International

Economics I
(Econ 3081)
B.A. Degree in
Economics International Economics I
Mengesha (Econ 3081)
Yayo
(Ph.D.)
B.A. Degree in Economics

Classical
Trade
Theories
Adam Mengesha Yayo (Ph.D.)
Smith’s
Principle of
Absolute
Advantage
David AAU, Department of Economics
Ricardo’s
Theory of Nov, 2021
Compara-
tive
Advantage
 Contents

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo
(Ph.D.)

Classical 1 Classical Trade Theories

Trade
Theories Adam Smith’s Principle of Absolute Advantage
Adam David Ricardo’s Theory of Comparative Advantage
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories

International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Classicals
Mengesha
Yayo The forerunners
(Ph.D.) David Hume
Richard Cantillon
Classical Adam Smith (Philosophy On Division of Labour, Public Finance, Wealth)
Trade
Theories David Ricardo (Rent and the Law of Diminishing Returns, Profits and the
Adam Theory of Distribution, Theory of Value and Price, The Theory of
Smith’s
Principle of Comparative Cost)
Absolute Thomas Robert Malthus ( The Theory of Gluts)
Advantage
David Bentham, Say, and Mill (Jeremy Benthamm, Jean Baptiste Say, John
Ricardo’s Stuart Mill)
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories

International
Economics I
(Econ 3081)
B.A. Degree in Adam Smith (1723 – 1790) provided the basic building block for the
Economics
construction of the classical theory of international trade. He
Mengesha enunciated the theory in terms of what is called Absolute Advantage
Yayo
(Ph.D.) model.
Another well known classiest, David Ricardo (1722 – 1823),
Classical articulated it and expanded it further into what is called
Trade
Theories Comparative Advantages model.
Adam The models of Smith and Ricardo together constitute what is
Smith’s
Principle of sometimes referred to as the supply version of the classical theory of
Absolute
Advantage trade, because Smith and Ricardo paid almost exclusive attention to
David considerations of supply or production costs in the determination of
Ricardo’s
Theory of terms of trade and the gains from trade.
Compara- The modern version of the classical theory of trade, however, treats
tive
Advantage supply and demand with equal weight.
 The Classical Trade Theories

International
Economics I
(Econ 3081)
B.A. Degree in
Economics
John Stuart Mill (1806 -1873), another renowned classical economist, was
Mengesha the first to indicate that demand considerations must be incorporated into
Yayo Comparative advantage model. But Mill was not very clear or articulate.
(Ph.D.)
The vagueness in Mill’s principle of Reciprocal Demand was
removed in the 19th century, first by F.Y.
Classical
Trade Edgeworth and later by Alfred Marshall.
Theories
Both Marshal and Edgeworth are credited with originating and
Adam
Smith’s developing the theory of offer curves, which is a geometric technique
Principle of of demonstrating the theory of reciprocal demand.
Absolute
Advantage All these contributions of Smith, Ricardo, Mill, Edgeworth and Marshall,
David put together, would constitute the modern version of the classical theory
Ricardo’s of comparative advantage, which is the oldest and the most famous model
Theory of
Compara- of international trade.
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha Adam Smith (1723 – 1790)

