Chapter 2: Classical Trade Theory and Standard Theory of International Trade

Introduction

The first scientific study of international trade begins with Adam Smith’s famous book, The Wealth of Nations, published in 1776. Later on, David Ricardo, John Stuart Mill, Alfred Marshall, Eli Heckscher, Bertil Ohlin, John Maynard Keynes, Jacob Viner and Paul Samuelson made significant contributions to this theory. It is important to understand why trade takes place between countries. The five basic reasons why trade may take place are summarized below:

1. Differences in Technology
2. Differences in Resource Endowments
3. Differences in Demand
4. Existence of Economies of Scale in Production
5. Existence of Government Policies

The Rise of International Trade Theory and Mercantilism

Mercantilism represented the dominant attitude toward international trade in the 17th and 18th centuries. Before the mercantilist period, it was difficult to talk about a common foreign trade in the world. The only exception to this situation silk road , made Turkey a bridge between Europe and the Far East. After the industrial revolution (with the use of steam power instead of muscle strength), liberal ideas began to be replaced by Mercantilism. Mercantilism can be said to be the first theory of international trade.

According to the mercantilist doctrine, countries should export more than they import. World wealth (gold or silver stock) is constant and cannot be increased. Therefore, there is always a contradiction among the foreign trade countries. While one side of trade is profitable, the other party suffers equally. Mercantilists assumed trade was a zero-sum game that it could not be mutually beneficial to all parties. Mercantilism is an economic theory that holds that the prosperity of a nation is dependent upon its supply of capital, and that the global volume of international trade is “unchangeable”.

David Hume constructed what has become known as the specie-flow theory of the movement of money and goods between nations to assure equilibrium among international prices and the distribution of specie (or commodity) money among countries that are trading with each other. Hume explained that as net exports increased and more gold flowed into a country to pay for them, the prices of goods in that country would rise. Thus, an increased flow of gold into England would not necessarily increase England’s wealth substantially.

The Birth of the Theory of International Trade: Classical Liberalism

In the economy, absolute advantage refers to the ability of a particular person or a country to produce a particular good with less resources than another person or country. Absolute advantage is the ability to produce more of a given product using a given amount of resources. It can be compared with the concept of comparative advantage, which means that a certain commodity can be produced at a lower opportunity cost. The idea of absolute advantage is generally attributed to Adam Smith, while “the principle of comparative advantage”, is generally attributed to David Ricardo in his 1817 “Principles of Political Economy and Taxation”.

Basic Views of Classical Liberalism

All individuals act according to their economic interests (homo economicus). The state does not restrict the individual entrepreneur’s rights ( laissez faire, laissez passer ) . Individuals pursue their own interests and serve social interests at the same time. There is an “invisible hand” that provides order in economic life.

Theory of Absolute Advantage

The theory was introduced in Adam Smith’s “Wealth of Nations”, published in 1776. By assuming that each country could produce some commodities using less labour than its trading partners, he showed that all parties could benefit from international trade. Trade improved the allocation of labour, ensuring that each good would be produced in the country where the good’s production required the least labour. Result would be a larger total quantity of goods produced in the world. Trade would be a positive-sum game .

In economics, the theory of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce more number of a good, product or service than competitors, using the same amount of resources. Absolute advantage compares the productivity of different producers or economies. The producer that requires a smaller quantity input to produce a good is said to have an absolute advantage in producing that good. Motto for Absolute advantage can be ‘Specialize in the production of certain products, export them, and import others’ .

Absolute advantage occurs in two ways: Natural Advantage and Acquired Advantage.

a. Natural Advantage ; A country’s advantage to other countries due to its climate, natural resources and labour ability.
b. Acquired Advantage; A country’s advantage in terms of products. The advantage gained in product technology is that a country produces unique products that can be easily distinguished from its competitors.

