Trade Theory
Why is trade mutually beneficial?
Sources: Baumol, Blinder and Scarth 1988 Economics:
Principles and Policy
Dicken 1998 Global Shift: Transforming the World Economy
David Ricardo
• 1772-1823
• The Principles of
Political Economy and
Taxation (1817)
• Law of Comparative
Advantage
Why trade?
• Global resources are not equally distributed: oil,
water, forests
• Natural endowments are also uneven: climate,
terrain
• Labour quality varies from place to place: skills,
productivity, and wages
• Specialization permits greater output per unit of
input
A Fallacy
• Nothing new is produced by trading therefore,
if one party gains, the other must lose
• Zero-sum game: one nation’s gain must be
another nation’s loss
• “Beggar thy neighbour,” Adam Smith’s term
for mercantilist approach to trade policy
International vs Intranational Trade
• Why is international trade different?
– Interprovincial trade takes place within a single
sovereign territory, one nation’s government
– Currency is the same in intranational trade
– Labour and capital are relatively mobile within
a nation and between regions
Absolute advantage
Output from 1 Person-year of Labour
In Canada
Bananas (kg)
Wheat (kg)
In Honduras
10
500
300
30
Canada has an absolute advantage in wheat
Honduras has an absolute advantage in bananas
50 years of labour are required in Canada to produce
500 kg of bananas
10 years of labour are required in Honduras to
produce 300 kg of wheat
Absolute Advantage
• It seems obvious that Canada and Honduras will
both be better off if they specialize in wheat and
bananas (respectively) and trade
• Absolute advantage results from the difference in
their factor endowments, mainly climate, soils,
and geomorphology
• But what if one country could produce both
products more efficiently? Should they trade?
• Yes!
The Principle of Comparative
Advantage
• A country (or region) should specialize in
producing and exporting those products in
which it has a comparative, or relative cost,
advantage compared with other countries
and should import those goods in which it
has a comparative disadvantage.
Ricardo’s Famous Example
of Comparative Advantage
• England and Portugal are the classic examples
• Labour is the only factor input
• Cloth and wine are the only products
Alternate Outputs from One Week of Labour Input
In England
In Portugal
Cloth (metres)
10
12
Wine (barrels)
1
6
The Arithmetic of Comparative Advantage 1
Alternate Outputs from One Week of Labour Input
In England
In Portugal
Cloth (kms)
10
12
Wine (bbls)
1
6
•
•
•
•
In England, 10 kms of cloth or 1 bbl of wine
In Portugal, 12 kms of cloth or 6 bbls of wine
So Portugal is more efficient at making both products!
But it will pay for Portugal to specialize in wine and
England to specialize in cloth…why?
The Arithmetic of Comparative Advantage 2
Alternate Outputs from One Week of Labour Input
In England
In Portugal
Cloth (kms)
10
12
Wine (bbls)
1
6
• How much more efficient is Portugal than England?
– in cloth, 12/10, 120% more efficient
– in wine, 6/1, 600 percent more efficient
• So Portugal has a comparative advantage in wine
– It is much more efficient at wine making
• And England has a comparative advantage in cloth
– It is only slightly less efficient at cloth making
Imagining Specialization
Alternate Outputs from One Week of Labour Input
In England
In Portugal
Cloth (kms)
10
12
Wine (bbls)
1
6
• Imagine that Portugal switches one week of
labour out of cloth and into wine, losing 12 kms
of cloth and gaining 6 bbls of wine
• And England switches two weeks of labour out of
wine and into cloth, losing 2 bbls of wine and
gains 20 kms of cloth
Gains from Specialization
Global Output after Specialization
Cloth (kms)
Wine (bbls)
In England
+ 20
-2
In Portugal
-12
+6
Total
+8
+4
• The world gains 8 kms of cloth and 4 bbls of
wine from the same labour force!
Opportunity Costs
Alternate Outputs from One Week of Labour Input
In England
In Portugal
Cloth (kms)
10
12
Wine (bbls)
1
6
• In England, having an additional bbl of wine means doing without 10
kms of cloth. Therefore
– The opportunity cost of 1 bbl of wine is 10/1 = 10 kms of cloth
– In Portugal, the opportunity cost of 1 bbl of wine 12/6 = 2 kms of
cloth
• Measured in opportunity costs, wine is cheaper in Portugal
– And cloth is cheaper in England
Trade makes both nations better off.
