International Economics I

(Econ 2081)

Chapter Two

International Trade Theories

Habtemariam
A. 1
Trade theories answers
Basis of trade
Patterns of trade
The gains from trade

Habtemariam A. 2
Evolution of Trade Theory
Mercantilism (1500–1800)
Classical Political Economy
◦ Price-Specie-Flow Mechanism (Hume,
1752)
◦ Absolute Advantage (Smith, 1776)
◦ Comparative Advantage (Ricardo,
1817)
Neo-Classical Economics
◦ Heckscher-Ohlin Model (1919, 1933)
and extensions
Modern Economics
Habtemariam A. 3
 2.1 Mercantilism
During the period of 1500-1800, a group of writers
appeared in Europe who were concerned with
the process of nation building.
 According to the mercantilists, the central
question was how a nation could regulate its
domestic and international affairs so as to
promote its own interest.
 The solution lay in strong foreign –trade sector.
 If a country could achieve a favourable trade
balance (a surplus of exports over imports), it
would enjoy payments received from the rest of
the world in the form of gold and silver.

Habtemariam A. 4
Central to the Mercantilists thinking:
wealth was reflected in a country’s
holdings of precious metals.
Important pillars of Mercantilist thought
was the static view of world resources.
 This meant that one nation’s gain from
trade came at the expense of its trade
partners; not all nations could
simultaneously enjoy the benefits of
international trade.
◦ An increase in money supply stimulates the
economy, resulting in growth of output and
employment and not simply in inflation.
Habtemariam A. 5
Mercantilist View of the
Economy
 Nations wealth = holdings of precious
metals
 Zero-sum economy
 “Favourable balance of trade”
◦ i.e. exports good, imports bad
 Implicit assumption that the economy
was operating at less than full
employment

Conclusion: Economic activity

should be regulated
Habtemariam A. 6
Role of the government
Prohibit the export of precious
metals.
Control international trade (+ TB)
◦ Exports were subsidized
◦ Quotas and high tariffs were placed
on imports of consumption goods
◦ Tariffs on imports of raw materials
that could be transformed by
domestic labor into exportable were,
however, low or nonexistent.

Habtemariam A. 7
Mercantilist Policy
Recommendations
International
◦ Tariffs & Quotas on imports
◦ Subsidies on exports
◦ Exclusive trading rights
◦ Government control on exchange of precious metals
Domestic
◦ Regulating production (exclusive product charters, tax
exemptions, subsidies, special privileges…)
◦ Regulating labour (crafts guilds, low wages, subsidies
for children, financial incentives for marriage…)
◦ By the eighteenth century, the economic policies of
mercantilists were under strong attack.
◦ David Hume was one of those who criticized their idea.

Habtemariam A. 8
 The challenge to Mercantilism
David Hume (1752)  price-specie-
flow mechanism.
◦ Questioned the effect of money supply
and impossibility of having an all-time
+TB.
Italy (trade surplus) Spain (trade deficit)
Export > import Export < import

1: Net inflow of specie Net outflow of specie

2: Increase in money supply Decrease in money supply
3: Increase in price and wage Decrease in price and wage
4: Decrease in export and increase in import Increase in export and Decrease in
import
Until export = import Until export = import
Habtemariam A. 9
David Hume – continued
Increased exports leads to
inflation and higher prices.
Increased imports lead to lower
prices.
Result: Country A sells less
because of high prices and
Country B sells more because of
lower prices.
In the long run, no one can keep
a trade surplus. Habtemariam A. 10
2.2. Trade Theories of the
Classical School
2.2.1. Adam Smith’s Absolute
Advantage Model
 The world’s economic pie is not a fixed quantity.
 International trade permits nations to take
advantage of specialization and the division of
labor, which increase the general level of
productivity within a country and thus increase
world output.
 Nation’s wealth was reflected in its productive capacity.
 Smith saw little need for government control of the
economy.
 Specialize and export of absolute advantage
commodity.

