CHAPTER 2: THEORY OF INTERNATIONAL TRADE.
QUESTION FOR REVIEW.
1.
What are the basic questions that we seek to answer in this chapter? In what way is the
model presented in this chapter an abstraction or a simplification of the real world? Can the model
be generalized?
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There are 2 fundamental questions that economics learners like ourselves need to answer:
The model is an abstraction for the real world since it could explain the pattern of trade and
gains from trade using the law of comparative advantage. That model can also be a simplification
for the real world by using 2 nations and 2 commodities, then generalizing to trade in more than 2
commodities and among more than 2 nations.
The model could be generalized as the following: Assuming there are 2 nations with 2
commodities, the law of comparative advantage will determine which commodities that a nation
should export and import to gain from international trade.
2.
What were the mercantilists’ views on trade? How does their concept of national wealth
differ from today’s view?
a. The mercantilists believed that a nation could gain in international trade only at the expense of other
nations. As a result, they supported restrictions on imports, incentives for exports, and strict government
regulation of all economic activities.
b. The mercantilists measured the wealth of a nation by the stock of precious metals it possessed.
Whereas in present days, we measure national wealth by its stock of human, man-made, and natural
resources available for producing goods and services.
3.
Why is it important to study the mercantilists’ views on trade? How were their views
different from those of Adam Smith? What is the relevance of all this today?
a. They play a vital role due to 2 reasons. First of all, the ideas of Adam Smith, David Ricardo, and other
classical economists can best be understood if they are regarded as reactions to the mercantilists’
views on trade and on the government’s role. In addition, today there seems to be a resurgence of
neo-mercantilism, as nations plagued by high levels of unemployment seek to restrict imports with an
aim to stimulate domestic production and employment.
b. While the mercantilists believed that only 1 nation can gain benefits from international
trade, Adam Smith indicated that both nations participating in this specific business activity can both
gain from it.
c. Today, though most nations claim to be in favor of free trade, most of them continue to implement
several restrictions on international trade (by using tariffs, quotas, etc…)
4.
What was the basis for and the pattern of trade according to Adam Smith? How were gains
from trade generated? What policies did Smith advocate in international trade? What did he think
was the proper function of government in the economic life of the nation?
a. According to Adam Smith, trade between nations (assuming there are 2 countries) is based
on absolute advantage. Both nations can gain by specializing in the production of the commodity of its
absolute advantage and exchanging part of its output with the other nation for the commodity
of its absolute disadvantage.
b. Resources can be best utilized and the output of both commodities will rise. This increase in the
output of both commodities measures the gains from specialization in production available to
be divided between the two nations through trade.
c. He strongly advocated the policy of laissez-faire (i.e., as little government interference
with the economic system as possible).
d. According to Smith’s opinion, the government may have a few functions in the economic life of the
nation, for example, protection of industries important for national defense.
5.
In what way was Ricardo’s law of comparative advantage superior to Smith’s theory of
absolute advantage? How do gains from trade arise with comparative advantage? How can a nation
that is less efficient than another nation in the production of all commodities export anything to
the second nation?
a. Smith only discussed two nations which had its own absolute advantage. In the meantime, Ricardo
added the appearance of a nation that was less efficient in the production of two commodities.
b. Gain from trade can arise with comparative advantage as long as the absolute disadvantage that the
first nation has with respect to the second is not in the same proportion in both commodities.
c. The less efficient nation should specialize in the production and export of the commodity in which its
absolute disadvantage is smaller.
6.
What is the exception to the law of comparative advantage? How prevalent is it?
a. The exception to the law of comparative advantage is that there is no comparative advantage. This
situation occurs when the absolute disadvantage that one nation has with respect to another nation
is the same in both commodities.
b. Its occurrence is rare and a matter of coincidence. Additionally, natural trade barriers such as transport
costs can prevent trade even when some comparative advantage exists.
7.
Why is Ricardo’s explanation of the law of comparative advantage unacceptable? What
acceptable theory can be used to explain the law?
a. Ricardo’s reliance on the labor theory of value in an effort to make a simple explanation of
comparative advantage is understandable, however, it is considered unacceptable. Because these
assumptions are not true, “either labor is the only factor of production or labor is used in the same fixed
proportion in the production of all commodities” and “labor is homogeneous (i.e., of only one
type)”.
b. An acceptable theory can be utilized to explain the law is the opportunity cost theory.
8.
What is the relationship between opportunity costs and the production possibility frontier
of a nation? How does the production possibility frontier look under constant opportunity costs?
What is the relationship between the opportunity cost of a commodity and the relative price of that
commodity? How can they be visualized graphically.
a. The Production Possibilities Curve (PPC) is a model that captures scarcity and the opportunity costs
of choices when faced with the possibility of producing two goods or services.
b. Production possibilities frontier (PPF) would be a downward straight line under constant opportunity
costs.
c. The opportunity cost of a commodity is equal to the relative price of that commodity.
d. They are visualized graphically by the slope of the production possibility frontier.
