Chapter 2

The Classical Theory of International Trade:

Comparative Advantage Model
 Chapter Organization
 Absolute Advantage Model of Adam Smith: Production Gain
and Consumption Gain

 Comparative Advantage Model of David Ricardo: Production

Gain and Consumption Gain

 Determination of Terms of Trade

 Impact of changes in Terms of Trade

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 Absolute Advantage Model of Adam Smith

Adam Smith (1723-1790) provided the basic building blocks

for the construction of the classical theory of International
Trade.

According to smith all countries would gain from trade

through division of labour- Everyone will be better of trade
without making any one worse off.

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 Absolute Advantage Model of Adam Smith
Let us make some assumption to understand smith’s model.
Suppose
1. There are two countries and two commodities- Malaysia &
India are two countries, Rubber and Textile are two goods
2. Constant Returns to scale prevails in the economy
3. Production possibilities allow both countries to produce both
goods
4. No transportation Cost
5. Perfect Competition prevails in the economy

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Absolute Advantage Model of Adam Smith
6. Both countries are endowed with x factors of production
Now also suppose that with x factor,
Malaysia can produce either 100 units of rubber or 50 units of textile
and any combination of this given the opportunity cost ratio is 2:1
(R:T) – For one more unit of textile it has to give up 2 units of rubber.
And
India can produce either 50 units rubber or 100 units textile and any
combination of this two goods given opportunity cost ratio is 1:2
(R:T)- For 1 more unit of textile it has to give up ½ units of rubber.

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Absolute Advantage Model of Adam Smith
From this production possibilities it is absolutely clear that
India has absolute advantage in the production of Textile and
Malaysia has absolute advantage in the production of Rubber.

This means there is a symmetrical factor distribution between

the two countries so that there is scope for mutually benefitted
trade between these countries.
Let us see what happens
i. First look at production gain- Compare Pre Trade and Post
Trade
ii. Then see at consumption gain- Compare Pre Trade and Post
Trade
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Absolute Advantage Model of Adam Smith
1. Pre Trade Situation: Autarky Production and Consumption
Level
Countries Rubber Textiles Total Output

Malaysia 50 25 75

India 25 50 75

World 75 75 150

Each country produces each good and the total world Output
is 150 unit

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 Production Gain
2. Post Trade Situation: Production Gain after trade

Countries Rubber Textiles Total Output

Malaysia 100 0 100
India 0 100 100
World 100 100 200

World Output increases from 150 to 200 by the amount of 50

due to specialization of countries according to their absolute
advantage.

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 Consumption Gain
Consumption gain depends on how gains from production are
distributed between two countries- that is on Terms of Trade
between two countries

Terms of Trade (TOT): is ratio of import divided by export. Here,

how many rubber exchange for one unit of textile or vice versa
between India and Malaysia?

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 Consumption Gain
To understand consumption gains, study of 3 situations are necessary
1. If TOT between India and Malaysia lies between internal
opportunity cost ratio of these two nations then the gains from
trade will be equally distributed among them. Both countries'
consumers will be benefitted equally.
2. If TOT between India and Malaysia equal to internal opportunity
cost ratio of India then the gains from trade will be unequally
distributed among them. India will be hurt but Malaysia will be
benefitted in terms of consumption.
3. If TOT between India and Malaysia equal to internal opportunity
cost ratio of Malaysia then the gains from trade will be unequally
distributed among them. Malaysia will be hurt but India will be
benefitted in terms of consumption.
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 Consumption Gain
a) Suppose TOT is 1:1 which is between the internal opportunity
cost ratio of two countries and internal opportunity cost ratio
is (R:T)=2:1 (in Malaysia), 1:2 (in India)
Countries Rubber Textiles Total Gains/loss
Consumpt
ion
Malaysia 60 40 100 25

India 40 60 100 25

World 100 100 200 50

Both countries benefitted in terms of consumption.

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 Consumption Gain
b) Suppose TOT is 1:2 : equal to internal opportunity cost ratio of
India
Countries Rubber Textile Total Gain or
consumpti loss
on
Malaysia 75 50 125 50

India 25 50 75 0

World 100 100 200 50

India is worse off since TOT= opportunity cost of India

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 Consumption Gain
c) Suppose TOT is 2:1 : equal to Opportunity cost ratio of Malaysia

Countries Rubber Textile Total Gain or

consumpti loss
on
Malaysia 50 25 75 0

India 50 75 125 50

World 100 100 200 50

Malaysia is worse off since TOT = opportunity cost ratio of
Malaysia

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 Consumption Gain
International trade ensure that world output will increases due
to trade than no trade situation according to classical theories.
But it does not ensure that consumers will be benefitted after
trade than no trade situation.

