International Economics
Chapter 1
Classical Theories of
International Trade
Chapter 1 Classical Theories of International Trade
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1.1 Mercantilism
1.2 Trade Based on Absolute Advantage: Adam Smith
1.3 Trade Based on Comparative Advantage: David
Ricardo
1.4 Comparative Advantage and Opportunity Costs
1.5 Comparative Advantage with More Than Two
Commodities and Countries
1.6 Theory of Reciprocal Demand
1.7 Offer Curves and the Terms of Trade
1.1 Mercantilism

The mercantilists advocated government regulation of
trade to promote a favorable trade balance.
 If a country could achieve a favorable trade balance, it
would receive payments from the rest of the world in the
form of gold and silver. Such revenues would contribute
to an increase in spending and thus a rise in domestic
output and employment.
 Critics
Possible only for short term
Assuming static world economy
Chapter 1 Classical Theories of International Trade







1.1 Mercantilism
1.2 Trade Based on Absolute Advantage: Adam Smith
1.3 Trade Based on Comparative Advantage: David
Ricardo
1.4 Comparative Advantage and Opportunity Costs
1.5 Comparative Advantage with More Than Two
Commodities and Countries
1.6 Theory of Reciprocal Demand
1.7 Offer Curves and the Terms of Trade
1.2 Trade Based on Absolute Advantage: Adam Smith

With free trade, countries could concentrate their
production on the goods they could produce most
cheaply and enjoy all the consequent benefits from
the labor division.
Cost
differences govern the international movement of
goods. The concept of cost is founded upon the labor
theory of value.
1.2 Trade Based on Absolute Advantage: Adam Smith

Two assumptions, within each country:
Labor
is the only factor of production and is
homogeneous (i.e. of one quality).
The cost or price of a good depends exclusively upon
the amount of labor required to produce it.
1.2 Trade Based on Absolute Advantage: Adam Smith
 An
arithmetic example
A Case of Absolute Advantage
Output per Labor Hour
Country
iPad
Cloth
U.K.
U.S.
5 sets
15 sets
20 yards
10 yards
The
U.S. has an absolute advantage in iPad production; its iPad workers'
productivity (output per worker hour) is higher than that of the U.K, which
leads to lower costs (less labor required to produce a set of iPad).
In
like manner, the U.K has an absolute advantage in cloth production.
Chapter 1 Classical Theories of International Trade







1.1 Mercantilism
1.2 Trade Based on Absolute Advantage: Adam Smith
1.3 Trade Based on Comparative Advantage: David
Ricardo
1.4 Comparative Advantage and Opportunity Costs
1.5 Comparative Advantage with More Than Two
Commodities and Countries
1.6 Theory of Reciprocal Demand
1.7 Offer Curves and the Terms of Trade
1.3 Trade Based on Comparative Advantage: David
Ricardo

Mutually beneficial trade can occur even when
one country is absolutely more efficient in the
production of all goods.
The
more efficient country should specialize in and
export that good in which it is relatively more efficient
(where its absolute advantage is bigger).
The less efficient country should specialize in and
export the good in which it is relatively less inefficient
(where its absolute disadvantage is smaller).
1.3 Trade Based on Comparative Advantage: David
Ricardo
Assumptions
of a simplified model
 There are only two countries with a fixed level of
technology in the world;
 Each country owns only one input – labor, which is
fixed endowed and homogenous and can move
across industries but cannot flow across countries;
 Each country produces two commodities;
 Perfect competition and free trade prevail in
markets.
1.3 Trade Based on Comparative Advantage: David
Ricardo

An Example of Comparative Advantage
A Case of Comparative Advantage
Output per labor hour
Country
iPads
Cloth
Relative cost
U.S.
5 sets
15 yards
1 iPad=3 yards of cloth
China
1 set
5 yards
1 iPad=5 yards of cloth
The
U.S. labor has a 5-to-1 absolute advantage in the
production of iPads. The U.S. labor also has a 3-to-1 absolute
advantage in the production of cloth. The U.S. has a greater
absolute advantage in producing iPads than in producing cloth.
China
has an absolute disadvantage in the production of iPads
and cloth. However, China’s absolute disadvantage is smaller in
producing cloth than in producing iPads.
1.3 Trade Based on Comparative Advantage: David
Ricardo