9.
Why is a nation’s production possibility frontier the same as its consumption frontier in the
absence of trade? How does the nation decide how much of each commodity to consume in the
absence of trade?
a. Without trade, a nation can only consume the commodities it produced, therefore, PPF
also represents the consumption frontier.
b. A nation can make its decision in consuming each commodity through its PPF.
10.
What is meant by complete specialization? By incomplete specialization? Why do both
nations gain from trade in the first instance but only the small nation in the second?
a. Complete specialization means the utilization of all of a nation’s resources in the production of only
one commodity with trade. This usually occurs under constant costs.
b. Incomplete specialization means the continued production of both commodities in both nations with
increasing costs, even in a small nation with trade.
c. This situation happens because at first, both nations gain by its own comparative advantage. The
small nation gains in the second thanks to its complete specialization and a smaller market
compared to the big nation.
11.
How is the combined supply curve of both nations for each of the traded commodities
determined? How is the equilibrium-relative commodity price determined with trade?
a. The combined supply curve of both nations for each commodity is determined if both nations used all
of their resources to produce that commodity.
b. With trade, the equilibrium-relative commodity price of each commodity is between the
pre-trade relative commodity price in each nation.
12.
What are the results of empirical testing of the Ricardian model?
The results from empirical testing by MacDougall stated that those industries where labor productivity
was relatively higher in the US than the UK were the industries with the higher ratios of US to UK exports
to third countries.
PROBLEM
1. Table 2.5 shows bushels of wheat and the yards of cloth that the United States and the United
Kingdom can produce with one hour of labor time under four different hypothetical situations. In
each case, identify the commodity in which the United States and the United Kingdom have an
absolute advantage or disadvantage.
In case A, the United States has an absolute advantage in wheat and the United Kingdom in cloth.
In case B, the United States has an absolute advantage (so that the United Kingdom has an
absolute disadvantage) in both commodities.
In case C, the United States has an absolute advantage in wheat but has neither an absolute
advantage nor disadvantage in cloth.
In case D, the United States has an absolute advantage over the United Kingdom in both
commodities.
2. With respect to Table 2.5, indicate in each case the commodity in which each nation has a
comparative advantage or disadvantage.
In case A, the United States has a comparative advantage in wheat and the United Kingdom in
cloth.
In case B, the United States has a comparative advantage in wheat and the United Kingdom in
cloth.
In case C, the United States has a comparative advantage in wheat and the United Kingdom in
cloth.
In case D, the United States and the United Kingdom have a comparative advantage in neither
commodity.
3. With respect to Table 2.5, indicate in each case whether or not trade is possible and the basis for
trade.
In case A, trade is possible based on absolute advantage.
In case B, trade is possible based on comparative advantage.
In case C, trade is possible based on comparative advantage.
In case D, no trade is possible because the absolute advantage that the United States has over the
United Kingdom is the same in both commodities.
4. Suppose that in Case B in Table 2.5 the United States exchanges 4W for 4C with the
United Kingdom.
(a) How much does the United States gain in terms of cloth?
(b) How much does the United Kingdom gain in terms of cloth?
(c) What is the range for mutually beneficial trade?
(d) How much would each nation gain if they exchanged 4W for 6C instead?
a)
b)
c)
d)
The United States gains 1C.
The United Kingdom gains 4C.
3C < 4W < 8C.
The United States would gain 3C while the United Kingdom would gain 2C.
5. Use the information for Case B in Table 2.5 and assume that labor is the only factor of production
and is homogeneous (i.e., all of one type).
(a) What is the cost in terms of labor content of producing wheat and cloth in the United States and
the United Kingdom?
(b) What is the dollar price of wheat and cloth in the United States if the wage rate is $6?
(c) What is the pound price of wheat and cloth in the United Kingdom if the wage rate is £1?
a) The cost in terms of labor content of producing wheat is 1/4 in the United States and 1 in the
United Kingdom, while the cost in terms of labor content of producing cloth is 1/3 in the United
States and 1/2 in the United Kingdom.
b) In the United States, Pw= $6/4=$1.50 and Pc=$6/3=$2.00.
c) In the United Kingdom, Pw=£1/1=£1.00 and Pc=£1/2=£0.50.
6. Answer the following questions with reference to Problem 5.
(a) What is the dollar price of wheat and cloth in the United Kingdom if the exchange rate between
the pound and the dollar is £1 = $2? Would the United States be able to export wheat to the United
Kingdom at this exchange rate? Would the United Kingdom be able to export cloth to the United
States at this exchange rate?
(b) What if the exchange rate between the dollar and the pound were £1 = $4?
(c) What is the exchange rate were £1 = $1?
