CHAPTER 2

THEORIES OF INTERNATIONAL TRADE

• Understand and interpret international trade related information
• Explain why nations trade by employing international trade theories
• Explain the gain of international trade by employing international
trade theories
 2.1 Classical Theories of International Trade

2.1.1 The Mercantilists Trade Theory

2.1.2 Theories of Absolute and Comparative Advantage
2.1.3 Comparative Advantage and Opportunity Costs
2.1.4 Offer Curve and Terms of Trade
 1. The Mercantilist View on Trade
▪ It was a popular economic philosophy in the 16th C and mid 18th C.

▪ It was developed for the purpose of building wealthy and powerful state.

▪ Mercantilism is a trade theory which holds that a government can improve the well-being
of the country by encouraging exports and stifling imports.

▪ To increase trade surplus and prosperity, a nation shall strive to maximize exports and
minimize imports to keep money (gold) at home.

▪ The system actively supported the establishment of colonies that would supply raw
materials and markets and relieve home nations of dependence on other nations.
 Economic Doctrine of Mercantilists
▪ The wealth of a nation is based on accumulation of Gold & other Precious Metals and Exports
of goods and services.
▪ In the process of nation building, the central question was how a nation could regulate its
domestic and international affairs so as to promote its own interest.
▪ Promote a favorable trade balance, advocated government regulation on trade: bullionism
❖Bullionism: the government control over the use and exchange of precious metals. Bullionists
believe as wealth is the function of precious metals.

▪ Tariffs, quotas, and other commercial policies were proposed by Mercantilists to minimize
imports in order to protect a nation's trade position.
 Flaws of Mercantilism
▪ The basic flaw of Mercantilism was that trade was regarded as a
“Zero-sum game”, but trade is actually a positive-sum game.
▪ Wealth is a function of precious metals
▪ Colonies are the source of raw material
 Modern Features of Mercantilism
▪ It was highly nationalistic

▪ It viewed the well-being of the home nation as of prime importance

▪ Mercantilism favored the regulation and planning of economic activity as an

efficient means of fostering the goals of the nation

▪ It generally viewed foreign trade with suspicion.

• According to mercantilists, briefly discuss the advantage and
disadvantage of IT?
 2. Theories of Absolute and Comparative Advantage
A. Theory of Absolute Advantage
Assumptions
• Labor is the only factor of production and is homogenous,
• Labor was completely free to move within a single country, yet it was entirely immobile
internationally.
• Both countries can produce both commodities,
• No transportation costs were involved in trade
• There existed no other barriers, such as tariffs and quotas, to trade between countries.
• Constant returns to scale.
• In a hypothetical two-country world, if Country A could produce a good cheaper or
faster (or both) than Country B, then Country A had the advantage and could focus
on specializing on producing that good.

• Similarly, if Country B was better at producing another good, it could focus on

specialization as well.

• By specialization, countries would generate efficiencies, because their labor force

would become more skilled by doing the same tasks.
• Production would also become more efficient, because there would be an incentive to create
faster and better production methods to increase the specialization.

• Smith’s theory reasoned that with increased efficiencies, people in both countries would benefit
and trade should be encouraged.

• His theory stated that a nation’s wealth should not be judged by how much gold and silver it
had but rather by the living standards of its people.

• According to Adam Smith, trade between two nations is based on absolute advantage.
Illustration

Output of one labor-hour

Commodity Country A Country B

Wheat (Quintals) 5 10

Oil (barrels) 10 5

6-11
Fig The Theory of Absolute Advantage

6-12
 Interpretation ……
• To see the benefit from an international trade, it is better to begin from autarky that shows
the combination of both goods produced and consumed by each country before trade

Table 2: Pre trade production and consumption

Commodity Country A Country B World

Wheat (Quintals) 5 10 15
Oil (barrels) 10 5 15

• When both countries produce wheat and oil for domestic consumption, and
absolutely no trade relations exist between two countries, the world production
would be 15 quintals of wheat and 15 barrels of oil.
production after specialization and gain from trade

Production Production Gain from

before trade After trade trade
Commodity
Country Country Country Country Country Country
A B A B A B

Wheat
5 10 - 20 -5 +10
(Quintals)
Oil
10 5 20 - +10 -5
(barrels)

14
Absolute Advantage

• As a result of trade, the total production of the two countries went up.