Yayo Although Adam Smith was the founder of the classical school, David
(Ph.D.) Ricardo was the leading figure in further developing the ideas of that
school.
Classical
Trade Adam Smith is regarded as the patriarch of economics. His major
Theories works (books) were:
Adam i. An Enquiry into the Nature and Causes of the Wealth of
Smith’s
Principle of Nations (1776)==>This is his most important work (his
Absolute masterpiece) which in short is known as ‘the Wealth of
Advantage Nations’.
David ii. The Theory of Moral Sentiments (1759).
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I Adam Smith (1723 – 1790)
(Econ 3081) Adam smith challenged the mercantilists views on what constituted the
B.A. Degree in
Economics wealth of Nations, and what contributed to "nation building" or increasing
the wealth and welfare of nations.
Mengesha
Yayo Smith was the first economist to show that goods, rather than gold (or
(Ph.D.) treasure), were the true measure of the wealth of a nation.
He argued that the wealth of a nation would expand most rapidly if
Classical the government would abandon mercantilist controls over foreign
Trade trade.
Theories
Adam Smith also exploded the mercantilist myth that in international trade one
Smith’s country gains at the cost of other countries.
Principle of
Absolute He showed how all countries would gain from international trade
Advantage through the international division of labor.
David
Ricardo’s Adam Smith, in his Wealth of nations (1776), argued that a country could
Theory of certainly gain by trading with other nations.
Compara-
tive Just as a tailor does not make his own shoes but exchanges a suit
Advantage for shoes, and hence both the tailor and the shoe maker gain by
trading, in the same manner, Smith argued that a country as a
whole would gain by having trade relations with other countries.
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International Adam Smith (1723 – 1790)-Assumptions

Economics I
(Econ 3081) 1 There are constant returns to scale in the production of both goods in the
B.A. Degree in two countries (i.e. constant marginal opportunity cost conditions).
Economics
2 The production possibilities are such that both countries can produce both
Mengesha the goods if they wish.
Yayo
(Ph.D.) 3 The countries are endowed with X amounts of factors of production such
that:
Classical a) With X factors of production country A can produce either 100
Trade units of rubber or 50 units of textile, or any other mix of rubber and
Theories
textile, that satisfies the opportunity cost ratio of 2:1
Adam
Smith’s b) With X factors of production country B can produce either 50
Principle of units of rubber or 100 units of textile, or some other combinations
Absolute of rubber and textile subject to the opportunity cost ratio of 1:2
Advantage
David From the above production possibilities (or supply conditions), it is
Ricardo’s quite clear that country A has an absolute advantage in the
Theory of production of rubber, and country B has an absolute advantage in
Compara-
tive the production of textile.
Advantage This means there is symmetrical factor distribution between the two
countries so that there is scope for specialization in production and
also a scope for establishing mutually beneficial trade between the
two countries.
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics Adam Smith started with the simple truth that for two nations to trade
with each other voluntarily, both nations must gain.
Mengesha
Yayo If one nation gained nothing or lost, it would simply refuse to trade.
(Ph.D.) The question is “how does this mutually beneficial trade take place,
and from where do these gains from trade come?”
Classical According to Adam Smith, trade between two nations is based on absolute
Trade advantage.
Theories
Adam When one nation is more efficient than (or has an absolute
Smith’s advantage over) another in the production of one commodity but is
Principle of less efficient than (or has an absolute disadvantage with respect to)
Absolute
Advantage the other nation in producing a second commodity,
David Then both nations can gain by each specializing in the
Ricardo’s production of the commodity of its absolute advantage and
Theory of
Compara- exchanging part of its output with the other nation for the
tive commodity of its absolute disadvantage.
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics By this process, resources are utilized in the most efficient way and the
Mengesha output of both commodities will rise.
Yayo This increase in the output of both commodities measures the gains
(Ph.D.) from specialization in production available to be divided between the
two nations through trade.
Classical
Trade For example,
Theories because of climatic conditions, Canada is efficient in growing wheat
Adam but inefficient in growing bananas .
Smith’s
Principle of On the other hand, Nicaragua is efficient in growing bananas but
Absolute inefficient in growing wheat.
Advantage Thus, Canada has an absolute advantage over Nicaragua in the
David cultivation of wheat but an absolute disadvantage in the cultivation
Ricardo’s
Theory of of bananas.
Compara- The opposite is true for Nicaragua.
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics Under these circumstances, both nations would benefit if each specialized
Mengesha in the production of the commodity of its absolute advantage and then
Yayo traded with the other nation.
(Ph.D.) Canada would specialize in the production of wheat (i.e., produce
more than needed domestically) and exchange some of it for
Classical (surplus) bananas grown in Nicaragua.
Trade As a result, both more wheat and more bananas would be grown
Theories
Adam and consumed, and both Canada and Nicaragua would gain.
Smith’s Unlike the Mercantilists, Adam Smith (and the other classical economists
Principle of
Absolute who followed him) believed that all nations would gain from free trade and
Advantage strongly advocated a policy of laissez-faire.
David Implication of trade based on absolute advantage
Ricardo’s
Theory of Free trade would cause world resources to be utilized most efficiently
Compara- and would maximize world welfare.
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics
There were to be only a few exceptions to this policy of laissez-faire and
Mengesha free trade.
Yayo
(Ph.D.) One of these was the protection of industries important for national
defense.
Classical In view of this belief, it seems paradoxical that today most nations
Trade impose many restrictions on the free flow of international trade.
Theories Trade restrictions are invariably rationalized in terms of national
Adam welfare.
Smith’s
Principle of Trade restrictions are advocated by the few industries and
Absolute their workers who are hurt by imports.
Advantage
Trade restrictions benefit the few at the expense of the many
David
Ricardo’s (who will have to pay higher prices for competing domestic
Theory of goods).
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo
(Ph.D.) Illustration of Absolute Advantage
Table 2.1: Absolute Advantage
Classical
Trade US Uk
Theories
Adam Wheat( bushels/hour) 6 1
Smith’s Cloth (yard/hour) 4 5
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha Table 2.1 shows that

