Classical Theory of International Trade Gipe 2
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Transcript of Classical Theory of International Trade Gipe 2
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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.