PART 1: INTERNATIONAL TRADE THEORY

CHAPTER 2: THE LAW OF COMPARATIVE ADVANTAGE

Learning goals
• Understand the law of comparative
advantage
• Understand the relationship between
the opportunity costs and relative
commodity prices
• Explain the basis for trade and the gains
from trade
Main parts
1. The Mercantilists’ view on trade
2. Trade based on Absolute Advantage: Adam Smith
3. Trade based on Comparative Advantage: David
Ricardo
4. Comparative advantage and Opportunity costs
5. The basis for and the gain from trade under constant
costs
 2.1 The Mercantilists’ views on trade
v An economy philosophy on international trade was known as Mercantilism during the 17th and 18th centuries
v The content of mercantilism:
• A nation become richer and more powerful when it exports more than imports.
• The export surplus is the inflow of bullion, precious metals (gold and silver).
• The more gold and silver a nation had, the richer and more powerful it was.
• The government have to stimulate the nation’s export and restrict its imports.
• A Nation could gain in trade only in the expense of of other nations à Trade was a zero-sum game
v Q&A
• What are the differences from the views on the wealth of a nation in Mercantilism and in the world
today?
• Why do they say that the Mercantilists 'views on trade was a zero-sum game?
• How are the Mercantilists ‘views important and appropriate in the trade policy?
Tips: Reading Case study 2-2
 2.2 Trade based on Absolute advantage: Adam Smith
v Assumption
(1)The world has 2 nations, 2 commodities. (2) No trade restrictions : perfect mobility of factors within the nations
but no international mobility, perfect competition. (3) The only element of cost of production is labor
v The content of theory
• Trade between two nations is based on absolute advantage and benefits for both nations
• Absolute advantage: When one nation is more efficient than another in the production of one commodity
• When each nation specializes in the production of the commodity of its absolute advantage and exchanges
part of its output for the commodity of its absolute disadvantage, both nations end up consuming more of
both commodities
• All nations would gain from free trade or follow a policy of ”laissez-faire” (a little government interference
with the economic system)
 2.2 Trade based on Absolute advantage: Adam Smith
v Example (Table 2.1)

Which is the absolute advantage of each nations (US and UK)?

- US has an absolute advantage in wheat because US produce 6 bushels of wheat more than 1 bushels of wheat
of UK in a hour à US can completely specialize in the production of wheat
- UK has an absolute advantage in cloth because UK produce 5 yards of cloth more than 4 yards of cloth of US in
a hour à UK can completely specialize in the production of cloth
- Both nations can gain from specialization in production and trade
 2.3 Trade based on Comparative advantage: David Ricardo
v Assumption
(1) The world has 2 nations, 2 commodities.
(2) Free trade
(3) Perfect mobility of labor within each nation, but immobility between two nations
(4) Constant costs of production
(5) No transportation costs
(6) No technical change
(7) The labor theory of value
v The content of theory: 1817 – Principles of Political Economy and Taxation
• Both nations can gain by each specializing in the production and exportation of the commodity of its
comparative advantage (even if one nation has an absolute disadvantage with the respect of another in the
production of both commodities). There is still a basis for mutually beneficial trade.
• Comparative advantage: The less efficient nation should specialize in the production and export of the
commodity in which its absolute disadvantage is smaller. This is the commodity of its comparative advantage.
 2.3 Trade based on Comparative advantage: David Ricardo

v Example (Table 2.2)

Which is the comparative advantage of each nations (US and UK)?

US UK
Wheat 1W= 2/3C 1W = 2C

Cloth 1C = 3/2W 1C = ½W

Answer:
US has an absolute advantage in both wheat and cloth, UK has an absolute disadvantage in both commodities
BUT
US’s production cost of wheat is smaller than UK’s
UK’s production cost of cloth is smaller than US’s

RESULT
UK has comparative advantage in the production of Cloth and export cloth to US (import wheat from US)
US has comparative advantage in the production of Wheat and export wheat to UK
 2.3 Trade based on Comparative advantage: David Ricardo
v Example (Table 2.2)

How does each nation gain from trade when 1Wheat exchange 1Cloth (the exchange rate is 1:1)?

How the rate at which commodities are exchanged for one another is determined?
 2.3 Trade based on Comparative advantage: David Ricardo
v Example (Table 2.2)

How does each nation gain from trade when 1Wheat exchange 1Cloth (the exchange rate is 1:1)?