Yayo One hour of labor time produces six bushels of wheat in the United
(Ph.D.) States but only one in the United Kingdom.
On the other hand, one hour of labor time produces five yards of
Classical cloth in the United Kingdom but only four in the United States.
Trade Thus,
Theories
Adam The United States is more efficient than, or has an absolute
Smith’s advantage over, the United Kingdom in the production of
Principle of
Absolute wheat,
Advantage Whereas the United Kingdom is more efficient than, or has an
David absolute advantage over, the United States in the production
Ricardo’s of cloth.
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I With trade,
(Econ 3081)
B.A. Degree in The United States would specialize in the production of wheat and
Economics exchange part of it for British cloth.
Mengesha British would specialize in the production of cloth and exchange part
Yayo of it for United States wheat.
(Ph.D.) If the United States exchanges six bushels of wheat (6W) for six
yards of British cloth (6C),
Classical the United States gains 2C or saves 1/2 hour or 30 minutes of
Trade labor time (since the United States can only exchange 6W for
Theories
4C domestically).
Adam
Smith’s Similarly, the 6W that the United Kingdom receives from the
Principle of United States is equivalent to or would require six hours of
Absolute labor time to produce in the United Kingdom.
Advantage
David These same six hours can produce 30C in the United Kingdom (6
Ricardo’s hours times 5 yards of cloth per hour).
Theory of
Compara- By being able to exchange 6C (requiring a little over one hour to
tive produce in the United Kingdom) for 6W with the United States, the
Advantage United Kingdom gains 24C, or saves almost five labor - hours.
The fact that the United Kingdom gains much more than the
United States is not important at this time.
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in According to Smith, if one country has an absolute advantage over
Economics
another in one line of production, and the other country has an absolute
Mengesha advantage over the first country in another line of production, then both
Yayo countries would gain by trading.
(Ph.D.)
A. Autarky (closed economy) situation
Classical The table to the right implies that country A produces and
Trade consumes 50 units of rubber and 25 units of textile with the given
Theories production technology and input supply.
Adam The total production, GDP, is 75 units and this is the
Smith’s
Principle of maximum consumption level if we assume that saving is zero.
Absolute Country B produces 25 units of rubber and 50 units of textile
Advantage
with its given technology and input supplies.
David
Ricardo’s The total production of country B is 75 units and total
Theory of consumption will also be 75 units if savings are assumed to be
Compara- zero. For our simple world of two countries, therefore, world
tive
Advantage production and consumption will be 150 units.
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo
(Ph.D.)

Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in The case of open economy
Economics
Opening trade provides the two countries an opportunity to
Mengesha specialize in production.
Yayo
It will lead to production and consumption gains.
(Ph.D.)
These effects can be seen in the following table.
Classical Country A will specialize in the production and export of
Trade rubber and B will specialize in the production and export of
Theories
textile.
Adam
Smith’s Trade will enable the countries to realize production and
Principle of consumption gains.
Absolute After trade both countries become richer by 25 units than
Advantage
David their situation without trade and this is due to production
Ricardo’s gain from international trade.
Theory of The world GNP has also increased from 150 to 200 units.
Compara- Country A has specialized in the production of rubber and
tive
Advantage country B has specialized in the production of textile.
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha Production Gain in an open economy

Yayo
(Ph.D.)

Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I What about consumption gains?
(Econ 3081)
B.A. Degree in
After trade, have the consumer in the two countries been happier as
Economics a result of their countries becoming richer and more specialized in
terms of production? This depends on how the gains from
Mengesha
Yayo production are distributed between the two countries.
(Ph.D.) In other worlds consumption gains to the two countries depend up
on the terms of trade (TOT) i.e. how many units of rubber
Classical exchanged for one unit of textile between country A and B.
Trade Case 1. Trade at TOT = 1:1
Theories
Adam At this TOT country A agree with country B to exchange 1 unit of
Smith’s rubber for 1 unit of textile.
Principle of
Absolute Then depending up an the taste pattern in the two countries
Advantage and up on how much or how little they want to trade each
David other’s goods, the consumption gains can be determined.
Ricardo’s If the two countries want to consume all that they have
Theory of
Compara- produced, it mean that their consumers have no taste for the
tive product of the other country then, there will be no trade
Advantage between countries.
But if each country wants to consume some mix of both
goods; then the countries will trade each other’s goods.
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Country A could export, say; 40 units of rubber for 40 units of textile
Mengesha import from country B (at terms of trade 1:1). The result of this trade
Yayo can be depicted in table 3 below.
(Ph.D.)
Country A, after trade, has produced 100 units of rubber (see table 2)
Classical consumers in country A want to consume 60 of rubber, which means that
Trade this country can export 40 units of rubber to country B in exchange for 40
Theories units textile imports.
Adam
Smith’s As a result, their consumption will increase by a total of 25 units
Principle of than the case without trade (see table 1).
Absolute Similarly, country B’s consumption level will also increase by 25
Advantage
David units than the situation without trade However, if the terms of trade
Ricardo’s is equal to the cost ratio of country A, all the gains from trade will
Theory of be attributed to country B.
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo
(Ph.D.)

Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo Conversely, if the term of trade is equal to the cost ratio of county
(Ph.D.) B, all the gains from trade will be attributed to country A.

