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International Economics
Foundations of Modern Trade Theory
 Modern trade theory is the product of an evolution of ideas in economic thought
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b) Understand the contemporary theoretical principles used in analyzing the effects
of international trade
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The Mercantilism

If a country could achieve a favorable trade balance, it would enjoy payments
received from the rest of the world in the form of gold and silver
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
Regulations (tariffs, quotas, commercial policies, etc) are used to ensure a positive
trade balance (surplus of exports over imports)
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b) Assumes static world economy, the world’s economic pie was of constant
size; one nation’s gains from trade came at the expense of its trading
partners
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Absolute Advantage (Adam Smith)

The world’s economic pie is not a fixed quantity
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
Both trading partners could simultaneously enjoy higher levels of production and
consumption with free trade (open market)
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
Cost differences govern the movement of goods among countries
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 Smith’s concept of cost was founded upon the labor theory of value, which
assumes that within each nation:
a) Labor is the only factor of production and is homogeneous (same quality)
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

Smith’s trading principle was the principle of absolute advantage:
a) In a 2-nation, 2-product world, international trade and specialization will
be beneficial when one nation has an absolute cost advantage in one good,
and the other nation has an absolute cost advantage in the other good
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Table 2
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Each nation benefits by specializing in the production of the good that it produces at a
lower cost than the other nation, while importing the good that it produces at a higher
costs
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Comparative Advantage (David Ricardo)

Smith: Nations without absolute advantage do not gain from trade
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
Ricardo’s trade theory know as the principle of comparative advantage which
emphasized comparative (relative) cost differences
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
The more efficient nation should specialize in and export that good in
which it is relatively more efficient (where its absolute advantage is
greatest)
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3: Comparative Advantage: The US has An Absolute Advantage in
Both Goods
Output per labor hour
Nation
Wine
Cloth
United States
United Kingdom

40 bottles
20 bottles

40 yards
10 yards

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



US is 4 times as efficient in cloth production (40/10=4) but only twice as efficient in wine
production (40/20=2) compare to UK
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The output gains from specialization will be distributed to the two nations through the
process of trade
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 Refer to Table 2
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• US has a comparative advantage in cloth production (UK in wine)
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• At this wage rate, UK average cost (in dollars) of producing wine is less than the
US average cost
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Table 2
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Wine (bottles)
Price
Quant
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50
40
$0
...
50
20
£0
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80
20
$0
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6 = £1)
 In which nation is wine less expensive and cloth cheaper?
 Before we can answer the question, we must express all prices in terms of one currency –
say, the US dollar
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Thus, the UK has a comparative advantage in wine
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 Generalizes theory (modern trade theory) includes all factors, not just labor
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 Question: How does a PPS illustrates the concept of comparative advantage?
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 Answer: It relies in the slope of the PPS
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 MRT = Wheat /  Autos = the absolute value of the PPS’s slope
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1 (a): Linear PPS (Marginal Rate of Transformation)


The relative cost of each auto produced is 0
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5 =
MRT)
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1 (a): PPS - Constant Opportunity Costs

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

Given constant opportunity cost conditions, the relative cost of producing one good in
terms of other good remains the same no matter where a nation chooses to locate along its
PPS
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1 (b): Supply Schedules: Constant Opportunity Costs



Constant opportunity costs lead to linear PPS and horizontal supply schedules
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 There are two reasons for constant costs:
a) First, the factors of production are perfect substitutes for each other
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 Refer to Figures 2
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5
bushel of wheat for the US, whereas it is 2 bushels of wheat for Canada
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Basis for Trade and Direction of Trade
 Refer to Figure 2
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 Meanwhile, Canada produces and consumes at point A’ on its PPS, with 40 autos
and 80 bushels of wheat
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 The relative cost of producing an additional auto is only 0
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 According to comparative advantage, a basis for mutually favorable trade exists
owing to the differences in the countries’ relative costs
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Trading Under Constant Opportunity Costs
Figure 2
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Production Gains from Specialization
 With constant production costs, a nation will specialize in the product of its comparative
advantage
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2 (a):
 If the US moves from production point A to B, it will totally specializing in auto
production
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2 (b):
 If Canada moves from production point A’ to B’, it will totally specializing in
wheat production
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5 (a))
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5 (a): Production Gains from Specialization: Constant Opportunity Costs