The Gains from Specialization and Trade with
Comparative Advantage
The Change in the World Output Resulting from Specialization
Change in the production of
Country
iPads
Cloth
U.S.
+5 sets
-15 yards
China
-3 sets
+15 yards
Change in the World Output
+2 sets
0
As
the U.S. transfers 1 worker from cloth production to iPad production, its
output of iPads increases by 5 and cloth production falls by 15 yards.
As
China transfers 3 workers from iPad production to cloth production, its
cloth production increases by 15 yards and iPad production falls by 3.
The
gain from production and trade is the increase in the world output that
results from each country specializing in its production according to its
comparative advantage.
1.3 Trade Based on Comparative Advantage: David
Ricardo

Comparative Advantage in Money Terms
Comparative Advantage in Money Prices
Country Labor Input
iPad (sets)
Cloth (yards)
Hourly Wage
Rate
Quantity
Price
Quantity
Price
U.S.
1
$20
5
$4
15
$1.33
China
1
$5
1
$5
5
$1
this wage rate, China’s average cost in dollars of producing cloth
is less than the U.S. average cost. With perfectly competitive markets,
China’s selling price of cloth is lower than its U.S. selling price, and
China exports cloth to the U.S.
At
Even
though China is not as efficient as the U.S. in the production of
cloth, its lower wage rate in terms of dollars more than compensates for
its inefficiency.
Chapter 1 Classical Theories of International Trade







1.1 Mercantilism
1.2 Trade Based on Absolute Advantage: Adam Smith
1.3 Trade Based on Comparative Advantage: David
Ricardo
1.4 Comparative Advantage and Opportunity Costs
1.5 Comparative Advantage with More Than Two
Commodities and Countries
1.6 Theory of Reciprocal Demand
1.7 Offer Curves and the Terms of Trade
1.4 Comparative Advantage and Opportunity Costs
Opportunity
Cost
 Opportunity cost is the amount of one good that
must be given up to release enough resources to
produce another good.
 The marginal rate of transformation (MRT) is the
amount of one good that it must abandon to
produce each additional unit of another good.
1.4 Comparative Advantage and Opportunity Costs

The gains from Specialization and Trade with Opportunity Costs
Production and Consumption with and without Trade
Based on an exchange ratio of 1 iPad=4 yards of cloth
Item
Country
U.S.
China
100 iPads
0 yard of cloth
0 iPad
300 yards of cloth
Consumption with Trade
50 iPads
200 yards of cloth
50 iPads
100 yards of cloth
Domestic Production and
Consumption without Trade
50 iPads
150 yards of cloth
40 iPads
100 yards of cloth
Gains from Specialization and
Trade
50 yards of cloth
10 iPads
Production at Full
Employment
Both
countries are better off when they specialize and trade .
1.4 Comparative Advantage and Opportunity Costs

The PPF and Constant Opportunity Costs
 A production possibilities
frontier (PPF) shows the different
combinations of two goods that can be produced when all of a
country’s factors of production are fully employed in their most
efficient manner.
 The slope of PPF is referred to as the marginal rate of
transformation (MRT), which shows the amount of one product
a country must sacrifice to get one additional unit of the other
product.
 Without specialization and trade, the U.S. and China can
produce and consume at any point along their respective
production possibilities frontiers.
1.4 Comparative Advantage and Opportunity Costs
PPF for the U.S. and China at Full Employment
U.S.
China
Numbers of iPads
Yards of Cloth
Numbers of iPads
Yards of Cloth
100
0
60
0
90
30
50
50
80
60
40
100
70
90
30
150
60
120
20
200
50
150
10
250
40
180
0
300
30
210
20
240
10
270
0
300
1.4 Comparative Advantage and Opportunity Costs
Cloth
Cloth
U.S.
300
China
300
C
C'
B
150
B'
A
MRT= −3
100
0


50
100
iPad
0
MRT= −5
A'
40
60
iPad
Points below the PPF, say, point B or B', represent possible production
combinations that can be produced but are inefficient because there would
be some unemployed resources.
Points above the PPF, say, point C or C', represent production combinations
that are not possible for a country to produce with available resources and
technology.
1.4 Comparative Advantage and Opportunity Costs
Cloth
Cloth
U.S.
300
E Trading possibilities line
export
(terms of trade:
1 ipad = 4 cloth)
A
150
import