The domestically exchange
rate
The world exchange rate
The gains from trade
US
6 Wheat = 4Cloth
3W : 2C or 1W : 2/3C
1W : 1C
1W = (1C - 2/3C) = 1/3C
UK
2Cloth = 1 Wheat
2C :1W or 1C : ½ W
1C: 1W
1C = (1W – 1/2W) = 1/2W

How the rate at which commodities are exchanged for one another is determined?

US only trade with UK in case US gains from trade or the world exchange rate is larger than the domestically
exchange rate : The world exchange rate = 1W > 2/3C (1)

UK only trade with US if the world exchange rate is larger than the UK’s exchange rate in the domestic market:
The world exchange rate = 1C > ½ W (2)

Results as the combination (1) and (2): 2/3 C < 1W < 2C or 1/2W < 1C < 3/2W
 2.4 Comparative advantage and Opportunity Cost
v The content of theory
• The Opportunity cost theory: the cost of a commodity is the amount of a second commodity that must be
given up to release enough resources to produce one additional unit of the first commodity.
• The nation with the lower opportunity cost in the production of a commodity has a comparative advantage in
that commodity.
• Opportunity costs can be illustrated with the production possibility frontier (PPF) that shows the alternative
combinations of the two commodities that a nation can produce by fully utilizing all of its resources with the
best technology available to it.
 2.4 Comparative advantage and Opportunity cost
v Example (Table 2.4)

v Draw the Production Possibility Frontier in both two nations based on Table 2.4
v Give explanations about the opportunity cost of two nations
v Determine the opportunity cost and the relative price of each commodity in both nations.
 2.4 Opportunity cost and the gains from trade
v Example (Table 2.4)

v Case 1: The absence of trade (a nation can consume the commodities that it produces)
US may choose consume at point A (90W, 60C)
UK may choose consume at point A’ (40W,40C)
v Case 2: Trade possible
US would specialize in the production of wheat and produce at B (180W, 0C)
UK would specialize in the production of Cloth and produce at B’ (120C, 0W)
IF the world exchange rate 1W: 1C
Assume US exchange 70W for 70C with UK à US would consume at E (110W, 70C) and UK would consume at E’(50C, 70W)
à The consumption frontier is above the production possibility frontier (When both nations specialize in the production of the
commodity of its comparative advantage, both nations would consume two commodities increasingly
 QUESTION FOR REVIEW

1. Groups (2 -3 participants) answer the question for review in page 52 (15min)

2. Do exercise in Problems 1 – 11 (page 52 – 53)
 PART 1: INTERNATIONAL TRADE THEORY
CHAPTER 3: THE STANDARD THEORY
OF INTERNATIONAL TRADE
Main parts
1. The Production Frontier with increasing costs
Learning goals
2. Community indifference curves
3. Equilibrium in isolation
• Understand how relative commodity 4. The basis for and the gain from trade with increasing
prices and the comparative advantage of costs
nations are determined under increasing 5. Trade based on differences in tastes
costs
• Show the basis and the gains from trade
with increasing costs
 3.1 The Production Frontier with increasing costs
v Increasing opportunity costs: the nation must give up more and more of one commodity to release just enough
resources to produce each additional unit of another commodity.
v Increasing opportunity costs result in a production frontier that is concave from the origin (rather than a straight line
in case of constant opportunity costs in chapter 2)
Example (Figure 3.1)
- Concave production frontiers reflect increasing
opportunity costs in each nation in the production
of both commodities.
- Nation 1 also faces increasing opportunity cost
in the production of Y
- Nation 2 also faces increasing opportunity cost
in the production of X
- The marginal rate of transformation (MRT) of X for Y refers to the amount of Y that a nation must give up to produce
each additional unit of X. (MRT = the opportunity cost of X = the (absolute) slope of the production frontier at the point
of production)
 3.1 The Production Frontier with increasing costs
v Why do the increasing opportunities costs arise?
• Resources or factors of production are not homogeneous
• are not used in the same fixed proportion or intensity in the production of all commodities

v Why do the production frontiers of nations have different curve?