Before
Specialization
Autos
Wheat

After
Specialization
Autos
Wheat

Net Gain
(Loss)
Autos
Wheat

US
Canada

40
40

40
80

120
0

0
160

80
-40

-40
80

World

80

120

120

160

40

40

Consumption Gains from Specialization
 Before trade, the consumption alternatives of US and Canada are limited to points along
their domestic PPS
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 The slope of PPS defines the domestic rate of transformation (domestic terms of trade),
which represents the relative prices at which two products can be exchanged at home
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 Table 2
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 For example:
 US and Canada agreed with a term of trade at 1:1 ratio that allows them to
consume at some points outside their respective PPS
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2, let line tt (trading possibilities line) represent the
international terms of trade for both countries
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 Point C represents the US post-trade consumption point where 60 autos is
exchanged with 60 bushels of wheat (terms of trade ration = 1:1)
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 The triangle BCD = trade triangle, showing the US exports, imports and terms
of trade
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5 (b): Consumption Gains from Specialization:
Constant Opportunity Costs

Before
Trade
Autos
Wheat

Autos

After
Trade
Wheat

Net Gain
(Loss)
Autos
Wheat

US
Canada

40
40

40
80

60
60

60
100

20
20

20
20

World

80

120

120

160

40

40

Productivity and Comparative Advantage
 Refer to Figure 2
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0
for US and 2
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 Thus, the US has comparative advantage in the production of computers
and a comparative disadvantage in auto production
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 The new MRT of auto into computers then becomes 0
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5 for Japan
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 The change in manufacturing productivity results in a change in the
direction of trade
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4: Changing Comparative Advantage



If productivity in the Japanese computer industry grows faster than it does in US, the
relative opportunity cost of US in producing computers will be higher
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Trade Restrictions
 For a nation to achieve the greatest possible gains from trade, it must produce only the
commodity of its comparative advantage
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 For example, see Figure 2
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 Thus, US should specialize in (export) manufactured goods at point B at
the terms of trade tt
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 Due to national security reasons, if US wants to produce both goods at
point D, US will achieve a lower post-trade consumption point under the
terms of trade tt’
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5: Trade Restrictions and Gains from Trade




At point C, US exports 175 manufactured goods and imports 275 barrels of crude oil at
the international terms of trade tt
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Trading under Increasing-Cost Conditions
 In the real world, a good’s opportunity cost increases as more to produce
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 The MRT = absolute slope of the PPS at a particular point
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6, the opportunity cost of
producing autos becomes larger and larger in terms of wheat scarified, and the respective
tangent lines become steeper (their slopes increases in absolute value)
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 Producers will offer more goods only if they are compensated for their rising costs of
production
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Figure 2
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7 (a): Trading under Increasing Costs: US






Before trade, US is located at point A along its PPS
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33W)
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As US specialize in auto production, it moves from point A to B, the relative cost of
autos rises (the PPS slope becomes steeper)
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7 (b): Trading under Increasing Costs: Canada

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




Before trade, Canada is located at point A’ along its PPS
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Wheat is relatively cheaper in Canada, so Canada will export wheat
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Increasing-Cost Trading Case
 The process of specialization continues in both countries until
a) The relative cost of autos is identical in both nations
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 This situation occurs when the domestic rate of transformation (domestic terms of trade)
of both nations converge at the rate given by line tt
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 Line tt becomes the international terms of trade line, it coincides with each nation’s
domestic terms of trade
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c

Table 2
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6 (b): Consumption Gains from Trade: Increasing Opportunity Costs
Before
Specialization
Autos
Wheat

After
Specialization
Autos
Wheat

Net Gain
(Loss)
Autos
Wheat

US
Canada

5
17

18
6

5
20

21
6

0
3

3
0

World

22

24

25

27

3

3

Partial Specialization
 One feature of the increasing-cost model is that trade generally leads each country to
specialize only partially in the production of the good in which it has a comparative
advantage
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 The unit costs rise as each nation produces additional amounts of its export good
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Comparative Advantage Extended to Many Products & Countries
 To move in the direction of realism, it is necessary to understand how comparative
advantage functions in a world of many products and countries
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 Each country exports the product(s) in which its comparative advantage is strongest,
and imports the product(s) in which its comparative advantage is weakest
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 A country can expect to run a sizable surpluses with trading partners that buy a lot of the
things the country exports, while trade deficits will be present with trading partners that
are low-cost suppliers of the items imported

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