Basic Trade Theory Revisited

Basic Introduction

Inter-personal : Domestic, International.

Intermediaries: Exporters, Importers.

Time: Intra-temporal, Inter-temporal.

Assumptions: no traders, one time point, 2 X 2 X 2, no

money, no transport cost.

Arbitrage: price difference, difference in relative prices

(as no money), price difference > transport cost
(positive transport cost).
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 Autarky

Situation when a country operates in ISOLATION.

+ y = c + c ∀ j = 1, 2
A B A B
y j j j j

This can be achieved either through –

y A
j = c A
j
OR

− c = c − y ∀ j = 1, 2
A A B B
y j j j j

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 Gains from Exchange

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 Autarky (Continued)

If we consider individual A then we have his/her
BUDGET CONSTRAINT to be

P1 y 1 + P2 y 2 = P1 c 1 + P2 c 2
A A A A

OR

p ( c1 − y 1 ) + ( c 2 − y 2 ) = 0
A A A A

This is nothing but WALRAS’ LAW.

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 Post-trade Equilibrium

GLOBAL BUDGET CONSTRAINT

p (S1 + S ) + (S2 + S2 ) = p ( D1 + D ) + ( D2 + D2 )
* * * * * *
1 1

Let’s assume HOME exports Good-2 and imports

Good-1 (without any loss of generality), then,

M1 = (D1 − S1) = (S − D ) = X
* * *
1 1 1

X 2 = (S2 − D2 ) = (D − S ) = M
* * *
2 2 2

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 Trade Balance Equations

HOME’s trade balance equation
p S1 + S 2 = p D1 + D 2
* *

⇒ p M =X
*

FOREIGN’s trade balance equation

p * S1* + S 2* = p * D1* + D 2*
⇒ p* X * = M *

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 Sources of Trade

Technology Difference (RICARDO)

Difference in Resources (HECKSCHER-OHLIN)

Taste Bias (Source of INVALIDATION of H-O

theorem)

Perverse (Tax and Subsidy, Externality, Entry Barrier

by Government)

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 Mercantilism

Adam Smith (1776). An Inquiry into the Wealth of
Nations.

Prior to that, merchants, bankers, government officials
and even philosophers advocated mercantilism.

Export more, import less.

Trade surplus consisted of precious metals, gold and
silver.

One nation gains at the expense of another (colonies).

Thomas Munn (1571-1641). England’s Treasure by
Foreign Trade. Reprinted in 1926.

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 Absolute Advantage

Adam Smith, 2 X 2

Efficient in one and inefficient in the other

Specialization in the commodity of absolute advantage

and trade ⇒ beneficial to both

Laissez faire ⇒ maximize world welfare, most efficient

utilization of world resources

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 Comparative Advantage

David Ricardo (1817), 2 X 2

One country has absolute disadvantage in BOTH

goods

It should specialize, produce and export the

commodity in which the absolute disadvantage is
COMPARATIVELY less.

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 Comp. Adv. (Assumptions)

2X2

Perfect sectoral but no trans-boundary movement of
labour

Constant cost of production

No transportation cost

No TECHNICAL change (sort of no FIR, we will study
later)

Labour theory of value (⇒ labour is the only factor of
production/used in same proportion for both
commodities + homogeneity)

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 Opportunity Cost

Haberler (1936), Comparative cost advantage

Cost of a commodity = amount of a second commodity

that must be given up

Country with lower OC in production of one

commodity ⇒ CCA in that commodity

If absolute disadv. is SAME for both ⇒ NO

MUTUALLY BENEFICIAL TRADE is possible.

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