Part 1
INTERNATIONAL TRADE THEORY
Chapter 2
Trade Theories
1.
2.
Early Trade Theories
The Classical Theory of Trade
A.
B.
C.
Absolute Advantage (Smith) Model
Comparative Advantage (Ricardian)
Model and some extensions
Reciprocal Demand Principle
Chapter 2
Trade Theories
3. Neoclassical Trade Theory
A.
B.
Factor Endowment and the Heckscher-Ohlin
Model
The Factor-Price Equalization Theorem
4. Modern Trade Theories
A.
B.
C.
D.
Intra-industry Trade
Imperfect Competition and Economies of Scale
Dynamic International Trade Theory (Product
Cycle, etc)
New Development in International Trade Theory
Chapter 2
Issues Mainly Discussed
1.
2.
Why do countries trade(gain from trade)?
What are the bases for trade?
——Price differences  Supply side (cost): Technology
Factor Endowment
Production scale
 Demand side: Income
Preference
3.
4.
What are the changes in trade pattern?
What are the effects of trade?
CHAPTER 2
Classical Trade Models
Objective
Chapter 2
1. Understand how everyone can benefit from
voluntary trade.
2. Learn the meaning of absolute and
comparative advantage.
3. Recognize how comparative advantage
forms the basis upon which specialization
and exchange benefit trading partner.
4. Be able to apply the theory of comparative
advantage to real-world situations
Chapter 2
Classical Trade Models
1.
2.
3.
Absolute Advantage Theory (Smith’s
Model, AA Model)
Comparative Advantage Theory
(Ricardian Model, CA Model)
Other Classical Trade Theories
Chapter 2
Smith’s Model
1.
2.
3.
4.
5.
6.
7.
8.
Adam Smith
Basic Assumptions
Basis for Trade: Absolute advantage
Measurements of absolute advantage
A numerical example
Pattern of Production & Trade
Graphical Representation
Gain from the Trade
Chapter 2
In his 1776 book An
Inquiry into the Nature
and Causes of the Wealth
of Nations, Adam Smith
performed a detailed
analysis of trade and
economic
interdependence, which
economists still adhere to
today.
Adam Smith
(1723-1790)
Chapter 2
Basic Assumptions
1. Supply (Producer)
A.
2*2*1 model
a)
b)
c)
B.
C.
One input:
Labor(L)
Two outputs: Wheat (Qw) and Cloth (Qc)
Two countries: US and China
Fixed input marginal product
Constant return to scale.
2. Demand (Consumer)
Income budget constraint —— no lending or loaning
Chapter 2
Basic Assumptions
3. Trade
A.
B.
C.
No transport or transaction costs
Trade balance
Factors of production are perfectly mobile within
nation, but not between nations
4. Market structure
Full Employment, Perfect Competition
5. Technology
Different technologies different productivity of
labor
Chapter 2
Basis for Trade
1. Difference in Technology
 Different Productivity
 Different Production cost
 Different Commodity price
 International trade
2. Absolute Advantage
Chapter 2
Absolute Advantage
A country is said to have an absolute advantage
over another country in the production of a
commodity if it can produce a larger amount of
the commodity than other country with the same
amount of resources.
A reciprocal absolute advantage
Two countries are said to have a reciprocal
absolute advantage over each other if each
country has an absolute advantage over the other
in producing one of the two commodities.
Chapter 2
Measurements of absolute advantage
Productivity:
1.
Q
L
If
,
 Q 1c 
 Q 1c 
 



L
L

 China

 US
China has an absolute advantage in product cloth.
2. Production cost (measured by input):
aLQ = L
Q
(labor required in each unit of output)
Chapter 2
Measurements of absolute advantage
3.
Commodity price:P * Q  W * L
P 
W *L
Q
L
 W * 
Q