Standard Assumptions in International Trade Theory Analysis

In its most simple form, the international trade models assume that two countries produce two goods using labour as the only factor of production. Goods are assumed to be homogeneous across firms and countries. Labor is homogeneous (identical) within a country but heterogeneous (non-identical) across countries. Goods can be transported costless between countries. Labor (workforce) can be re-allocated costless between industries within a country but cannot move between countries. Labor is always fully employed. There is no expense such as insurance. There is no technical change; technology differences exist across industries and across countries and are reflected in labor productivity parameters.

The Theory of Comparative Advantage

Comparative advantage is the cornerstone of international trade theory. Origins of the theory Comparative advantage was first described by Robert Torrens in 1815 in an essay on the “Corn Laws”. He concluded it was England’s advantage to trade with Poland in return for grain, even though it might be possible to produce that grain at a lower cost in England than Poland.

To be simple, assumptions will initially refer to only two countries and two commodities like in absolute advantage theory. Trade can also rely on other causes, such as largescale production and product differentiation. The theory of comparative advantage is an economic theory about the potential gains from trade for individuals, firms, or nations that arise from differences in their factor endowments. Moreover, the comparative advantage of nations may change over time as a result of technological change.

The primary argument in the analysis of this model regards the effects of trade when each country moves from autarky to free trade with the other country? The main things we care about are the prices of goods in every country, production levels of the goods, levels of employment in each sector, structure of trade (exporters and importers), consumption levels in each country, wages and incomes, and prosperity effects both nationally and individually.

The Case of No Comparative Advantage

There is one rare case where there is no comparative advantage. Even if a nation has an absolute disadvantage with respect to the other nation in the production of both products, there is still a basis for mutually beneficial trade, unless the absolute disadvantage is the same proportion for the two commodities. Although it is important to note this situation, its occurrence is rare and as a matter of coincidence, the applicability of the comparative advantage law is largely unaffected. In addition, natural trade barriers, such as transport costs, may hinder trade even if there are some comparative advantages. At this point, however, we assume that there are no natural or artificial barriers such as tariffs, quotas, and non-tariff restrictions.

Weaknesses of Early Theories

The Ricardian model assumes only two countries producing two goods using just one factor of production. No capital or land or other resources are needed for production. The real world, on the other hand, consists of many countries producing many goods using many factors of production. In the model, each market is assumed to be perfectly competitive when in reality there are many industries in which firms have market power.

Labour productivity is assumed to be fixed when in actuality it changes over time, perhaps based on past production levels. Full employment is assumed when clearly workers cannot immediately and costlessly move to other industries. Also, all workers are assumed to be identical. This means that when a worker is moved from one industry to another, he or she becomes immediately as productive as every other worker who was previously employed there. Finally, the model assumes that technology differences are the only differences that exist between the countries.

Comparative Advantage with Opportunity Costs and Production Possibilities

Following on from Smith and Ricardo, economists in the nineteenth century modified and finally abandoned the labour theory of value. Instead, it was replaced with a concept, the value of a commodity is related to its market price, which depends not only on supply and cost conditions, but also on demand.

Opportunity cost is usually defined as the value of the next best opportunity. In the context of national production, the nation has opportunities to produce lemonade and yoghurt. If the nation wants to produce more yoghurt, because of labour resources are scarce and fully employed, in order to increase yoghurt production, it is necessary to remove the worker from the production of lemonade. The loss of lemonade production, which is necessary to produce more yoghurt, represents the opportunity cost for the economy.

Production Possibilities and Opportunity Cost

Since the resources of any economy are limited, there are limits on what they can produce and there are always trade-offs in order to produce more commodity, the economy must sacrifice the production of another commodity. These trade-offs are shown graphically by a production possibility frontier indicating the maximum amount of lemonade that can be produced after deciding to produce any amount of yoghurt.