Trading possibilities line
100
F

D'
300
200
0
China
F'
A'
(terms of trade:
1 ipad = 4 cloth)
E'
import
D
50 export 100
iPad
0
40 50 60
iPad
With each country specializing in the production of the good in which it has
a comparative advantage, 10 more iPads and 50 more yards of cloth are
produced in the world.
With trade, the set of consumption points that a country can achieve is
determined by the terms of trade – the relative price of trading iPads for
cloth, and vice versa.
Both countries are better off by specializing and trade than they would be
without trade.
1.4 Comparative Advantage and Opportunity Costs
Changes
in the Gains from Specialization and Trade
Production and Consumption with and without Trade
Based on an exchange ratio of 1 iPad=3.5 cloth
Item
Production at Full Employment
Country
U.S.
China
100 iPads
0 yard of cloth
0 iPad
300 yards of cloth
Consumption with Trade
50 iPads
50 iPad
175 yards of cloth 125 yards of cloth
Domestic Production and
Consumption without Trade
50 iPads
40 iPads
150 yards of cloth 100 yards of cloth
Gains from Specialization and Trade
0 iPad
25 yards of cloth
10 iPads
25 yards of cloth
1.4 Comparative Advantage and Opportunity Costs
 As the international exchange ratio (terms of trade) changes
from 1 iPad for 4 yards of cloth to 1 iPad for 3.5 yards of cloth,
the trading possibilities curve moves for each country.
Cloth
Cloth
U.S.
China
300 D'
300
E
200
G
175
150
A
G'
125
100
A'
E'
D
0
50
100
iPad
0
40 50 60
Changes in the Terms of Trade for the U.S. and China
iPad
1.4 Comparative Advantage and Opportunity Costs
Distribution of
 Changes
the Gains from Trade
in a country’s terms of trade over time indicate
whether a country can obtain more or less quantity of
imports per unit of exports.
– A change in a country’s terms of trade may reflect a
change in either international or domestic economic
conditions.
– When the terms of trade change as a result of a change
in domestic economic conditions, the effect on the
country’s welfare is uncertain.
1.4 Comparative Advantage and Opportunity Costs
 Complete
Specialization
 Each country specializes completely in the production
of the good in which it has a comparative advantage
and imports the other good.
 Complete specialization occurs because as production
expands in the industry with a comparative advantage,
the domestic cost of producing the product does not
rise. Constant costs are assumed to prevail over the
entire range of production.
1.4 Comparative Advantage and Opportunity Costs
 The
firm’s cost curves and the product’s supply
curves are horizontal.
Yards of
Cloth per
iPad
Cloth
U.S.
300
SU.S.
3
0
150
100
iPad 0
A
50
MRT= −3
100
Supply Curves of a Good and the PPF
iPad
1.4 Comparative Advantage and Opportunity Costs

Trade under Increasing Opportunity Costs
Increasing
Costs and the PPF
Yards of Cloth
per iPad
Cloth
D
300 A
B
E
F
C
C
B
G
0
H
100
iPad
0
100
The PPF and Supply Curve under Increasing Cost Conditions
iPad
1.4 Comparative Advantage and Opportunity Costs
The
slope of the PPF at any point is represented
graphically by the slope of a line tangent to that point.
 A country has increasing opportunity costs.
 the tangent line FG is steeper than DE.
Two reasons:
 the factors of production used to produce the
products are specialized in the production of a
particular product.
 the premise that all resources are identical in the
sense that all workers and capital have the same
productivity in the production of both commodities
is unrealistic.
1.4 Comparative Advantage and Opportunity Costs
 Production
and Consumption without Specialization and Trade
 Without specialization and trade, the U.S. and China can
produce and consume at any point on their PPF.
 Production
and Consumption with Specialization and Trade
Cloth
C
Cloth
F
F'
K
A
Trade Triangle
J
H'
C'
D
H
Trade Triangle
A'
G
J'
K'
D' G'
0
iPad 0
Specialization and Trade under Increasing Cost Conditions
iPad
1.4 Comparative Advantage and Opportunity Costs
 Specializing
in and exporting the good in which the
country has a comparative advantage and trading for the
other good enables both countries to become better off by
consuming beyond their respective PPFs.
 Production under increasing cost conditions constitutes a
mechanism that forces prices to converge and results in
neither country specializing completely in the production
of the good in which it has a comparative advantage.
 In the case of increasing costs, both countries continue
to produce both goods after trade and it is called as
partial specialization.
Chapter 1 Classical Theories of International Trade







