International Trade

Classical Trade Theory and Comparative Advantage

References

Textbooks Appleyard, D., Field, A. and Cobb, S. (2005) International Economics, McGraw-

Hill Ch. 3 Husted, S. and Melvin, M. (2007), International Economics, Addison-Wesley

Ch. 3 Krugman, P. and Obstfeld, M. (2009) International Economics: Theory and

Policy Addison-Wesley Ch. 2 & 3

Articles Balassa, B. (1963) "An Empirical Demonstration of Classical Comparative Cost

Theory“, The Review of Economics and Statistics, 45(3), pp. 231-38. Helpman, E. (1999), “The Structure of Foreign Trade”, Journal of Economic

Perspectives, 13(2), pp.121-144. Krugman, P. (1997), “Ricardo’s difficult idea”,

http://web.mit.edu/krugman/www/ricardo.htm

Importance of International Trade

World GDP is over 7 times what it was in 1950 but volume of world exports is now over 27 times what is was in 19501

MASSIVE INCREASE IN WORLD TRADE

But why? Reduction in trade barriers is certainly an important factor

1Husted and Melvin, 2007

EU trade

In 2007 the EU was the top exporter and importer of both goods and services in the world (International Trade Statistics, WTO)

So who does the EU trade with?

EU(27) exports by destination in 2007

Source: International Trade Statistics, WTO

EU(27) imports by origin in 2007

Source: International Trade Statistics, WTO

What do we trade?

In 2007 83% of the EU exports were manufactures and 61% of imports were manufactures (International Trade Statistics, WTO)

World trade is similarly dominated by manufactures (Krugman and Obstfeld, 2009)

Developing countries are also increasingly export manufactures and less agricultural products (Krugman and Obstfeld, 2009)

It is very important to understand patterns of trade, the terms of trade as well as the gains from trade.

This will then allow us to assess the impact

of various trade policies.

Rationale for International Trade

Self sufficiency means no specialisation therefore low productivity

Exchange allows specialisation in what we are good at producing

This applies to both internal and external trade Opportunity cost of self sufficiency is the loss of

foregone output in high efficiency areas Specialisation with trade allows overall production to

increase

Absolute Advantage

If Britain can produce cloth more efficiently than America and…

America can produce food more efficiently than Britain….

Both countries can gain from trade if they specialise in what they do best

On this basis Adam Smith advocated free trade (allows division of labour)

Potential Output per Unit of Labour

No Trade With Trade

Cloth Food Cloth Food

Britain 30 45 60 0

America 15 60 0 120

World 45 105 60 120

Absolute Advantage

Britain will export cloth and America will export food

Absolute Advantage

If Britain exchanges 30 units of cloth for 60 units of food…..

Both countries could have 30 units of cloth and 60 units of food

Britain gains 15 units of food and America gains 15 units of cloth

But what if America is more efficient than Britain at producing both food and cloth?

Ricardian Model

David Ricardo was an English political economist in the early 1800s who introduced the concept of comparative advantage.

Ricardo demonstrated that trade can be beneficial with only comparative advantage

A country will export a good in which their productivity is relatively high.

Assumptions of the Ricardian Model

One factor of production – labour Two goods Two countries Labour is immobile internationally but mobile

nationally (=> wages are equalised nationally but not internationally)

Zero transport costs Free trade

Potential Output per Unit of Labour

No Trade With Trade

Cloth Food Cloth Food

Britain 30 45 60 0

America 40 80 15 130

World 70 125 75 130

Comparative Advantage

Comparative Advantage

America’s superiority in cloth is 40/30 = 33% whereas superiority in food is 80/45 = 78%=> America will still export foodNotice if the ratios were the same there would be no basis for trade

Hence Britain has a comparative advantage in cloth production => Britain will still export cloth

There are also still gains from trade since a country’s consumption possibilities are greater

But do both countries always gain from trade?

It depends on:– what your production would have been with no

trade taking place– the units labour requirements for each of the

goods.

What is the impact on trade on prices (terms of trade)?

Pre-trade relative prices are equal to relative unit labour requirements

If both countries completely specialise their production the traded price of each good ends up somewhere between the two countries pre-trade prices.

As long as prices rise when countries begin trading then there are gains from trade, since the real wage rises and everybody in a country gets the same wage.

Ricardian Model

The Ricardian model is simple but nevertheless very useful in explaining trade flows.

This model allows us to reject a whole series of common claims…

‘A country will only benefit from free trade if strong enough to stand up to foreign competition’

‘Competition from foreign countries with low wages is damaging’

But there are some serious limitations of the Ricardian model…

Assumes a high degree of specialisation Assumes constant return to scale Does not discuss the effects of trade on

income distribution within countries Does not take into account the different

resources held by different countries

Supportive Empirical Evidence

Source: Balassa (1963)

Summary

We have examined the simple Ricardian model that shows countries export goods in which their productivity is relatively high, in other words in which they have a comparative advantage.

This model implies gains from trade There are gains no matter whether the trade is

‘competitive’ or ‘fair’ Studies such as that by Balassa (1963) have

confirmed the predictions of the Ricardian model empirically.