UNIT 2

INTERNATIONAL TRADE THEORY

Professor: Álvaro de la Barra Croquevielle

August, 2023
XVI and XVIII Century Physiocrats
Mercantilists XVIII Century

David Hume
Adam Smith
1711 - 1776
1723 - 1790

David Ricardo
1772 - 1823
 CLASICAL ECONOMICS
ADAM SMITH: (1723-1790)

· “Nature and Causes of the Wealth of

Nations”: 1776.
· Market laws, individual interest and
competition.
· Postulates of state non-intervention in
economic affairs.
 CLASICAL ECONOMICS
ADAM SMITH: (1723-1790)
• The Theory of Accumulation. How income is
distributed. Profits are invested (saved) and
necessary capital is accumulated for economic
development.
• The Invisible Hand: The market is the best
resource allocator. It determines what, how and
for whom to produce.
• Division of labor - Specialization.
 CLASICAL ECONOMICS
ADAM SMITH: (1723-1790)
• Division of Labor – International Specialization.
• Countries must specialize and export godos
that present absolute advantages and import
those goods which the other country has
absolute advantages.
• Advantage in absolute resources that are used
in the production of a good.
• With specialization, resource use by each
nation are more efficient.
 ABSOLUTE ADVANTAGES
Example

Output per worker/year Japan Chile

Copper (tons) 3 8

Cars (units) 4 1
 ABSOLUTE ADVANTAGES
 In one year a worker produces 3 tons of Copper in Japan
and 8 in Chile.
 One worker in Japan produces 4 cars and 1 in Chile.
 Japan is more efficient than Chile in car production and
Chile is more efficient than Japan in copper.
 Each country presents absolute advantages in production:
copper in Chile an cars in Japan.
 Each nation will specialize in production that presents
absolute advantages.
 ABSOLUTE ADVANTAGES
Output per worker/year Japan Chile

Copper (tons) 3 8

Cars (units) 4 1

•Assumption: International Terms of Trade of 6 tons of copper per car.

•If Chile exchanges 6 tons of copper per car with Japan, the country will win 2
units, due that in autarchy it must exchange 8 tons of copper to obtain a car.
•If Japan produces one tonn of copper, the opportunity cost in autarchy is 4/3
car and if it produces one car the opportunity cost is ¾ tonns of copper. When
it exchanges, receives 6 tonns of copper per car, and it wins 5,25 tonns of
copper.
 ABSOLUTE ADVANTAGES

•Assumption: Trade is NOT a cero sum game.

Globally, countries win.
•Generally, this absolute advantages are
explained by natural resources of some
countries.
 DAVID RICARDO
(1772-1823)
• He criticizes Adam Smith's analysis of absolute
advantages.
• Development of International Trade Theory:
• Countries have comparative advantages in production,
which allows their specialization in those goods that
have lower relative comparative costs.
• More efficient use of capital and labor.
 DAVID RICARDO
(1772-1823)
KEY ISSUES
• The fundamental aspects of Ricardo’s theory is that technologies differ
between countries. The implication is that each country has differents
production possibilities frontiers and, though the pattern of comparative
advantage (assuming similar demand across countries).
• How technology (and factor endowments) determine the pattern of
comparative advantage and welfare? What are the welfare gains of trade
between factors of production?
• How changes in the trading environment are transmitted to the different
factors?
 DAVID RICARDO
(1772-1823)
BASIC MODEL
Assumptions
• Competitive labor and output markets.

• Two countries and two goods.

• One factor of production, labor, and earn the same wage.
• Constant returns to scale.
• Factor of production is internationally immobile, although it may be

domestically mobile.
• The technology of the two countries are given.
• There are no transportation costs or barriers.

• This model cannot the distributional effects of trade.