Classical
Any other terms of trade between the cost ratios of the two
Trade countries may lead to unequal gains to country A and B.
Theories
Adam The country whose domestic cost ratio is larger by small amount
Smith’s than the TOT will gain the smaller share and vice versa i.e.
Principle of
Absolute if TOT closer to the domestic opportunity cost ratio of country
Advantage
David
A, country A will gain the smaller and B will gain larger.
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Case 2: Trade at TOT =Domestic opportunity cost ratio of country A =
2:1
Mengesha
Yayo All the consumption gains from international trade go to country B
(Ph.D.) because the TOT is equal to the domestic opportunity cost ratio of
country A.
Classical Thus such a TOT is favorable to country B but does not
Trade bring any change in welfare level of A.
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics Case 3: Trade at TOT =Domestic opportunity cost ratio of country B =
1:2
Mengesha
Yayo All the consumption gains from international trade go to country A
(Ph.D.) because the TOT is equal to the domestic opportunity cost ratio of
country B. Thus such a TOT is favorable to country A. It does not
Classical bring any change in the consumption level of country B.
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive The welfare of country B before and after trade remains constant.
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Case 4: Trade at TOT = 2:3
Mengesha
Yayo Most of the consumption gains from international trade go to
(Ph.D.) country A because the TOT is closer to the domestic opportunity
cost ratio of country B than country A. Thus such a TOT is more
Classical favorable to country A than country B.
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics Case 5: Trade at TOT = 3:2
Mengesha Most of the consumption gains from international trade go to
Yayo country B because the TOT is closer to the domestic opportunity
(Ph.D.) cost ratio of country A than country B. Thus such a TOT is more
favorable to country B than country A.
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics Case 5: Trade at TOT = 3:2
Mengesha It is important to note that production gains alone are not sufficient
Yayo to determine the profitability of international trade from the
(Ph.D.) standpoint of an individual member country.
The consumption gains (welfare gains) are also equally important.
Classical How the consumption gains are determined is crucial in
Trade determining whether the economic well being (standard of
Theories
Adam living measured by consumption gains) of a member country
Smith’s has gone up as a result of international trade.
Principle of International TOT, therefore, plays a very important part in
Absolute determine the welfare gains from trade.
Advantage
David International trade would be beneficial and profitable for a
Ricardo’s country if it results in consumption gains.
Theory of
Compara- Production gains alone do not bring profitable trade from the stand
tive point of the country concerned, but it may from world point of view.
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha Limitation of Absolute advantage

Yayo Absolute advantage, however, can explain only a very small part of world
(Ph.D.)
trade today, such as some of the trade between developed and developing
countries.
Classical
Trade Most of world trade, especially trade among developed countries, could
Theories not be explained by absolute advantage.
Adam
Smith’s It remained for David Ricardo, with the law of comparative advantage, to
Principle of truly explain the basis for and the gains from trade.
Absolute
Advantage Absolute advantage will be seen to be only a special case of the more
David general theory of comparative advantage.
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha Exercise
Yayo Suppose there are two regions in Ethiopia which produce two products
(Ph.D.) (Salt and Wheat).

Classical The differences in productivity (given in table below) could be caused by

Trade differences in labour skills, weather, or soil quality.
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo
(Ph.D.) Exercise
Questions
Classical Calculate and fill the opportunity cost of producing the two products
Trade for each region in the space provided in the above table
Theories
Adam Identify the product that each region can have Absolute e advantage
Smith’s Identify the product that each region can have comparative
Principle of advantage
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics In 1817, Ricardo published his Principles of Political Economy and
Taxation, in which he presented the law of comparative advantage.
Mengesha
Yayo This is one of the most important and still unchallenged laws of
(Ph.D.) economics, with many practical applications.
The Law of Comparative Advantage
Classical According to the law of comparative advantage, even if one nation is
Trade
Theories less efficient than (has an absolute disadvantage with respect to)
Adam the other nation in the production of both commodities, there is still
Smith’s a basis for mutually beneficial trade.
Principle of The first nation should specialize in the production and export of
Absolute
Advantage the commodity in which its absolute disadvantage is smaller (this is
David the commodity of its comparative advantage) and
Ricardo’s The other nation should import the commodity in which its absolute
Theory of
Compara- disadvantage is greater (this is the commodity of its comparative
tive disadvantage).
Advantage
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo The Case of No Comparative Advantage
(Ph.D.) There is one (not very common) case where there is no comparative
advantage. This occurs when the absolute disadvantage that one nation
Classical has with respect to another nation is the same in both commodities.
Trade
Theories
USA UK US-opp.cost UK-opp.cost
Adam
Smith’s
Principle of Wheat (bushels/hour) 6 6 0.6 0.6
Absolute Cloth ( yards/hour) 4 4 1.6 1.6
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo A ssumptions of the basic Ricardian Model
(Ph.D.) 1.Each country has a fixed endowment of resources, and all units of
each particular resource are identical.
Classical 2. The factors of production are completely mobile between
Trade alternative uses within a country. This assumption implies that the
Theories
prices of factors of production also are the same among these
Adam
Smith’s alternative uses.
Principle of 3. The factors of production are completely immobile externally;
Absolute that is, they do not move between countries. Therefore, factor
Advantage
David prices may be different between countries prior to trade.
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha A ssumptions of the basic Ricardian Model