Habtemariam A. 11
Smith’s View of the Economic
System
Nations wealth = Production capacity
Positive-sum economy
Self-interest combined with competition serves
public interest

Conclusion: Policy of laissez faire promotes

economic growth
Smith was advocating free trade.
With free trade, nations could concentrate their
production on goods they could make most
cheaply.
Cost differences governs the movement of goods
among nations.
Habtemariam A. 12
Labour theory of value
The amount of labour required to
produce a good determines its’
value
◦ Let’s assume that it takes two hours
to produce A and an hour to produce
B → A is two times more valuable
than B
The prevailing value theory until
1870s
◦ Main problem: Does not consider
utility
◦ Other problems: measurement, Habtemariam A. 13
Illustration
Considera two country, two
commodity
Assume a labor theory of value
◦ Labor is the only factors of
production and homogeneous
◦ Goods exchange for each other at
home in proportion to the relative
labor time embodied in them.
Output perU.S labor hour
U.K
Wheat 6 bags 1 bag
Cloth 4 yards 5 yards
Habtemariam A. 14
Gains from trade
 Autarky (pre-trade) price ratio
◦ U.S  6 W: 4 C
◦ U.K  1 W: 5 C or 6 W : 30 C
◦ In this example, US has an absolute advantage in production
of wheat and UK has an absolute advantage in production of
cloth.
 After trade agree to exchange 6W:6C
◦ Both countries gain
 The range for mutually beneficial trade
◦ 4C < 6W < 30C
◦ US to engage in trade should receive more than four
yards of cloth in giving six bags of wheat.
◦ U.K to engage in trade and receive 6 bags of wheat
must give an amount of cloth less than thirty.
Note: trade is mutually beneficial and results in a
positive sum game.
Habtemariam A. 15
2.2.2. David Ricardo’s Theory of
Comparative Advantage
What if a nation is more efficient
than its trading partner in the
production of all goods?
◦ Potential gains from international
trade exists
Basic assumptions
◦ Fixed endowment of resources &
identical
◦ Mobility of F.P. within and not across
◦ A labor theory of value is employed
◦ Technology is fixed Habtemariam A. 16
 ◦ Full employment level of the economy
◦ Perfect competition
◦ No government imposed obstacles
◦ Zero Internal and external
transportation costs
◦ A two country, two commodity
“world”
If one nation is efficient in both,
the more efficient nation should
specialize in the production and
export of the good in which it is
relatively more efficient.
Habtemariam A. 17
Illustration
Output per labor hour
U.S U.K
Wheat 6 bags 1 bag
Cloth 4 yards 2 yards

Gains from trade

Autarky (pre trade) price ratio
◦ U.S  6 W: 4 C
◦ U.K  1 W: 2 C or 6 W : 12 C
After trade agree to exchange 6W:6C
◦ Both countries gain
The range for mutually beneficial trade
◦ 4 C < 6 W < 12 C
Habtemariam A. 18
2.2.3. Modern Version of
Ricardo’s Comparative
Advantage Model
The law of comparative
advantage is based on a number
of simplifying assumptions:
◦ Labour theory of value
  Unrealistic
In 1936 Haberler came up with
the opportunity cost theory.
◦ lower opportunity cost  comparative
advantage.
◦ Opportunity cost can be illustrated
with PPF. Habtemariam A. 19
Consider the same illustration
Output per labor hour
U.S U.K
Wheat 6 bags 1 bag
Cloth 4 yards 2 yards

◦ Opportunity cost of wheat

 2/3  U.S and 2  U.K.
◦ Opportunity cost of cloth
 3/2  U.S and ½  U.K
U.S has a comparative advantage
in wheat and U.K has a
comparative advantage in cloth.
Habtemariam A. 20
Graphical Illustration
120 120
U.S
U.K
Cloth

Cloth

180 60
Wheat

Note: while opportunity costs are

constant in each nation, it differs
among nations, providing the basis
for trade. 21 Habtemariam A.
The basis for and the gain from
trade
No trade  the nation’s PPF also
represents its consumption
frontier
Trade  permits consumption
combinations
120 that are 120
B’

unattainable without trade.