 DAVID RICARDO
(1772-1823)
Example

Output per worker/year France Germany

Machines (unit) 2 4
Cars(unit) 4 6

•France presents a disadvantage compared with Germany in the production of both

goods. Based on the Theory of Absolute Advantage, it would be not possible trade
between France and Germany.
•Even in this scenario, Germany is relatively more efficient in the production of
machines than cars, because each worker is two times more productive in machines
in Germany and a worker is only 1.5 times more productive in cars.
 DAVID RICARDO
(1772-1823)
•France has a comparative advantage in car output,
even if Germany has absolute advantages in the
production of both goods.
•Germany has comparative advantages in the
production of machines.
•Specialization of each country allows to produce the
good that presents comparative advantages with
respect to the other country.
 DAVID RICARDO
(1772-1823)
•The conditions of International Trade
 The necessary and sufficient condition for the existence of international
trade is that countries must have different comparative costs.
 By this way, each country will specialize in the production of a good with the
lower comparative costs, or that presents a higher labor productivity.

•Comparative advantages can be explained in terms

of opportunity costs (Labor Theory of Value, Ricardo)
 Benefits from Trade
Output per worker/year France Germany

Machines (unit) 2 4
Cars(unit) 4 6
Relative Prices in Autarchy 1M:2C 1M:3/2C

•In a closed economy, the terms of trade in France is 1 machine per 2

cars, meanwhile in Germany the same machine can be exchanged by
3/2 cars.
•As a consequence, Germany will Benefit only if it specializes in
machines and buys cars at a ratio of 0.5M:C. France will Benefit if it
specializes in cars and buys machines at a ratio of 1M: 3/2C.
 Benefits from Trade
Output per worker/year France Germany

Machines (unit) 2 4
Cars(unit) 4 6
Relative Prices in Autarchy 1M:2C 1M:3/2C
C:0,5M C:2/3M

•Germany benefits with a specialization in machines, exporting to

France and exhanging at a ratio of 1M:2C, different of what it
receives in the domestic market for 1M:3/2CA.
•France benefits exporting cars to Germany at a terms of trade of
C:2/3M, instead of the ratio of C:0,5M that it would receive en the
domestic market.
 Benefits from Trade
•For France, any price relationship PM/PC smaller
than 1M:2C will be beneficial.
•For Germany, autarchy relationship is 1M:3/2C,
hence it will export and benefit if the relative Price
is PM/PC is greater. That is to say, PM/PC is greater
than 1,5.
•PM / PC : Terms of Trade.
 Benefits from Trade
•Condition for International Trade

3/2 < PM/PC < 2

•In conclusion, countries will benefit and

trade when international relative prices are
in between that condition.
 Production Possibilities Frontier (PPF) of
the Ricardian Autarchy Model

• Suppose, aLC and aLm are the unit labor requirements for Machine
and Car production, so 1/aLm and 1/aLc are the labor productivity
in each sector (# units of M and C produced by 1 worker).
• QC and QM = Aggregate output of Cars and Machine.
• LC and LM = Aggregate employment in Cars and Machine sectors.
• L = LM + LC the fixed labor endowment for the country.
• LC = aLC*QC and LM = aLM*QM
• So, the aggregate labor endowment constraint is:

aLC*QC + aLM*QM = L the country’s PPF.

 Production Possibilities Frontier (PPF) of
the Ricardian Autarchy Model in each
aLC*QC + aLM*QM = L
country
PPF for Germany PPF France aLC*QC + aLM*QM = L
PPF Germany
Cars PPF for France
Cars

Qc

Qc

Machines Machines
Qm Qm
Assumption: Technology of Constant Costs.
 Trade Benefits from full specialization

Cars Cars

Consumption
Possibilities
Frontier CPF
Qc
Qc

Machines
Qm Qm Machines
 Formalization
 Formalization of notions of comparative
advantage
• The production technology is defined by a unit labor
requirement (units of labor required to produce 1 unit of
output).
• Any additional units of output are produced using same unit
labor requirement.
The input-product coefficient is the input used Li
(labor) to obtain one unit of production (Qi).

