International Trade
Classical Trade Theory and Comparative Advantage
References
Textbooks
 Appleyard, D., Field, A. and Cobb, S. (2005) International Economics, McGrawHill 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
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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
United States
Switzerland
Russian Federation
China
Turkey
Source: International Trade Statistics, WTO
EU(27) imports by origin in 2007
China
United States
Russian Federation
Switzerland
Japan
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
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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


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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)
Absolute Advantage
Potential Output per Unit of Labour
No Trade
Cloth
Food
With Trade
Cloth
Food
Britain
30
45
60
0
America
15
60
0
120
World
45
105
60
120
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


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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
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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
Comparative Advantage
Potential Output per Unit of Labour
Britain
No Trade
Cloth
Food
30
45
With Trade
Cloth
Food
60
0
America
40
80
15
130
World
70
125
75
130
Comparative Advantage

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America’s superiority in cloth is 40/30 = 33%
whereas superiority in food is 80/45 = 78%
=> America will still export food
Notice 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)?

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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

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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…

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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
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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.