70
E
Cloth
Cloth E’
A
60 50
A’
40

B
180
90 110 40 60 70 Wheat
Wheat
Habtemariam A. 22
Gains
◦ U.S gains 20W and 10C
◦ U.K gains 30W and 10C
 An increment in world output is by 50W
and 20C resulting from specialization.
Complete specialization
◦ The gain from trade will be
maximum when the two nations
completely specialize.
◦ Exception  if one of the country is
too small to supply what the trading
partner needs.
Habtemariam A. 23
Misconceptions about
Comparative Advantage
Productivity and Competitiveness -
(Myth 1): Free trade is beneficial only if
your country is strong enough to stand
up to foreign competition.
◦ “What if there is nothing you can produce
more cheaply or efficiently than anywhere
else, except by constantly cutting labor
costs?”
 The competitive advantage of an industry
depends not only on its productivity relative to
the foreign industry, but also on the domestic
wage rate relative to the foreign wage rate. A
country’s wage rate, in turn, depends on relative
productivity in its other industries.
Habtemariam A. 24
The Pauper Labor Argument –
(Myth 2): Foreign competition is
unfair and hurts other countries
when it is based on low wages.
◦ Industries should not have to cope
with foreign industries that are less
efficient but pay lower wages.
 One country wage rate is irrelevant to the
gain by other.
Exploitation – (Myth 3): Trade
exploits a country and makes it
worse off if its workers receive
much lower wages than workers
in other nations. Habtemariam A. 25
2.2.4. An Extension and Critical
Examination of the Classical
Model of Trade
The classical model in money
terms
Illustration
◦ Labor requirements and money price
in a RicardianCloth
framework Wine
Wage/hr Labor/unit Price Labor/unit Price
England £1/hr 1hr/yard £1 3hrs/bottle £3
U.S $0.6/hr 2hrs/yard $1.2 4hrs/bottle $2.4

Habtemariam A. 26
England has an absolute
advantage in both goods.
Assume that the fixed exchange
rate is $1 = £1.
◦ England  Comparative adv.  Cloth
◦ U.S.  Comparative adv.  Wine

Habtemariam A. 27
Comparative advantage
extended to many products and
many countries
Multiple commodities
◦ Commodities should be placed in
ascending order according to their
relative labor requirements.
◦ Each country export the product(s) in
which it has the greatest
comparative
Wine Cutlery
advantage
Cloth Hardware Wheat Cheese

Spain 4hrs 12hrs 6hrs 15hrs 5hrs 7hrs

Germany 3hrs 4hrs 5hrs 6hrs 2.8hrs 3hrs

Habtemariam A. 28
Cloth < Wine < Wheat < Cheese < Hardware <
Cutlery
6/5 4/3 5/2.8 7/3 15/6 12/4
Spain comparative advantage Germany comparative
advantage

Multiple countries
Labor requirement in a two good, three country case
Fish Cutlery Autarky price ratio
Sweden 4hrs/kg 10hrs/unit 1C : 2.5F
Germany 5hrs/kg 15hrs/unit 1C : 3F
France 5hrs/kg 20hrs/unit 1C : 4F

The incentive for trade will be greatest

between the two countries with the
greatest difference in autarky prices.
Habtemariam A. 29
The equilibrium ToT 1C : 2.5F and 1C :
4F
◦ Sweden has a comparative
advantage in cutlery,
◦ France has a comparative advantage
in fish.
◦ But, what of Germany?
 Depends on the international terms of
trade.
 Case one:- 1C : 3F
 no any incentive for Germany to engage in trade
 Case two:- 1C : > 3F
 Germany export cutlery and import fish.
 Case three :- 1C : < 3F
 Export of fish and import of cutlery. Habtemariam A. 30
Evaluating the classical model
 MacDougall in 1951 examined the
relative export performance in U.S and
U.K.
◦ Relative to the U.K, the U.S has been more
competitive in world markets whenever its
labor was more productive than that of U.K
 Stephen S. Golube (1996) focused on
U.S trade with various countries.
◦ Unit labor costs differ by specific industries
across countries, reflecting comparative
advantage in production.
◦ Relative productivity, unit labor costs, and
bilateral trade patterns did appear to be
consistent with classical theory.
Habtemariam A. 31
2.3. The Neoclassical Trade Theory

Analyze the impact of

international trade in a more
rigorous and less restrictive
manner.
Centered on a fuller development
of the demand side and the
production side of the economy.
◦ Introduce the more realistic case of
increasing opportunity cost.