Li
aL i 
Qi
 Formalization
 Represents the inverse of labor productivity, and it is
defined as the quantity of product obtained by a unit
of input used. With one factor of production (labor)
and constant returns to scale, the price is equal to
its average production cost:

 CMi = Average producton cost i = Total Cost /

quantity produced
 Total Cost = w*Li , w = wage, Quantity produced =
Qi

w Li
CMi   w  aL i
Qi
 Formalization
 To determine the prices of goods in the Ricardian
Model, the prices are independent of the
quantity produced (constant return to scale-
constant costs):

p2 aL 2
p1  w  aL1 ; p2  w  aL 2  P  
p1 aL1
 Formalization
 The world economy is constituted by two
countries: National Economy and the Foreign
Economy.
 Each country presents different production
technologies. The difference affect the
productivity and, as a consequence, relative
prices, where P  P*.
 P* represents the foreign economy price level, so
that:
*
p *
a L2
P*= 2
*
= *
p 1 a L1
 Formalization
 This relation confirms that the
difference in relative price levels are
due to differences in technology of
countries.

*
aL 2 aL*2
P P  
aL1 aL*1
 Formalization
The Comparative Advantages

aL1 aL2 p2 p*2 aL1 aL2 p2 p*2

1) * > * and < * 2) * < * and > *
aL1 aL2 p1 p1 aL1 aL2 p1 p1
 In the first case, the national economy presents a comparative advantage in
the production of good 2. The relative price of good 2 is less in the national
economy than in the foreign economy.
 The other country obtains a comparative advantage in good 1.
 The inverse situation can be observed in the second case. This advantages
con be interpreted in terms of labor productivity.
 Relative Supply and Demand
The RD curve shows that demand of good
1 relative to good 2 is a decreasing
P1/P2
funtion of the price of good 1 related to
good 2; curve RS shows that the supply of
good 1 relative to good 2 is an increasing
function of the same relative prices.
a*L1/ a*L2 RS
In A, the relative price of good 1 is located
between the price in both countries before
A trade. In this case, each country specialize
in the production of that good that
B presents comparative advantages.
RD
aL1/ aL2
In B, the world relative price of good 1
RD’
after the opening is al1/aL2, the same as
the opportunity cost of good 1 in terms of
L/aL1 Q1/Q2 good 2. In this situation, the country must
L* /a*L2 produce both goods, 1 and 2 (with no
specialization).
 Conclusions
• One country exports a good if the opportunity cost
of that good in the country is lower than other
countries.
•One country imports a good if the opportunity cost
of that good in the country is higher than other
countries.
•The principle of Comparative Advantage does not
say anything about absolute productivity. It uses
information on:
a L1 a L1*
relative to
*
a L2 a L2
•It does not say nothing about a L1 relative to aL1*
 Conclusions
• It is possible that:
al1 < al1* y al2 < aL2*
Labour in the domestic economy is more productive
than labour in the foreign economy.
 The country has absolute advantages in both sectors.
•If this is the case:
The real wage in the national economy is > than the
real wage in the foreign economy (both in autarchy and
in Free Trade)
 Conclusions
• The absolute advantages determine
relative real wages.
•The comparative advantages
determine trade pattern.
 Conclusions
Arguments usually incorrect against free trade:
(argument of low wages)
•Our industries can not compete against
countries with low wages.
•Countries that present industries with low wages
will increase cheap goods imports that would
affect our national industry.
•As a consequence, we can not open to free
trade.
 Conclusions
But,
• the reason of low wages is low productivity
(absolute advantage)
• low wages does not have anything to do with
relative productivity (comparative advantage)
• Even if wages are very low in the rest of the
world:
• One of the industries of our country will
export.
• Workers of our country will receive greater
real wages after trade.
 Summary of Conclusions
• The differences in opportunity costs between
countries are the basis for trade: Principle of
Comparative Advantages.
• One country specializes in the production of a
good with the lower opportunity cost relative to
other countries. Exports that good and imports the
other good.
• All the countries win with trade.
• Low wages are a consequence of low productivity.
• Low wages in the foreign economy does not
change the benefits from trade.