(d) What is the range of exchange rates that will allow the United States to export wheat to the
United Kingdom and the United Kingdom to export cloth to the United States?
a) With the exchange rate of £1=$2, Pw=2/1= $2.00 and Pc= 2/2=$1.00 in the United Kingdom, so that
the United States would be able to export wheat to the United Kingdom and the United Kingdom would
be able to export cloth to the United States.
b) With the exchange rate of £1=$4, Pw=4/1=$4.00 and Pc=4/2=$2.00 in the United Kingdom, so that
the United States would be able to export wheat to the United Kingdom, but the United Kingdom would
be unable to export any cloth to the United States.
c) With £1=$1, Pw=1/1=$1.00 and Pc=1/2=$0.50 in the United Kingdom, so that the United Kingdom
would be able to export both commodities to the United States.
d) $1.50 < £1.00 < $4.00
7. Assume that the data in Case B in Table 2.5 refer to millions of bushels of wheat and millions of
yards of cloth.
(a) Plot on graph paper the production frontiers of the United States and the United Kingdom.
(b) What is the relative price of wheat (i.e., PW/PC in the United States and in the United Kingdom
in autarky (no trade)?
(c) What is the relative price of cloth (i.e., PC/PW in the United States and in the United Kingdom
in autarky?
a) See Figure 1.
b) In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.
c) In the United States Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.
8. Using the United States and United Kingdom production frontiers from Problem 7, assume that
the no-trade or autarky point is 3W and 3/4C (in million units) in the United States and 1/2W and
1C in the United Kingdom. Also assume that with the opening of trade the United States exchanges
1W for 1C with the United Kingdom. Show graphically for the United States and the United
Kingdom the autarky (or no-trade) point of production and consumption, the point of production
and consumption with trade, and the gains from trade.
See Figure 2.The autarky points are A and A' in the United States and the United Kingdom,
respectively. The points of production with trade are B and B' in the United States and the United
Kingdom, respectively. The points of consumption are E and E' in the United States and the United
Kingdom, respectively. The gains from trade are shown by E > A for the U.S. and E' > A' for the U.K.
9.
(a) What would be the equilibrium-relative commodity price of wheat if DW(US+UK) shifted up by
one-third in the left panel of Figure 2.3? How much wheat and cloth would the United States and
the United Kingdom then produce?
(b) What does the answer to part (a) imply for DC(UK+US) in the right panel of Figure 2.3?
a) If DW(US+UK) shifted up in Figure 2.3, the equilibrium relative commodity price of wheat would also
rise by 1/3 to PW/PC=4/3. Since the higher DW(US+UK) would still intersect the vertical portion of the
SW(US+UK) curve, the United States would continue to specialize completely in the production of wheat
and produce 180W, while the United kingdom would continue to specialize completely in the production
of cloth and produce 120C.
b) Since the equilibrium relative commodity price of cloth is the inverse of the relative commodity price
of wheat, if the latter rises to 4/3, then the former falls to ¾.This means that DC(UK+US) shifts down by 1/3
in the right panel of Figure 3.
10. What would happen if DW(US+UK) intersected the horizontal portion of SW(US+UK) at
PW/PC = 2/3 and 120W in the left panel of Figure 2.3? What would this imply for specialization in
production and the distribution in the gains from trade between the two nations?
If DW(US+UK) intersected SW(US+UK) at PW/PC =2/3 and 120W in the left panel of Figure 2.3, this
would mean that the United States would not be specializing completely in the production of wheat. The
United Kingdom, on the other hand, would be specializing completely in the production of cloth and
exchanging 20C for 30W with the United States. Since the United Kingdom trades at U.S. the pre-trade
relative commodity price of PW/PC=2/3 in the United States, the United Kingdom receives all of the
gains from trade.
12. (a) How was the Ricardian trade model tested empirically?
(b) In what way can the results be said to confirm the Ricardian model?
(c) Why do we then need other trade models?
a) The Ricardian model was tested empirically by showing the positive correlation between relative
productivities and the ratio of U.S.to U.K. exports to third countries and by the negative correlation
between relative unit labor costs and relative exports
b) The Ricardian trade model was confirmed by the positive relationship found between the relative labor
productivity and the ratio of U.S. to U.K. exports to third countries, as well as by the negative relationship
between relative unit labor costs and relative exports.
c) Even though the Ricardian model was more or less empirically confirmed we still need other models
because the former assumes rather than explains comparative advantage (i.e., it does not explain the
reason for the different labor productivities in different nations) and cannot say much regarding the effect
of international trade on the earnings of factors of production.
13. How would you counter the argument that the United States needs to restrict textile imports in
order to save American jobs?
The United States has a comparative disadvantage in the production of textiles. Restricting textile imports
would keep U.S. workers from eventually moving into industries in which the United States has a
comparative advantage and in which wages are higher.