• This means that both countries become richer or have become better off in
terms of production, after trade as compared to before trade, without
making any country worse off.
Criticism

❑ Smith assumes that international trade requires an exporting country to have superiority with
a given amount of capital and labor to produce a larger output than any rival.

❑ But this basis of trade is not realistic.

❑ There are many underdeveloped countries which do not possess absolute advantage in the
production of any commodity, and yet they have trade relations with other countries.

❑ Thus, Smith's analysis is weak and unrealistic.

 So….
Is Absolute Advantage the only basis for trading?

What if a person or a nation has an absolute advantage in producing

everything….would there still be a reason to specialize and trade?

Good X Good Y
Country A 15 20
Country B 10 12
 B. Theory of Comparative Advantage
• The challenge to the absolute advantage theory was that some countries may be better at
producing both goods and, therefore, have an advantage in many areas.

• In contrast, another country may not have any useful absolute advantages.

• To answer this challenge, David Ricardo, an English economist, introduced the theory of
comparative advantage in 1817.

• Ricardo reasoned that even if Country A had the absolute advantage in the production of
both products, specialization and trade could still occur between two countries.
i. The less efficient nation should specialize in the production and export of the
commodity in which the nation has comparative advantage.

ii. On the other hand, the nation should import the commodity in which it’s
absolute disadvantage is greater.
o This is the area of it’s comparative disadvantage.

✓ This is known as the law of comparative advantage.

• Illustration: indicate what happens if;
a. 6W are exchanged for 9C
b. 6W are exchanged for 3C
c. 6W are exchanged for 12C

Output of one labor-hour

Commodity Country A Country B

Wheat
6 1
(Quintals/labor hour)

Cloth
3 2
(yards/labor hour)
Assumptions
• Two nations and two commodities.
• Free trade
• Perfectly mobile labor with in a nation but completely immobile labor
internationally.
• No transport cost
• No technological difference
• The labor theory of value
 Labor theory of Value:

• The labor theory of value states that the value or price of a commodity is equal to the amount
of labor time going into the production of commodity.
i. Labor is the only factor of production or it is used in the same fixed proportion in the
production of all commodities.
ii. Labor is homogenous (only one type).

• Today we reject labor theory of value .

WHY?
i. Labor is neither the only factor of production nor is it used in the same fixed
proportion in the production of all commodities.
ii. Labor is not homogenous (only one type).
Criticisms

• It is based on the labor theory of value.

• We reject Ricardo’s explanation of comparative advantage but not CA itself.

N.B: The law of comparative advantage is valid and can be explained in terms of
opportunity costs.
 3. Comparative Advantage and Opportunity Costs

• According to the opportunity cost theory, the cost of a commodity is the amount of a second
commodity that must be given up to release just enough resources to produce one additional unit of
the first commodity.

• Consequently, the nation with the lower opportunity cost in the production of a commodity has a
comparative advantage in that commodity (and a comparative disadvantage in the second
commodity).
• There is one basic difference between trade model under increasing and the constant
opportunity costs case.

• Under constant costs, both nations specialize completely in production of the commodity of
their comparative advantage.
i.e. the production of only one commodity in a nation with trade.

• However, under increasing opportunity costs, there is incomplete specialization in production

in both nations.
i.e. there is a continued production of both commodities in both nations (even with trade)
• Comparative Advantage is the situation where someone or a
country can produce a good at lower opportunity cost than
someone else or another country can.