Habtemariam A. 32
The explanation is based on
◦ PPF  concave (increasing OC) b/c
F.P.
 are not homogeneous
 are not used in the same fixed proportion
◦ Slope of PPF  MRT = MCx/MCy
◦ Community indifference curve
(CIC)
 represents the welfare of a country
 differ across countries because of
difference in tastes or demand
preferences.
◦ Slope of CIC  MRS = MUx/MUy
Habtemariam A. 33
 Gains from Trade in Neoclassical
Theory
Autarky (pre-trade)
Good Y equilibrium Good Y
Nation 2
Nation 1

E’
(px/py)

(px/py)

Good X Good X

Habtemariam A. 34
 Introduction of international
trade
Opening of a country to
international trade  a new set of
relative prices.
Source of gain is the difference in
Good Y
relative prices in autarky between
Good Y
Nation II
Nation I

countries. Y5
A’

Y3 B

Y1 F’ B’
E Y6
(px/py)I Y4 E’
(px/py)II’
Y2 F A
(px/py)I’ (px/py)II

X1 X3 X2 X5 X4 X6
Habtemariam A. 35
The total gain from trade can be
divided into two conceptually
distinct parts
◦ The consumption gain (gain from
exchange)
◦ The production gain (gains from
Good Y

specialization)
E”

E’

(px/py)1
(px/py)2
A

Habtemariam A. 36
Offer Curves and the Terms of
Trade
The offer curve (reciprocal
demand curve) shows the
country’s willingness to trade at
various terms of trade.
Good Y
Nation I

Nation I Imports

Nation I offer curve

y4
D (px/py)2
Y3 B

E (px/py)1
(px/py)0
Y2 F
A

Y5 G (px/py)1 y2y3 (px/py)0

C

(px/py)2
x1x3 x4 x2 Nation I Exports
Good X x3 x2 x4x5
x5
Habtemariam A. 37
There is nothing new analytically
about country II’s offer curve. The
only difference is that country II
exports good Y and imports good
X.
Nation II Export (px/py)0 (px/py)2
(px/py)1

Nation II offer curve

y2y3

E x3 x2 Nation II Imports
x24x5

Habtemariam A. 38
Determination of equilibrium price
ratio
With the two countries offer
curve it is possible to determine
the equilibrium terms of trade.
◦ Terms of trade is defined as the ratio
of the price of country’s export
commodity to the price of its import
commodity.
◦ The equilibrium terms of trade is at
the intersection of the offer curves of
the two nations.
 Balanced trade

Habtemariam A. 39
 Good Y

Nation I imports
(Px/Py)E
Nation I offer curve
Nation II exports
(Px/Py)1

y2 E Nation II offer curve

B

y1 A

x1 x2
Good X
Nation I exports

Nation II imports

A nation offer curves might

change because of a change in
the nation’s testes and demand
preferences.
◦ New terms of trade Habtemariam A. 40
2.3.1. Factor Endowment and
the Heckscher-Ohlin Theory
Difference in relative prices in
autarky is the basis for trade. Why
price difference?
◦ Factor endowments
Assumptions
◦ 2 countries, 2 goods, and 2 inputs
◦ Technology is identical in both
countries
◦ Constant return to scale
◦ Different factor intensities
Habtemariam A. 41
◦ Tastes and preferences are the same
 ◦ Mobility of factors within but not across
◦ No transportation costs & other barriers
◦ Incomplete specialization
◦ All resources are fully employed
◦ International trade is balanced.
Factor endowment/abundance
◦ Physical definition
◦ Price definition
Factor intensity
◦ The slope of a straight line drawn from
the origin shows the capital-labor ratio
in the production of the commodity.