Opportunity cost is the value or quantity of something that must be given up to obtain something else. In the Ricardian model, opportunity cost is the amount of a good that must be given up to produce one more unit of another good. In other words, the opportunity cost for a good X is the amount of other goods which have to be given up in order to produce one unit of X.

Production Possibility Frontier-PPF is a curve that shows the alternative combinations of the two commodities that an economy can produce by fully utilizing all of its resources. : In the Ricardian model, the PPF is linear under constant cost.

Opportunity Costs and Relative Prices

Under the labour theory of value, the price of a commodity depends on the amount of labour used for the production of that commodity. However, labour is not the only factor of production and it is not used in the same fixed proportion in the production of all goods. Different numbers of workers are needed to produce different products.

In order to determine what the economy will actually produce, we need to look at the prices. In particular, we need to know the relative price of the two goods of the economy, that is, the price of one good compared to the other.

Constant opportunity cost arises when factors of production are perfect substitutes for each other or used in fixed proportion in the production of both goods. At the same time, all units of the same factor are identicalhomogeneous or of exactly the same quality. Thereby as each nation transfers resources from one production to another, it will not have to use resources that are less. Thus, we have constant costs in the sense that the same amount of one commodity must be given up to produce each additional unit of the second commodity. While opportunity costs are constant in each country, they differ among countries and provides the basis for trade.

Why have different productivity rates? The modern version of the comparative advantage (developed by the Swedish economists Eli Heckscher and Bertil Ohlin at the beginning of the twentieth century) attributes these differences in productivity to the differences in the factor endowments of nations. A country will have a comparative advantage in the production of a good that uses the abundant factor.

The Standard Theory of International Trade

It is more realistic for a nation to face increasing costs rather than constant opportunity costs. Increased opportunity costs mean that the nation has to give up more of one commodity to release sufficient resources to produce each additional unit of another commodity. Increased opportunity costs result in a concave PPF from the origin instead of a straight line. Concave production frontier reflect increasing opportunity costs in the nation and in the production of the two goods (See Figure 2.3). Thus, Nation Z must give up more of Y for each additional X it produces.

Increasing opportunity costs are more realistic than constant opportunity costs. Increasing opportunity costs arise because factors of production are not homogeneous and they are not used in the same fixed proportion or intensity in the production of all commodities. The difference in the production frontiers of different nations is due to the fact that the two nations have different factor endowments or resources or use different technologies in production. In the real world, the production frontiers of different nations will usually differ since practically no two nations have identical factor endowments. As the supply or availability of factors or technology changes over time, a nation’s production frontier shifts.

Community Indifference Curves

A community indifference curve shows the various combinations of the two commodities that provide equal satisfaction or happiness to the community. The higher the curves the more satisfaction, the lower the curves the less satisfaction is expressed. Community indifference curves are negatively sloped and convex from the origin. They must not cross. The declining slope of the curve reflects the diminishing marginal rate of substitution (MRS) of X for Y in consumption.

The marginal rate of substitution (MRS) is the amount of a good that a consumer is willing to give up for another good, as long as the new good is equally satisfying. The marginal rate of substitution is calculated between two goods placed on an indifference curve, displaying a frontier of equal utility for each combination of good X and good Y. Declining MRS means that community indifference curves are convex from the origin.

Equilibrium in Isolation

In the absence of trade, a country is in equilibrium when it reaches the highest indifference curve possible given its production frontier. This happens at the point where a community indifference curve is tangent to the country’s production frontier. The common slope of the two curves at the tangency point gives the internal equilibriumrelative commodity price in the country and reflects the comparative advantage of the country.

The Gains from Trade

A country gains more from trade if it receives a higher price for its exports compared to the price that it pays for its imports. For each country, trade gains depend on the country’s international terms of trade, which are the price the country receives from foreign buyers for its export products, relative to the price that the country pays foreign sellers for its import products. The distribution of gains from trade between the two countries depends on several factors, but one important factor is each country’s absolute economic size by which we mean the distance of it production frontier from the origin.