SECTION 4

MONEY, BANKING AND

INTERNATIONAL
TRADE

Part One:
Basics of International
Trade and Its Applications

0
 International Trade Theories of Goods

Absolute Comparative
Opinion of
Advantage Advantage
Mercantilism
Theory Theory

Classical Modern
Trade Trade
Theories Theories

Constant Opportunity Cost

Comparative Advantage:
Opportunity Cost Theory
Increasing Opportunity Cost

***
Modern trade theory is a result of an evolution of ideas of the
mercantilists, classical economists such as Adam smith, David
Ricardo, John Stuart Mill and other economists.

1
Opinion of Mercantilism (The mercantilists 1500-1800):
A group of writers appeared in Europe, where the central
question was ... How could a nation regulate its domestic and
international affairs to promote and maximize its own interest?
The solution from mercantilism's point of view was promoting
favourable trade balance by increasing exports and decreasing
imports at least the increasing of exports should be more than
the increasing of the imports.
The net payments received from the world in the form of gold and
silver should be positive.

Revenue of Exports > Payments of Imports

Gold & Silver > Gold & Silver

The mercantilists advocated government regulations of trade as

tariffs, quotas and other restricted policies.
Accordingly, the mercantilists policy aims to minimize the
imports to protect nations position in the trade. By 18th
century, the economic policies of mercantilists were attacked by
many economists especially David Hume.
Why favourable trade balance only will be existed in the short run,
but in the long run will be eliminated?
The Answer is that surplus increase the stock of the precious
metals of gold and silver, but the increasing of money supply leads
to increasing of market prices as a result of these reasons Less
exports and more imports and the surplus will be eliminated.

2
Absolute Advantage (Adam Smith):
Adam smith is the leader of absolute advantage theory, according to
this theory the international movements of goods among nations is a
result of the difference of absolute advantages among the
countries. It will be generated from highly productivity of labour and
less labour cost.
Smith sought that:
* The production cost of goods differs among nations
because of the differences of the productivity of labour.
* The productivity in any nation is based on the natural
and acquired advantages (Climate, Soil and mineral
Wealth). Each nation would produce goods that have
absolute advantage in, this advantage makes the nations
more competitive than its trading partner (it could
produce with low cost).
* According to smith theory, the cost of production based
on the labour theory of value which means that the labour
is the only factor of production, and it is homogenous
(the same quality).

To explain the theory of absolute advantage, there are some

simplified and main assumptions:

Simplified assumptions Main assumptions

Two countries Free trade and market system

Two products Cost of production measured

by working hours (labor).

3
 Let’s make it clearer using an Example!

Nations Wine Cloths

Simplified Assumptions:
1- Two countries which are USA and UK.
2- Two goods which are Cloths and Wine. 5 20
USA
Main Assumptions: Bottles Yards
1- Free trade and free market system
2- The cost of production measured only 15 10
by working hours (labor).
UK
Bottles Yards

Based on this table,

UK can produce wine with low cost as it uses less labour to produce
wine product than USA.
Therefore, UK has an absolute advantage in producing wine
(more efficient).
USA can produce cloths with low cost as it uses less labour to produce
cloths product than UK.
Therefore, USA has an absolute advantage in producing
cloths (more efficient).
After Trade,
USA will specialize in producing cloths and export it because it has an
absolute advantage in producing it and will import wine because it has
an absolute disadvantage in producing it.

4
UK will specialize in producing wine and export it because it has an
absolute advantage in producing it and will import cloths because it has
an absolute disadvantage in producing it.

In Conclusion, international specialization and trade will be

beneficial for both nations because:
Each nation will import its need with low cost and low price, the
consumers in both nations will achieve more welfare.
The earn from international trade generates from specialization and
labour division which leads to high productivity and less cost.

Comparative advantage theory (Recardo):

According to Ricardo, the international trade is a result of the
differences of the comparative advantage among nations.
He answered a question that Adam Smith didn’t explain or answer,
the question was ... what happens If a country has absolute
advantages in both products?
The answer according to Adam Smith is that in this case there is
no international trade but according to comparative advantage
principle, if a nation has an absolute advantage in both goods, the
mutual benefits from international trade still existed.
How will it still exist?
* The less efficient nations in both goods should
specialize in and exports the good that is relatively less
inefficient in producing it because the country is
inefficient in both goods, so that it should specialize in
5
 good that is less inefficient in its production, where
its absolute disadvantages least.
* The more efficient nations should specialize in and
export good that is relatively more efficient in
producing it, where its absolute advantage is greater.

Ricardo formulated as simplified model based on the

following assumptions:
1- Two nations, each using a single input to produce two
products.
2- No money illusion. ‫النه يعتبر تبادل بين سلعتين‬
3- Exports must pay for imports.
4- The cost of each product is measured only by labor
based on the labor theory of value, labor fully
employed and homogenous and fixed.
5- labor can move free among industries in each nation
and can`t move among nations. (freedom of labor
movement in the same nation)
6- The production methods are similar (The level of
technology) and fixed inside the same nation but could
be different among nations.
7- Perfect competition in all markets.
8- Free trade between nations, no government barriers.
9- No transportation cost.
10- The producers aim to maximize their profit, and
consumers aim to maximize their satisfaction.

6
 Let’s make it clearer using an Example!

Nations Wine Cloths

40 40
USA
Bottles Yards
20 10
UK
Bottles Yards

Based on this table,

USA could produce 40 yard of clothes per hour, but UK only produce 10
per hour.
USA could produce 40 bottles of wine per hour, but UK could produce
only 20 bottles.
It means USA has absolute advantages in both goods and there is NO
absolute advantage for UK.
According to comparative advantage,
USA workers comparing UK are four times efficient in clothes (40/10),
but only two times efficient in wine (40/20), for this reasons USA
relatively is more efficient in producing clothes and less efficient in
producing wine although it could produce both goods with low cost
than UK.
USA has an absolute advantage in clothes and wine, while UK has an
absolute disadvantage in wine and clothes.
After Trade,
USA will transfer its economic resources from wine to cloths after
international trade then it will specialize in cloths and export it.

7
UK will transfer its economic resources from cloths to wine after
international trade then it will specialize in wine and export it.

In Conclusion,
Applying comparative advantage, the USA should
specialize in clothes, but UK specialize in wine, both countries
achieve gains from specialization and trade.
Each country will specialize and export those goods that their
labour productivity relatively high.

NOTE THAT:
According to Smith, no mutual benefits from specialization and trade
because there is no difference of the absolute advantage between two
nations, but according to Ricardo and the comparative advantage, the
mutual benefits between two nations existed and both countries can
achieve gains from trade.

***
Exit Barriers (Constraints of Specialization):
According to principle of comparative advantage, an open trading system
competition enforces the highly cost firms to exit from the market and
only the firms that could produce with low cost will continue in
operation in the long term.

Let’s make it clearer using an Example!

8
 USA Steel Industry: -
Throughout the past three decades, the industry analysts
maintained that overcapacity has been a key problem facing
USA steel companies.
Overcapacity has been caused by many factors such as
imports with low price, as a result reduced demand on USA
steel, more stock, overcapacity existed.
The Solutions,
Installation of modern technology that allows greater
productivity and increase the output of steel with fewer
inputs of capital and labour.