Yayo
(Ph.D.) 4. A labor theory of value is employed in the model. Thus, the
relative value of a commodity is based solely on its relative labor
Classical content. From a production standpoint, this implies that
Trade (a) no other inputs are used in the production process, or
Theories
(b) any other inputs are measured in terms of the labor
Adam
Smith’s embodied in their production, or
Principle of (c) the other inputs/labor ratio is the same in all industries.
Absolute
Advantage In simple terms, this assumption means that a good embodying two
David hours of labor is twice as expensive as a good using only one hour.
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081) A ssumptions of the basic Ricardian Model
B.A. Degree in
Economics 5. The level of technology is fixed for both countries, although the
technology can differ between them.
Mengesha
Yayo 6Unit costs of production are constant. Thus, the hours of labor per
(Ph.D.) unit of production of a good do not change, regardless of the
quantity produced. This means that the supply curve of any good is
Classical horizontal.
Trade 7. There is full employment.
Theories 8. The economy is characterized by perfect competition. No single
Adam consumer or producer is large enough to influence the market;
Smith’s
Principle of hence, all are price takers. All participants have full access to
Absolute market information, there is free entry to and exit from an industry,
Advantage and all prices equal the marginal cost of production.
David 9. There are no government-imposed obstacles to economic activity.
Ricardo’s
Theory of 10. Internal and external transportation costs are zero.
Compara- 11. The analysis is confined to a two-country, two-commodity
tive “world” to simplify the presentation. This simplification will be
Advantage
dropped later to make the model more realistic.
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha Ricardian Comparative Advantage

Yayo Ricardo began by noting that Smith’s idea of absolute advantage
(Ph.D.) determined the pattern of trade and production internal to a
country when factors were perfectly mobile.
Classical Theories of why trade occurs can be grouped into three categories:
Trade
Theories Market size and distance between markets determine how
Adam much countries buy and sell. These transactions benefit both
Smith’s buyers and sellers.
Principle of Differences in labor, physical capital, natural resources and
Absolute
Advantage technology create productive advantages for countries.
David Economies of scale (larger is more efficient) create productive
Ricardo’s advantages for countries.
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo
(Ph.D.) The Ricardian model says differences in productivity of labor between
countries cause productive differences, leading to gains from trade.
Classical Differences in productivity are usually explained by differences in
Trade technology.
Theories
Adam The Heckscher-Ohlin model says differences in labor, labor skills, physical
Smith’s capital and land between countries cause productive differences, leading to
Principle of
Absolute gains from trade.
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
 The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage

International
Economics I
(Econ 3081)
B.A. Degree in
Economics The Ricardian model uses the concepts of opportunity cost and
Mengesha comparative advantage.
Yayo The opportunity cost of producing something measures the cost of
(Ph.D.) not being able to produce something else.
A country faces opportunity costs when it employs resources to
Classical produce goods and services.
Trade
Theories For example, a limited number of workers could be employed to produce
Adam either roses or computers.
Smith’s
Principle of The opportunity cost of producing computers is the amount of roses
Absolute not produced.
Advantage The opportunity cost of producing roses is the amount of computers
David not produced.
Ricardo’s
Theory of A country faces a trade off: how many computers or roses should it
Compara- produce with the limited resources that it has?
tive
Advantage
 References

International
Economics I
(Econ 3081)
B.A. Degree in
Economics

Mengesha
Yayo
(Ph.D.)
Tantau, Till et al.:
Appendix
The beamer class.
https://ctan.org/tex-archive/macros/latex/
contrib/beamer/doc/beameruserguide.pdf.