1.1 Mercantilism
1.2 Trade Based on Absolute Advantage: Adam Smith
1.3 Trade Based on Comparative Advantage: David
Ricardo
1.4 Comparative Advantage and Opportunity Costs
1.5 Comparative Advantage with More Than Two
Commodities and Countries
1.6 Theory of Reciprocal Demand
1.7 Offer Curves and the Terms of Trade
1.5 Comparative Advantage with More Than Two
Commodities and Countries

Comparative Advantage with More Than 2 Commodities
Each country will then have a comparative advantage
in the commodities that it exports at the particular
equilibrium exchange rate established .
Commodity Prices in the U.S. and U.K.
Commodity
A
B
C
D
E
Price in the U.S. ($) Price in the U.K. (￡)
2
4
6
8
10
6
4
3
2
1
1.5 Comparative Advantage with More Than Two
Commodities and Countries

If the exchange rate is ￡ 1=$2, the dollar prices of the
commodities in the U.K. would be:
Commodity
A
B
C
D
E
Dollar price in the U.K
12
8
6
4
2
The
U.S. will export Commodities A and B to the U.K. and
import Commodities D and E from the U.K., leaving
Commodity C not traded.
1.5 Comparative Advantage with More Than Two
Commodities and Countries

If the exchange rate becomes ￡1=$3. The dollar prices of the
commodities in the U.K. would be:
Commodity
A
B
C
D
E
Dollar price in the U.K
18
12
9
6
3
 The
U.S. will export Commodities A, B and C to the U.K. and
import Commodities D and E from the U.K.
1.5 Comparative Advantage with More Than Two
Commodities and Countries

If the exchange rate turns to be ￡1=$1, the dollar prices of the
commodities in the U.K. would be:
Commodity
A
B
C
D
E
Dollar price in the U.K
6
4
3
2
1
 The
U.S. would export only Commodity A to the U.K. and
import all other commodities, with the exception of
Commodity B.
1.5 Comparative Advantage with More Than Two
Commodities and Countries

Comparative Advantage with More Than 2 Countries
Ranking of Countries in Terms of International PW/PC
Country
A
B
C
D
E
PW/PC
1
2
3
4
5
Given
the equilibrium PW/PC=3 with trade, Countries A and B will export
wheat to Countries D and E in exchange for cloth. Country C will not engage
in international trade in this case because its pre-trade PW/PC equals the
equilibrium PW/PC with trade.
Given
a trade equilibrium PW/PC=4, Countries A, B and C will export
wheat to Country E in exchange for cloth, and Country D will not engage in
the international trade.
If
the equilibrium turns to be PW/PC=2 with trade, Country A will export
wheat to all the other countries except Country B, in exchange for cloth.
Chapter 1 Classical Theories of International Trade







1.1 Mercantilism
1.2 Trade Based on Absolute Advantage: Adam Smith
1.3 Trade Based on Comparative Advantage: David
Ricardo
1.4 Comparative Advantage and Opportunity Costs
1.5 Comparative Advantage with More Than Two
Commodities and Countries
1.6 Theory of Reciprocal Demand
1.7 Offer Curves and the Terms of Trade
1.6 Theory of Reciprocal Demand

Theory of reciprocal demand suggests that the actual
price at which trade takes place depends on the trading
partners’ interacting demands.
 According to the theory of reciprocal demand, final terms
of trade will be closer to the domestic price ratio of the
country with stronger demand for the imported good.
 The reciprocal demand theory contends that the
equilibrium terms of trade depend on the relative strength
of each country’s demand for the other country’s product.
1.6 Theory of Reciprocal Demand
 The
stronger the Canadian demand for autos relative to the U.S.
demand for wheat, the closer the terms of trade will be to the
Canadian domestic price ratio, and vice versa.
Wheat
Canada Price Ratio (2:1)
Improving U.S.
Terms of Trade
Terms of Trade
(1:1)
2
C
Improving Canadian
Terms of Trade
1
E
A
0.5
0
U.S. Price Ratio (0.5:1)
D
B
0.5
1
2
Autos
Equilibrium Terms-of-Trade Limits
1.6 Theory of Reciprocal Demand

The reciprocal demand theory best applies when both
countries are of equal economic size, so that the demand
of each country has a noticeable effect on the market
price.
 If one country is significantly larger than the other, the
larger country attains fewer gains from trade while the
smaller country attains most of the gains from trade. This
situation is characterized as the importance of being
unimportant.
Chapter 1 Classical Theories of International Trade