• The difference in the production frontiers of two nations is due to the fact that the two nations have
different factor endowments or resources at their disposal and/or use different technologies in
production
• As the supply or availability of factors and/or technology changes over time, a nation’s production
frontier shifts.
 3.2 Community indifference curves
v Community indifference curves: shows the various combinations of two commodities that yield equal satisfaction
to the community or nation.
à Higher curves refer to greater satisfaction and vice versa. Community indifference curves are negatively slope and
convex to the origin.
à Community indifference curves are different from nations to nations due to tastes, demand preferences.
v The Marginal rate of substitution (MRS): The marginal rate of substitution (MRS) of X for Y in consumption refers
to the amount of Y that a nation could give up for one extra unit of X

Example: Figure 3.2

Give an explanation with points on the figure 3.2
Give a comparison between community indifference
curves in Nation 1 and Nation 2
 3.3 Equilibrium in the absence of trade
v Equilibrium in the absence of trade: when it reaches the highest indifferent curve possible given its production
frontier (or where a community indifferent curve is tangent to the nation’s production frontier)

Example: Figure 3.3

1. Give an explanation with point A on the figure 3.3
2. Give a comparison between point A and B
3. Why does Nation 1 equilibrium in isolation by
producing and consuming at point A?
4. Determine the comparative advantage of Nation 1 and
Nation 2
 3.4 The basic for and the gains from trade with increasing costs
v The nation with the lower relative price for a commodity has a comparative advantage in that commodity, then the nation
should specialize in the production of the commodity of its comparative advantage and exchange parts of its output with
the other nation for the commodity of its comparative disadvantage.
v As Each nation specializes in producing the commodity of its comparative advantage, its incurs increasing opportunity
costs.
v Specialization will continue until relative commodity prices in the two nations equal at the level at which trade is in
equilibrium à Equilibrium-relative commodity price with trade is the common relative price in both nations with at which
trade is balanced
Example: Figure 3.4
Based on Figure 3.3, Nation 1 has comparative advantage in
producing commodity X, Nation 2 in commodity Y
Q& A: Determine the gains from trade of Nation 1 and Nation 2 at the
equilibrium (X:Y = 1: 1)
 PART 1: INTERNATIONAL TRADE THEORY
CHAPTER 4: DEMAND AND SUPPLY, OFFER CURVES, AND THE TERMS OF
TRADE
Main parts

Learning goals 1. Partial Equilibrium Analysis

2. Offer curves
• Show how the equilibrium price at which trade 3. General Equilibrium Analysis
takes place is determined by demand and 4. Relationship between Partial and General Equilibrium
supply Analyses
• Show how the equilibrium price at which trade 5. The terms of trade
takes place is determined with offer curves
• Explain the meaning of the terms of trade and
how they changed over time
 4.1 Partial Equilibrium Analysis
• Curve Dx and Sx on Panel A and C refer the demand and supply curves for commodity X of Nation 1 and Nation 2
• At Panel A : In the absence of trade), Nation 1 produce and consume at point A with the relative price Px/Py = P1
If Px/Py > P1 Nation 1 produce X more than consume X à surplus supply
• At Panel C: In the absence of trade), Nation 2 produce and consume at point A’ with the relative price Px/Py = P3
If Px/Py <P3 Nation 2 consume X more
Than consume X à excess demand
• With the opening of trade, Nation 1 export
the surplus of supply of commodity X
And Nation 2 import the deficit of demand
of commodity X from Nation 1
• At the relative price P2 (the intersection of D and S
at point E* in panel B) where the quantity of
exports X supplied by Nation 1 (BE) equal to the quantity of
Imports of X demanded by Nation 2 (B’E’).
à P2 is the equilibrium – relative price of commodity X
 4.2 Offer Curves
• Offer curves (or reciprocal demand curves) were devised by Alfred Marshall and Ysidro Edgeworth
• The offer curve of a nation shows how much of its import commodity the nation demands for it to be willing to supply various amounts of its
export commodity or the willingness of the nation to import and export at various relative commodity prices
• Example: Derivation of the offer curve of nation 1 and 2
At the autarky, Nation 1 start to produce at point A
If trade takes place at the relative price PB = 1, Nation 1 produce more X at point B ( A move to B in production) and exchange 60X= 60Y to consume at
point E on its indifferent curve III.
If trade takes place at the relative price PF = ½ , Nation 1 produce more X at point F ( A move to F in production) and exchange 40X= 20Y to consume at
point H on its indifferent curve II.
--> The offer curve of Nation 1 is generated by joining the point H and E ( The right panel in Figure 4.3)
 4.3 General equilibrium analysis
• The intersection of the offer curves of two nations defines the equilibrium – relative commodity prices at which trade takes place between them
• Only at the equilibrium price will trade be balanced between two nations.
• Example: Equilibrium – relative commodity price with trade (Figure 4.5)
• The two offer curves intersect at point E with Px/Py = PB = PB’ = 1. It means Nation 1 offers 60X for 60Y and Nation 2 offers exactly 60Y for 60X
àTrade is in equilibrium (both nations happen to gain equally from trade)
• At any other Px/Py trade would not be in equilibrium and move toward its equilibrium level
• Relationship between the partial equilibrium and general equilibrium illustrate on Figure 4.6
 4.4 The terms of trade
• The terms of trade of a nation is the ratio of the price of its export commodity to the price of its import commodity
• In the world (more than 2 nations), the terms of trade of a nation are given by the price index of its export to the price index of its import
• An improvement in a nation’s terms of trade is usually regarded as beneficial to the nation in the sense that the prices that the nation receives for
its exports rise relative to the prices that it pays for imports.