Nations Output per labor hour

Wine Cloth

USA 40 bottles 30 yards

UK 20 bottles 10 yards
• Assume that in one hour's time, U.S. workers can produce 40 bottles
of wine or 30 yards of cloth,

• While UK workers can produce 20 bottles of wine or 10 yards of

cloth.

• The United States is three times as efficient in cloth production (30/10

= 3) but only twice as efficient in wine production (40/20 = 2).
• The United States thus has a greater absolute advantage in cloth than in
wine,

❖It has lower opportunity cost (40/30=1.33)

• while the United Kingdom has a smaller absolute disadvantage in wine

than in cloth

❖It has lower opportunity cost (10/20=0.5)

• Each nation specializes in and exports that good in which it has a
comparative advantage.

❖United States in cloth

❖United Kingdom in wine

• The output gains from specialization will be distributed to the two

nations through the process of trade.
 4. Offer Curve and Terms of Trade
• Incorporate elements of both demand and supply

• How international terms of trade are established by the interaction of supply and
demand?

• The offer curve of a nation shows the willingness of the nation to import and
export at various re1ative commodity prices.

• The offer curve sometimes is also referred to as reciprocal demand curve.

Derivation of Offer Curve
• Derived from the nation's production frontier, its indifference map, and the various
hypothetical relative commodity prices at which trade could take place.

• Pattern of trade depends not just on supply, but also on demand - which is determined
by individual tastes.

• Tastes can be shown graphically with indifference curves, which show the various
combinations of two goods that give a consumer the same total level of satisfaction
A consumer’s indifference map

33
 Indifference curves
• Indifference curves have a negative slope
• Keeping satisfaction constant means giving up some of one good for more of
another
• Indifference curves are convex
• As the consumer gets more of one good, she is less willing to give up what is
left of the other
• The rate of substituting one good for another is shown by the slope of the
curve, the marginal rate of substitution

34
Indifference curves
•“Higher” indifference curves (those farther from the origin) represent
greater levels of satisfaction

• Individual preferences cannot really be added up into a “community

indifference curve” but it is useful to imagine that they can for the
purposes of trade theory

35
Indifference curves and international trade

F
G
E III
Wheat

Domestic
II equilibrium
without trade
(autarky)
H I

36
Basis for trade, gains from trade

323

tUS
Wheat

14
37
Equilibrium terms-of-trade limits
Canada price ratio (2:1)

C tt1 (1:1)
Wheat

D E
A US price ratio (0.5:1)

38
Offer curves: supply and demand

US
tt1 (1A=0.67W)

60
B

tt0 (1A=0.4W)
20
A

50 90

39
 Offer curves: supply and demand

60 Canada
B’
(Canadian export)
Wheat

50
tt1’ (1W=0.67A)

20 60

40
 Equilibrium terms of trade

Wheat (Canadian export/US imports)

tt0

tt1
B
113
100 Canada
A
60

80 100 150

41
 Changing equilibrium terms of trade
United States tt1 Canada1

Wheat (Canadian export/US imports)

160 tt0
B
Canada0
100
A

100 120

42
2.2 Modern Theories of International Trade
1. Heckscher-Ohlin Theory of Trade

• Developed by two Swedish economists, Eli Heckscher, and Bertil Ohlin, in

1920s.

• States that the main determining factor for the pattern of production,
specialization and trade among countries is the relative availability of factor
endowments and factor prices.
• A country will export the commodity whose production requires the intensive
use of the country's relatively abundant and cheap factor and import the
commodity whose production requires the intensive use of the country's
relatively scarce and expensive factor.