1.1 Mercantilism
1.2 Trade Based on Absolute Advantage: Adam Smith
1.3 Trade Based on Comparative Advantage: David
Ricardo
1.4 Comparative Advantage and Opportunity Costs
1.5 Comparative Advantage with More Than Two
Commodities and Countries
1.6 Theory of Reciprocal Demand
1.7 Offer Curves and the Terms of Trade
1.7 Offer Curves and the Terms of Trade

Offer Curves
The
offer curve (or reciprocal demand curve) of a
country indicates the quantity of imports and exports
the country is willing to buy and sell on the world
market at all possible relative prices.
In short, the curve shows the country’s willingness to
trade at various possible terms of trade.
The offer curve really is a combination of a demand
curve and a supply curve.
1.7 Offer Curves and the Terms of Trade
Deriving
an offer curve: trade triangle approach
Y
Y3
Y
C'
C
Y1
S1
Y2
R
S2
P
 PX 
 
 PY 1
R'
Y4
P'
V
O
X1
X2
(a)
X
 PX 
 
 PY  2
V'
O
X3
X4
(b)
Trade Triangles at Two Possible Terms of Trade
X
1.7 Offer Curves and the Terms of Trade
 The construction of the offer curve is completed by connecting
all possible points at which a country is willing to trade.
OCI
Imports of
Good Y
T"'
T"
(PX/PY)4
(PX/PY)3
(PX/PY)2
(PX/PY)1
T'
Y6
Y5
T
O
X5 X6
Exports of
Good X
Alternative Terms of Trade and Export-Import Combinations
on the Offer Curve
1.7 Offer Curves and the Terms of Trade

Equilibrium Terms of Trade
 Point
E is the trading equilibrium. TOTE is the market-clearing
price ratio.
I's Imports of Good Y
II's Exports of Good Y
OCI
(PX/PY)E or TOTE
(PX/PY)1 or TOT1
Y2
YE
Y1
O
B
E
OCII
A
X1 XE
X2
Trading Equilibrium
I's Eports of Good X
II's Imports of Good X
1.7 Offer Curves and the Terms of Trade
 Shifts
of Offer Curves
I's Imports
of Good Y
OCI
OCI"
OCI'
Decreased
Willingness
to Trade
H
G
F'
F
O
Reasons for Shifts:
H'
A change in tastes for the
TOTE
imported good;
G'
A rise in income that leads to
TOT1 an increased demand for
imports;
An improvement in
Increased
productivity in Country I’s
Willingness
to Trade
export industries.
TOT2
I's Exports of Good X
Shifts in Country I’s Offer Curve
1.7 Offer Curves and the Terms of Trade

When offer curves shift, the equilibrium terms of trade and volume
of trade change.
I's Imports of Good Y
II's Exports of Good Y
OCI
OCI'
TOTE
E''
TOT1
Y2
E'
Y1
YE
OCII
E
O
XE
X1 X2 I's Exports of Good X
II's Ixports of Good X
Increased Demand for Imports by Country I
1.7 Offer Curves and the Terms of Trade
Terms
 The
of Trade Estimates
relative price ratio PX/PY in the offer curve diagram is
called as the commodity terms of trade, or net barter terms
of trade .
 The economic interpretation of the terms of trade:
– As the price of exports rises relative to the price of
imports, each unit of a country’s exports is able to
purchase a larger quantity of imports. Thus, more
imports, which like any other goods bring utility to
consumers, can be obtained with a given volume of
exports, and the country’s welfare on the basis of those
price relations alone has improved.
1.7 Offer Curves and the Terms of Trade
 In
calculating the terms of trade for any given
country, a price index must therefore be calculated
for exports and imports.
– The price index is a weighted average of the prices of
many goods, calculated for comparison with a base year.
» The base-year price indices are then set at values of
100, and other years can be compared with them.
 Over
a long period, terms of trade illustrates how a
country’s share of the world gains from trade
changes and gives a rough measure of the fortunes
of a country in the world market.
1.7 Offer Curves and the Terms of Trade

Other Concepts of the Terms of Trade
Income Terms
of Trade
(PX/PM)×QX or (PX×QX)/PM
– where QX is the quantity index of exports.
 Single Factoral Terms of Trade
 TOTSF = (PX/PM)×OX
– where OX is the productivity index.
 Double Factoral Terms of Trade
 TOTDF = (PX/PM)×(OX/OM)
– where OM represents the foreign productivity index for
the home country’s imports.
 TOTY =