Thus:
• England should specialize in producing
cloth and export some of it
• Portugal should specialize in producing
wine and export some of it
But all this assumes…
• Factors of production are immobile
• Transportation costs are zero
• Technology is constant in both time
and space
• Perfect competition of classical trade
theory denies economies of scale
However,
• Capital and labour are mobile to some
degree
• Transportation costs are vital in many
industries e.g. concrete blocks
• Technology spreads unevenly
• Economies of scale are real
The plot thickens…
• Specialization efficiencies are enhanced by
economies of scale
• But the gains to specialization begin to
decline as the resources switched from one
product to another are not perfect
substitutes or infinitely transferable
• Actual prices and quantities traded depend
on supply and demand
So what does all this mean for regions?
• Heckscher-Ohlin Theory (1933)
– Factor endowments vary from region to region
• A country (region) should export those goods
which use intensively the factors of production
with which it is best endowed and import those
goods which require factors of production with
which it is poorly endowed.
In light of the H-O Theory, let’s
speculate on Canada’s trade structure.
What are your hypotheses?
1. What is our balance of trade in livestock?
2. What is our balance of trade in agricultural
produce and crude resource products?
3. What is our balance of trade in intermediate
goods?
4. What is our balance of trade in manufactured
goods for final sale to consumers?
Canada’s International Trade Balance, 2001
($ 000,000)
Commodity Classification
Section I Live animals
Section II Food, feed, bev. & tobacco
Section III Crude materials, inedible
Section IV Fabricated materials, inedible
Section V End products, inedible
Special transactions, trade, exports
Other balance of payments adjustments
United States
United Kingdom
Other EEC
Japan
Other OECD
All other countries
Exports
2,394
25,723
54,558
109,058
208,566
8,119
6,221
350,908
6,574
15,727
9,482
10,925
21,023
Imports Balance
398
1,996
18,674
7,050
20,939 33,619
69,444 39,614
227,895 (19,329)
6,843
1,275
6,430
(209)
255,028 95,880
11,863
(5,290)
23,225
(7,498)
10,585
(1,104)
18,626
(7,701)
31,295 (10,272)
Source: Statistics Canada 2003, Cansim II Table 228
Canada’s International Trade Balance, 2001
($ 000,000)
Commodity Classification
Section I Live animals
Section II Food, feed, bev. & tobacco
Section III Crude materials, inedible
Section IV Fabricated materials, inedible
Section V End products, inedible
Special transactions, trade, exports
Other balance of payments adjustments
United States
United Kingdom
Other EEC
Japan
Other OECD
All other countries
Exports
2,394
25,723
54,558
109,058
208,566
8,119
6,221
350,908
6,574
15,727
9,482
10,925
21,023
Imports Balance
398
1,996
18,674
7,050
20,939 33,619
69,444 39,614
227,895 (19,329)
6,843
1,275
6,430
(209)
255,028 95,880
11,863
(5,290)
23,225
(7,498)
10,585
(1,104)
18,626
(7,701)
31,295 (10,272)
Source: Statistics Canada 2003, Cansim II Table 228
Canada’s International Trade Balance, 2001
($ 000,000)
Commodity Classification
Section I Live animals
Section II Food, feed, bev. & tobacco
Section III Crude materials, inedible
Section IV Fabricated materials, inedible
Section V End products, inedible
Special transactions, trade, exports
Other balance of payments adjustments
United States
United Kingdom
Other EEC
Japan
Other OECD
All other countries
Exports
2,394
25,723
54,558
109,058
208,566
8,119
6,221
350,908
6,574
15,727
9,482
10,925
21,023
Imports Balance
398
1,996
18,674
7,050
20,939 33,619
69,444 39,614
227,895 (19,329)
6,843
1,275
6,430
(209)
255,028 95,880
11,863
(5,290)
23,225
(7,498)
10,585
(1,104)
18,626
(7,701)
31,295 (10,272)
Source: Statistics Canada 2003, Cansim II Table 228
Implications
• These lessons were an integral part of an age of
nineteenth century liberalism.
• Corn Laws 1815 to protect large landowners,
repealed 1846 by urban industrial interests
• Yet Protectionism in Canada from National Policy
of 1879 until 1989 (?)
• Neoliberalism: a new doctrine based in part on
Ricardian concept of Comparative Advantage