• In short, the relatively labor-rich country exports the relatively labor-intensive

commodity and imports the relatively capital-intensive commodity.
Assumptions

➢It is a two-by-two-by-two model: there are two countries (A and B), two commodities
(X and Y), and two factors of production (capital and labor).
➢Both nations use the same technology in production
➢Commodity X is labor intensive and commodity Y is capital intensive in both
countries:
➢Constant returns to scale in the production of both commodities in both countries
➢Incomplete specialization in production in both countries
➢Equal tastes in both countries
➢Perfect competition in both commodities and factor markets in both countries
➢Perfect factor mobility within each country but no international factor mobility
➢No transportation costs, tariffs, or other obstructions to the free flow of
international trade
Criticisms
➢Two-by-two-by-two Model.
➢No Constant Returns.
➢Static Theory.
➢Transport Costs influence Trade.
➢Factors not Homogeneous.
➢Unrealistic Assumptions of Full Employment
➢Production Techniques not Homogeneous. and Perfect Competition
➢ Tastes and Demand Patterns not Identical.
Merits
• Rightly points out the basis for international trade

• Explains the reasons for the difference in the cost of production in terms of difference in
factor endowments.

• Points out the general demand and supply analysis.

• Considers the difference in the production function.

• Indicates the impact of trade on the product and factor price.

2. Factor Price Equalization Theorem

• States that when the prices of the output goods are equalized between countries, as when
countries move to free trade, then the prices of the factors (capital and labor) will also be
equalized between countries.

• This implies that free trade will equalize the wages of workers and the rents earned on
capital throughout the world.

• Free trade should cause a tendency for factor prices to move together if some of the trade
between countries is based on differences in factor endowments.
3. Extensions of The Heckscher-Ohlin Theory
• We need to make the H-O model more realistic by allowing for more than two goods, factors,
and countries.
❖This is the first modification to the model.

• In the second modification, we will allow the technologies used to produce each good to differ
across countries.
❖ Many Goods, Factors, and Countries

• The predictions of the H-O model depend on knowing what factor a country has in
abundance, and which good uses that factor intensively
• When there are more than two goods, it is more complicated to evaluate factor
intensity and factor abundance

• Measuring the Factor Content of Trade

❖ How do we measure the factor intensity of exports and imports when there are
thousands of products traded between countries?

❖ How can we use this to test the H-O model?

• To determine whether a country is abundant in a certain factor, we compare the
country’s share of that factor with its share of world GDP

• If the share of a factor > share of world GDP

❖ The country is abundant in that factor

• If the share of factor < share of world GDP

❖ The country is scarce in that factor
Capital Abundance
• For example, 24% of the world’s physical capital is located in the US,
8.7% is located in China, 13.3% in Japan, etc.
• The final bar in the graph shows the % of each country in world
GDP
• The US had 21.6% of world GDP, China had 11.2%, Japan had
7.5%, etc.
• We can conclude that the US was abundant in physical capital in
2000
Capital Abundance
• This is true for Japan and Germany
• The opposite holds for China and India—their shares of world capital are
less than their share of GDP
• They are scarce in capital

Labor and Land Abundance

• We can use a similar comparison to determine whether each country is
abundant or not in R&D scientists, in types of labor distinguished by skill, in
arable land, or any other factor of production
• For example
• US is abundant in R&D scientists: 26.1% of the world’s total as compared to
21.6% of the world’s GDP

• The US is also abundant in skilled labor but is scarce in less-skilled labor and
illiterate labor

• India is scarce in R&D scientists: 2.5% of world’s total as compared to 5.5% of

the world’s GDP
• The US is also scarce in arable land which is surprising since we think of the US as a
major exporter of agriculture
• Another surprise is that China is abundant in R&D scientists
• These findings seem to contradict H-O model

• It is likely that the productivity of R&D scientists and arable land are not the same in
both countries
• In this case, shares of GDP are not the whole story
• We need to allow for differences in productivity
 Differing Productivities Across Countries
• If the US was exporting labor-intensive products even though it was capital-
abundant at that time

• One explanation is that labor is highly productive in the US and less productive
in the rest of the world
❖Then the effective labor force in the US is much larger than if we just count people
❖Effective labor force is the labor force times its productivity

• We can now look at differing productivities in the H-O model