Habtemariam A. 42
The Heckscher-Ohlin Theorem
Differing factor endowment
◦  Different PPF
◦  Different relative commodity prices
Heckscher-Ohlin (H-O) theory can
be stated as:
◦ A nation will export the commodity
whose production requires the intensive
use of the nation’s relative abundant
and cheap factor and import the
commodity whose production requires
the intensive use of the nation’s
relatively scarce and expensive factor.43
Habtemariam A.
 Illustration
IC0 IC1
Commodity Y Nation II Nation II
Commodity Y

y2
B’

A’
A’
Nation I y3 Nation I C’ E

A A IC1
C
y1
IC0
(Px/Py)II B
(Px/Py)I
(Px/Py) e
x2 x3 x1

Commodity X Commodity X

Habtemariam A. 44
Alternative Explanation of H-O
Theory: Price Criterion (Reading
Assignment)
The fact that the price of capital
is lower in U.S indicates that U.S
is a capital abundant nation and
the price of land is lower in
Canada because she is endowed
Capital
PU
PU

with land.
X Y
A

PC

PC

B W
aa
C Z
ww
PC
O D E PU PU F PC
Land

Habtemariam A.
45
Empirical Tests of the Factor
Endowments Model
Empirical tests showed some
conflicting results on the real
world validity of the H-O theorem.
The Leontief Paradox
◦ Leontief made use of his own
invention – an input-output table
using U.S. data of 1947.
◦ Leontief expected to find that US
exported capital intensive
commodities and imported labor
intensive commodities. Habtemariam A. 46
 ◦ Leontief statistic for the U.S. was 1.3,
which is totally an expected for a
relatively capital abundant country.
Suggested explanations for the
Leontief paradox
Possible explanations for these
findings include
◦ that the U.S. has a special advantage
in producing products made with
innovative technologies that are less
capital intensive
◦ differences in technology lead to
differences in productivity which
then drives trade patterns.
Habtemariam A. 47
2.3.2. The Factor Price
Equalization (H-O-S) Theorem
and Income Distribution
Factor Price Equalization
Theorem
International trade will bring
about equalization in the relative
and absolute returns to
homogeneous factors across
(Px/Py)2

nations.
(Px/Py)1= (Px/Py)2

A
(Px/Py)1

(w/r)1 (w/r)2

Habtemariam A. 48
Factor Price Equalization

•Unlike the Ricardian model, the Heckscher-

Ohlin model predicts that factor prices will
be equalized among countries that trade.
Free trade equalizes relative output prices.
Due to the connection between output
prices and factor prices, factor prices are
also equalized.
Trade increases the demand of goods
produced by relatively abundant factors,
indirectly increasing the demand of these
factors, raising the prices of the relatively
abundant factors.
Habtemariam A. 49
Factor Price Equalization
In the real world, factor prices are not
equal across countries.
The model assumes that trading
countries produce the same goods, but
countries may produce different goods if
their factor ratios radically differ.
The model also assumes that trading
countries have the same technology, but
different technologies could affect the
productivities of factors and therefore
the wages/rates paid to these factors.

Habtemariam A. 50
The model also ignores trade barriers and
transportation costs, which may prevent
output prices and thus factor prices from
equalizing.
The model predicts outcomes for the long
run, but after an economy liberalizes trade,
factors of production may not quickly move
to the industries that intensively use
abundant factors. –In the short run, the
productivity of factors will be determined by
their use in their current industry, so that
their wage/rental rate may vary across
countries.
Habtemariam A. 51
The Stolper-Samuelson Theorem

With full employment both before

and after trade takes place, the
increase in the price of the
abundant factor and the fall in the
price of the scarce factor because
of trade imply that the owners of
the abundant factor will find their
real incomes rising and the
owners of the scarce factor will
find their real incomes falling.
Habtemariam A. 52
Income Distribution and Trade:
the Stolper-Samuelson Theorem
Stolper-Samuelson Theorem:
real income of the owners of
abundant factor increases and
the real income of owners of
scarce factor decreases
◦Think about the labour
abundant country (e.g. China):
Free trade → r ↓ w ↑ →
capital/labour ratio ↑ → labour
productivity ↑ → real wages ↑