Example:
Nation1 export commodity X and import commodity Y à The term of trade of nation 1 is given by Px/Py
Nation 2 import commodity X and export commodity Y à The term of trade of nation 2 is in the reverse of Nation1’s term of trade

If the term of trade of Nation 1 rise from 100 to 120 (%) à this means that the nation 1’s export prices rose 20% in relation to its import prices or the
nation 2’s term of trade is deteriorated from 100 to (100/120)*100 = 83%
 CHAPTER 5
FACTOR ENDOWMENTS AND THE HECKSCHER -
OHLIN THEORY
MAIN PARTS
MAIN GOALS

• Explain how comparative

advantage is based on
differences in factor
endowments across nations
• Explain how trade affects
relative factor prices within and
across nations
• Explain why trade is likely to be
only a small reason for higher
skilled–unskilled wage
inequalities
• Factor intensity, factor
abundance and the shape of
the production frontier
• Factor endowments and the
Heckscher – Ohlin Theory
• Factor – Price equalization and
income distribution T
 5.1 Assumptions of the theory
1. There are two nations (Nation 1 and Nation 2), two commodities (commodity X and commodity Y), and two
factors of production (labor and capital).
2. Both nations use the same technology in production.
3. Commodity X is labor intensive, and commodity Y is capital intensive in both nations.
4. Constant returns to scale for X and Y in both nations.
5. Incomplete specialization in production in both nations.
6. Tastes are equal in both nations.
7. Perfect competition in both commodities and factor markets in both nations.
8. There is perfect factor mobility within each nation but no international factor mobility.
9. There are no transportation costs, tariffs, or other obstructions to the free flow of international trade.
10. All resources are fully employed in both nations.
11. International trade between the two nations is balanced
5.2 Factor intensity, Factor abundance and the shape of the Production Frontier
1. Factor intensity
if the capital–labor ratio (K/L) used in the production of Y is greater than K /L used in the production of X
Ky/Ly > Kx/Lx à Commodity Y is capital intensity
2. Factor Abundance
- In term of physical units, if the ratio of the total amount of capital to the total amount of labor (TK/TL) available in
Nation 2 is greater than that in Nation 1
TK2/TL2 > TK1/TL1 à Nation 2 is capital abundant
- In terms of relative factor prices, if the ratio of the rental price of capital to the price of labor time (PK /PL) is lower
in Nation 2 than in Nation 1. PK2/PL2 < PK1/PL1 à Nation 2 is capital abundant
Rental price of capital is usually considered to be the interest rate (r), while the price of labor time is the wage rate
(w), so Pk/PL = r/w
5.2 Factor intensity, Factor abundance and the shape of the Production Frontier
3. The shape of production frontier
Since Nation 2 is the K-abundant nation and commodity Y is the K-intensive commodity, Nation 2 can produce
relatively more of commodity Y than Nation 1.
& Nation 1 is the L-abundant nation and commodity X is the L-intensive commodity, Nation 1 can produce relatively
more of commodity X than Nation 2.

Example: Figure 5.2

The production frontier of Nation 1 is flatter and wider than
the production frontier of Nation 2, indicating that Nation 1
can produce relatively more of commodity X than Nation 2.
The reason for this is that Nation 1 is the L-abundant nation
and commodity X is the L-intensive commodity.
 5.3 Factor endowments and the Heckscher-Ohlin theory
3. The Heckscher – Ohlin theory
A nation will export the commodity whose production requires the intensive use of the nation’ s relatively abundant
and cheap factor and import the commodity whose production requires the intensive use of the nation’s relatively
scarce and expensive factor
Or the relatively labor-rich nation exports the relatively labor-intensive commodity and imports the relatively capital-
intensive commodity
Example:
Nation 1 is labor abundance and commodity X is labor intensity à Nation 1 should specialize and export X
Nation 2 is capital abundance and commodity Y is capital intensity à Nation 2 should specialize and export Y

Sum up: the H–O model is often referred to as the factor-proportions or factor-endowment theory. That is, each
nation specializes in the production and export of the commodity intensive in its relatively abundant and cheap
factor and imports the commodity intensive in its relatively scarce and expensive factor.