INTERNATIONAL ECONOMICSINTERNATIONAL ECONOMICSLecture 3 | Lucía Rodríguez| Why do countries trade? Some early answersLecture 3 | Lucía Rodríguez| Why do countries trade? Some early answers

CLASSICAL THEORY: DAVID RICARDOCLASSICAL THEORY: DAVID RICARDOTable 1. Comparative Advantage

Source: International Economics (2009). Eicher et al.

Table 2. Efficiency Gains

Source: International Economics (2009). Eicher et al.

• Portugal must shift more days than England because of less efficiency in absolute terms• Price ratios will converge (unless there are additional costs) Intermediate Equilibrium

ToT

Days of L required Portugal England

Wine (barrels)Cloth (bolts)

310

24

Portugal England Total

Wine (barrels) 20 -18 2

Cloth (bolts) -6 9 3

CLASSICAL THEORY: DAVID RICARDOCLASSICAL THEORY: DAVID RICARDO

• Trade Benefits: – Broader markets, greater supply, higher welfare.– Real Income increases because of specialization– Overcomes Smith’s limitations: There is scope for mutually

beneficial trade between the two countries, if both specialize according to their pattern of CA, even when one of them has an AA in every commodity.

• Economic Policy: Laissez-faire. Any intermediate ToT is mutually beneficial (No zero-sum game)

• Limitations:– What if relative costs are equal?– ToT indetermination (Barone)

CLASSICAL THEORY: J. STUART MILLCLASSICAL THEORY: J. STUART MILL

Amount of output produced by a

given amount of labor

Boradcloth Linen

England 10 15

Germany 10 20

• J.S. Mill

CLASSICAL THEORY: J.STUART MILLCLASSICAL THEORY: J.STUART MILL

• Reciprocal Demand Theory:Cloth Market– Definition: Equilibrium barter ToT (ratio of exchange) will

equate Exports Supply with Imports Demand internationally.– Demand elasticity is crucial due to the shape of the Supply curve

(L Theory of Value+constant productivity of Labour). – World curves as differences. Walras’ law.

England World Trade Germany

Se Sx,e Sg

2

1.7

De Dm.g Dg

1.5

C* C* C*

CLASSICAL THEORY: LIMITATIONSCLASSICAL THEORY: LIMITATIONS– Only two goods: What happens in a more realistic set-up?

• Consider a rank ordering: relative marginal costs will predict the trade pattern

• Compare Cloth with other goods and export the one with the lower ratio.• MC will depend on wages and the inverse of productivity• As long as there is a single wage rate in each country, relative labour

productivities will determine the ranking.• Countries should tend to export those goods in which their productivity is

relatively high.• Relative productivity must be high compared with other sector's relative

productivity.• Chinese surge as an export powerhouse

( )A A AC C

LMC w

Q

( )

( )

A ACA

CB

B BCC

Lw

MC QLMC wQ

( )B B BC C

LMC w

Q

CLASSICAL THEORY: LIMITATIONSCLASSICAL THEORY: LIMITATIONS

• Strong assumptions– No trade barriers: transportation costs, information costs,…

• If they fall relative to the value of the good being transported, more goods are likely to become available.

– Just one Input: L. Labor Theory of Value.– Labor is internationally immobile.– Constant costs of production, Leontieff production function.– Fixed amount of inputs: Vertical Aggregate Supply .

CLASSICAL THEORY: EMPIRICAL EVIDENCECLASSICAL THEORY: EMPIRICAL EVIDENCE

• It predicts an extreme degree of specialization.• It assumes away effects of International Trade on the

distribution of income within countries.• Allows no role for differences in resources among countries

as a cause of trade.• Neglects the possible role of economies of scale as a cause

of trade.

CLASSICAL THEORY: MISCONCEPTIONSCLASSICAL THEORY: MISCONCEPTIONS

• Free trade is beneficial only if your country is strong enough to stand up to foreign competition.

• Foreign Competition is unfair and hurts other countries when it's based on low wages.

• Trade exploits a country and makes it worse off if its workers receive much lower wages than workers in other nations