The study of terms of trade helps us to understand how

consumers are benefitted from trade.

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 Limitations and Comparative advantage
model
 What happens if Malaysia has absolute advantage in both lines
of production?

 To answer the questions economists use the comparative

advantage model of international trade.
 Each country should specialize in the production of goods in
which it has more comparative advantage and export it and
should import the goods in which it has less comparative
advantage. Or
 Each country should specialize in the production of goods in
which it has less comparative disadvantage and export it and
should import the goods in which it has more comparative
disadvantage.
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 Comparative advantage model
 Just like the absolute advantage model, comparative advantage
model ensures that free trade is better than no trade in terms of
raising output but does not ensure that consumers will be
equally benefitted from trade.

 Again consumer’s gain depends on the terms of trade. This

gives rise to study about terms of trade.

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  Price determination in Comparative Advantage Model

 Determination of Terms of Trade.

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 Determination of Terms of Trade
In order to understand the determination of terms of trade the
analysis of offer curve is necessary
Offer Curve: The offer curves try to show how the terms of trade
are determined by the interactions of demand and supply. They
resolve the problem of determining the exact terms of trade that
emerge in trade equilibrium. The offer curve of a country is both
a demand curve and supply curve. It represents domestic
demand for foreign goods and it represents quantities of
exportable goods offered in exchange for imported goods.

An offer curve of a country is therefore a composite curve ,

representing demand for foreign goods and supply of domestic
goods for foreigners
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 Determination of Terms of Trade
Derivation of offer curves to determine equilibrium level of
Terms of trade Between two nations

Assumptions:

1. A world consists of two countries- A and B

2. Two goods are produced- Textiles and Rubber
3. Country A (Home) export Textile and Import Rubber
4. Country B (Foreign) export Rubber and Import Textile

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 Determination of Terms of Trade

The terms of trade between these two countries are determined

by Country A’s demand for Country B’s products and vice
versa.

The offer curve of home country say country A stands for the
intensity of domestic demand for foreign goods (country B)
and the offer curve of foreign country say country B stands
for the intensity of foreign demand for domestic goods
(country A). The equilibrium terms of trade between these
two nations are determined at a point where the two offer
curves intersect each other.

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 Determination of Terms of Trade
Deriving Offer Curve of Country A (Home Country):

Schedule of Trade Propensity for Country A

Textiles Rubber Terms of Trade
(Exportable) (Importable) (Ratios, T:R)

25 5 5:1
40 10 4:1
60 20 3:1
80 40 2:1
100 100 1:1
90 120 0.75:1

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 Determination of Terms of Trade
Offer Curve of Country A

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 Determination of Terms of Trade
The horizontal axis shows Importable (Rubber) and
vertical axis shows exportable (Textile) for Country
A.
The shape of offer curve is non linear. At the first stage
it increases at increasing rate and than increases at
decreasing rate. So the offer curve becomes concave
to the origin.
After point u country A is willing to trade with country
B but Country B does not since offer is not favorable
for it beyond point u.

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 Determination of Terms of Trade
Similarly another offer curve can be drawn for
country B.

In order to have the equilibrium TOT the offer curves

of two countries should be taken together in the same
graph.
As a result the exportable of country A becomes
importable of country B and vice versa.

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 Determination of Terms of Trade
Terms of Trade between Country A and B: Y= Textile
(Exportable of A and importable of B), X= Rubber
( Importable of country A and Exportable of Country B)

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 Determination of Terms of Trade
Changes in Terms of Trade:
Changes in Terms of Trade occur due to changes in Offer curves
of two countries. The direction of changes in Terms of trade
depends on the direction of changes in Offer curves.

Leftward shift of offer curve of B: Following reasons

1. Drop in the taste in country B for the product of country A
2. Country B diverts its trade direction away from Country A
3. Country B launched a program of import substitution

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 Determination of Terms of Trade
Changes in Terms of Trade:
Changes in Terms of Trade occur due to changes in Offer curves
of two countries. The direction of changes in Terms of trade
depends on the direction of changes in Offer curves.

Leftward shift of offer curve of A: Following reasons

1. Increase in export in country A
2. A technological revolution in Country A

Leftward shift of Country A and B’s offer curve causes terms of

trade to be deteriorated for country A.

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 Determination of Terms of Trade
Changes in Terms of Trade: Leftward shift of Country B’s offer curve

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 Determination of Terms of Trade
Straight Line Offer Curve: Indicates large country with high
bargaining power.

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