and trade

• Absolute advantage results from the difference in their factor endowments, mainly climate, soils, and geomorphology

• But what if one country could produce both products more efficiently? Should they trade?

• Yes!

The Principle of Comparative Advantage

• A country (or region) should specialize in producing and exporting those products in which it has a comparative, or relative cost, advantage compared with other countries and should import those goods in which it has a comparative disadvantage.

Ricardo’s Famous Example of Comparative Advantage

• England and Portugal are the classic examples• Labour is the only factor input• Cloth and wine are the only products

Alternate Outputs from One Week of Labour Input

In England In PortugalCloth (metres) 10 12

Wine (barrels) 1 6

The Arithmetic of Comparative Advantage 1

• In England, 10 kms of cloth or 1 bbl of wine• In Portugal, 12 kms of cloth or 6 bbls of wine• So Portugal is more efficient at making both products!• But it will pay for Portugal to specialize in wine and

England to specialize in cloth…why?


In England In PortugalCloth (kms) 10 12

Wine (bbls) 1 6

The Arithmetic of Comparative Advantage 2

• How much more efficient is Portugal than England?– in cloth, 12/10, 120% more efficient– in wine, 6/1, 600 percent more efficient

• So Portugal has a comparative advantage in wine– It is much more efficient at wine making

• And England has a comparative advantage in cloth– It is only slightly less efficient at cloth making



Wine (bbls) 1 6

Imagining Specialization

• Imagine that Portugal switches one week of labour out of cloth and into wine, losing 12 kms of cloth and gaining 6 bbls of wine

• And England switches two weeks of labour out of wine and into cloth, losing 2 bbls of wine and gains 20 kms of cloth



Wine (bbls) 1 6

Gains from Specialization

• The world gains 8 kms of cloth and 4 bbls of wine from the same labour force!

Global Output after Specialization

In England In Portugal TotalCloth (kms) + 20 -12 + 8Wine (bbls) - 2 +6 + 4

Opportunity Costs

• In England, having an additional bbl of wine means doing without 10 kms of cloth. Therefore– The opportunity cost of 1 bbl of wine is 10/1 = 10 kms of cloth– In Portugal, the opportunity cost of 1 bbl of wine 12/6 = 2 kms of

cloth• Measured in opportunity costs, wine is cheaper in Portugal

– And cloth is cheaper in England



Wine (bbls) 1 6

Trade makes both nations better off.

Thus:

• England should specialize in producing cloth and export some of it

• Portugal should specialize in producing wine and export some of it

But all this assumes…

• Factors of production are immobile• Transportation costs are zero• Technology is constant in both time

and space• Perfect competition of classical trade

theory denies economies of scale

However,

• Capital and labour are mobile to some degree

• Transportation costs are vital in many industries e.g. concrete blocks

• Technology spreads unevenly• Economies of scale are real

The plot thickens…

• Specialization efficiencies are enhanced by economies of scale

• But the gains to specialization begin to decline as the resources switched from one product to another are not perfect substitutes or infinitely transferable

• Actual prices and quantities traded depend on supply and demand

So what does all this mean for regions?

• Heckscher-Ohlin Theory (1933)– Factor endowments vary from region to region

• A country (region) should export those goods which use intensively the factors of production with which it is best endowed and import those goods which require factors of production with which it is poorly endowed.

In light of the H-O Theory, let’s speculate on Canada’s trade structure. What are your hypotheses?

1. What is our balance of trade in livestock?2. What is our balance of trade in agricultural

produce and crude resource products?3. What is our balance of trade in intermediate

goods?4. What is our balance of trade in manufactured

goods for final sale to consumers?

Canada’s International Trade Balance, 2001($ 000,000)

Commodity Classification Exports Imports Balance Section I Live animals 2,394 398 1,996 Section II Food, feed, bev. & tobacco 25,723 18,674 7,050 Section III Crude materials, inedible 54,558 20,939 33,619 Section IV Fabricated materials, inedible 109,058 69,444 39,614 Section V End products, inedible 208,566 227,895 (19,329) Special transactions, trade, exports 8,119 6,843 1,275 Other balance of payments adjustments 6,221 6,430 (209) United States 350,908 255,028 95,880 United Kingdom 6,574 11,863 (5,290) Other EEC 15,727 23,225 (7,498) Japan 9,482 10,585 (1,104) Other OECD 10,925 18,626 (7,701) All other countries 21,023 31,295 (10,272)

Source: Statistics Canada 2003, Cansim II Table 228







Implications• These lessons were an integral part of an age of

nineteenth century liberalism.• Corn Laws 1815 to protect large landowners,

repealed 1846 by urban industrial interests• Yet Protectionism in Canada from National Policy

of 1879 until 1989 (?)• Neoliberalism: a new doctrine based in part on

Ricardian concept of Comparative Advantage

Trade Theory

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