Habtemariam A. 53
Why Don’t We Observe Price
Equalization?
Inreality most of the assumptions
needed for price equalization do not
hold
◦ e.g. differences in productivity /
technology, transportation costs, tariffs,
subsidies, imperfect competition,
unemployed resources, externalities…
However, the model provides an
important insight on the tendency of
price movements due to increasing
international trade.
Habtemariam A. 54
2.3.3. The Rybczynski Theorem
Developed in 1955 by
The theorem demonstrates how a
change in an endowment affects the
outputs of the goods when full
employment is maintained.
It states that at constant relative goods
prices, a rise in the endowment of one
factor will lead to a more than
proportional expansion of the output in
the sector which uses that factor
intensively, and an absolute decline of
the output of the other good.
Habtemariam A. 55
Illustration

Habtemariam A. 56
Summary of the Heckscher-Ohlin
model
Differences in relative
endowments of factors of
production → Comparative
advantage
Trade leads to
◦ Expansion of the industry using
intensively the abundant factor of
production (Heckscher-Ohlin Theorem)
◦ Changes in distribution of
income (international factor price
equalization, Stolper-Samuelson theorem)
Habtemariam A. 57
2.4. The New Trade
Theories
[Link] Linder’s (Overlapping
Demand) Theory
 A dramatic departure from the H-O
model because it is almost exclusively
demand-oriented.
 The main force influencing
manufactured-goods trade is a
domestic demand condition.
◦ manufacture goods for which there is a large
domestic market.
◦ This market determines the set of goods that
these firms will have to sell when they begin
to export. Habtemariam A. 58
Linder contends that tastes of
consumers are conditioned
strongly by their income levels.
Nations with similar per capita
incomes will have overlapping
demand structures.

Habtemariam A. 59
2.4.2. Technological Gap and
Product Cycle Model
The Imitation and Demand Lags Theory
Michael V. Posner introduced the
hypothesis
It assumes that the same technology
is not always available in all countries
There is a delay in the transmission or
diffusion of technology from one
country to another.
Trade exists only if the imitation lag is
greater than the demand lag.
Habtemariam A. 60
The Product Cycle Theory

Developed in 1966 by Raymond

Vernon. It builds on the imitation
lag model of Posner in its
treatment of delay in the
diffusion of technology.
The life cycle of a “new product”
is divided into five stages/phases.

Habtemariam A. 61
 Graphical illustration
Quantity Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Consumption
Innovating
Exports country
Production

Production
Imitating
country
Exports
Consumption

Imports

Time

Habtemariam A. 62
2.4.3. Economies of Scale and
Specialization
Developed by Marray C. Kemp in
1964.
Mutually beneficial trade can
take place with increasing return
to scale, even when the two
Good Y

nations are identical in every

A

respect. D

E’

Good X
63
Habtemariam A.
How might trade operate with
economies of scale relaxing the
assumption that the two nations
are identical in every respect?
Computer

125 D

United States

B
South Korea
A

C
Tons of steel

Habtemariam A. 64
2.4.4. Inter-Industry versus
Intra-Industry Trade
Inter-industry trade is a trade of
products that belong to different
industries.
Intra-industry trade is a trade of
products that belong to the same
industry.
Benefits intra-industry trade:
◦ Provides a wide range of choice in
products
◦ Economies of scale Habtemariam A. 65
Armstrong and Taylor suggest that
the level of intra-industry trade is
highest in closely integrated
economies.
Greenaway (1995), suggests that
intra-industry trade is of two
types:
◦ Horizontal where goods of roughly
the same quality are traded.
◦ Vertical where goods are exchanged
within the same industry but at
different levels of quality and at
different stages in the production
Habtemariam A. 66
-----End of Chapter Two-----

Habtemariam A. 67