W
 
 (Q )
L
where W is wage rate.
Given a fixed W, P is positively related to
production cost aLQ
Chapter 2
A numerical example
In this case, China has an absolute
advantage in producing cloth and the US has
an absolute advantage in growing wheat.
(presentation of China & USA)
Chapter 2
Pattern of Production & Trade
1.
2.
3.
“Each country should specialize in and
export the Product in which it has an
absolute advantage”
Pattern of Production:in this case,
China should specialize in production
of cloth and US should produce wheat.
Pattern of Trade:China should export
cloth and import wheat. US should
import cloth and export wheat.
Chapter 2
Graphical Representation
(1) Some Conceptions
1.
Returns to scale
Constant Returns of Scale
B. Increasing Returns of Scale
C. Decreasing Returns of Scale
A.
2.
Production Possibility Frontier or Curve
(PPF or PPC)：
Points describing alternative combinations
of output levels for two different products
to be produced by given resources
Chapter 2
C
C
C
Q
Q
Q
Decreasing Returns Constant Returns Increasing Returns
Qw
Qw
PPF
QC
PPF
QC
Graphical Representation
(1) Some Conceptions
Chapter 2
3. Community Indifference Curve Higher
(CIC)
Satisfaction
CIC2
CIC
CIC1
the points describing same level of satisfaction
(or utility) by given resource.
Graphical Representation
(1) Some Conceptions
4. Equilibrium in Autarky
PPF
CIC
Chapter 2
Graphical Representation
(2) PPF of China & USA
Wheat
1C
50
0
Chapter 2
China
Max. amount of Wheat can be
produced: 50W
Slope = Cost of 1C
= 0.5W
Max. amount of Cloth can be
produced: 100C
PPFChina
100
Cloth
Graphical Representation
(2) PPF of China & USA
USA
Wheat
100
Chapter 2
1C
Max. amount of wheat can be
produced: 100W
Slope = Cost of 1C
=1.25W
PPFUSA
Note: The PPC with a
gentler slope will have a
comparative advantage
in food production.
Max. amount of Cloth can be
produced: 80C
Cloth
0
80
Chapter 2
Graphical Representation
(3) Equilibrium without trade
China
Wheat
50
CIC
PPFChina
EChina
25
Cloth
O
50
100
Chapter 2
Graphical Representation
(3) Equilibrium without trade
USA
Wheat
100
CIC
PPFUSA
EUSA
50
Cloth
O
40
80
Graphical Representation
(3) Equilibrium with trade
Chapter 2
Wheat
100
China
 CChina
50
PPFChina
TOT=1
25
0
EChina
Export
50
100
PChina
Cloth
Graphical Representation
(3) Equilibrium with trade
Chapter 2
Wheat
PUSA
USA
100
 CUSA
50
PPFUSA
Import
EUSA
0
40 50
TOT=1
Cloth
80 100
Gain From the Trade
(1) Consumption
Chapter 2
P=Produce;C=Consumer;Labor both 100
Labor be used equally on the production of C&W
Exchange Rate (TOT) must between 0.8~2
China
&
USA
Consumption Gains: Both consume more
（China 25 more wheat ; US 10 more cloth）.
Chapter 2
Exchange Rate (TOT)
China exchange 100 unit Cloth for Wheat not
less than 50 unit, or else produce Wheat itself；
USA exchange 100 unit Wheat for Cloth not less
than 80 Unit, or else produce Cloth itself；
So the exchange rate of Cloth/Wheat must
between 0.8 (=80/100) and 2 (=100/50)。
Gain From the Trade
(2) Production
Chapter 2
When Autarky, the total productions of Cloth is
90 (=50+40), that of Wheat is 75 (=25+50);
When Trade, the total productions of Cloth is
100 (>90), that of Wheat is 100 (>75).
So the world has production gains from trade.
Chapter 2
Summary
Given that two countries have a reciprocal
absolute advantage over each other, if each
specializes in producing the commodity in
which it has an absolute advantage,
then the world’s total output will increase
and each country will gain by being able
to consume more than autarky.
Chapter 2
Implications of Smith’s Theory
Access to foreign markets helps create wealth
A.
B.
C.
D.
If no nation imports, every country will be limited
by the size of its home country market
More importantly, the macro division of labor will
be limited by the extent of the market
Imports enable a country to obtain goods that it
cannot make itself or can make only at very high
costs
Trade barriers decrease the size of the potential
market, hampering the prospects of specialization,
technological progress, mutually beneficial
exchange, and, ultimately, wealth creation.
Chapter 2
Limitation of the Smith’s Model
compare
In this case, the US has the absolute
advantage in both goods (it is very common for a
developed country to have absolute advantages in
most sectors). According to the Smith theory, there
will be no trade.(Really?)