Chapter 2:

TRADE THEORIES AND

THE GAINS FROM TRADE
Contents
The Mercantilist period
The Ricardian Model
The HO model
Adam Smith The Wealth of Nations
The Gains from Trade
Readings
Required:
International Economics (RC): Chapter 3, 4
International Economics (KO): Chapter 2, 3

History of economic thought on
trade policy
Other Trade Theories
The HO model
The Ricardian Model Principles of
Political Economy and Taxation -
1817
Adam Smith The wealth of
nations - 1776
The Mercantilist period
1500 - 1800
1
2
3
5
4
The Mercantilist Period
The Mercantilist Period
History:
Prevailed in Europe from the early XVI late
XVIII century
Its exponents live in different countries
Represents the view of national wealth and the
policies best suited to promote it
The Mercantilist Period
The Mercantilist Period

The Mercantilist Period
The Mercantilist Period
Factors driving Mercantilism:
Consolidation of regional power centers by
large, competitive nations
Establishment of colonies outside Europe
Growth of European commerce and industry
Increase in volume and breadth of trade
Increase in the use of metallic monetary systems

The Mercantilist Period
Economic thought:
Nations wealth:
Promote a favorable balance of trade
Accumulate the different in the form of precious
metals
Foreign trade: Emphasize the importance of
foreign trade
Profit: Trade is zero sum game
Governments role: Focus on the power of
government to control the economy


The Mercantilist Period
Trade Policies:
Domestic trade policies:
Economic and non economic goals are
complementary
Protect certain infant industries with export bounties
and import duties
Excise taxes are levied on domestic consumption
Allowing monopolies in certain foreign markets
Develop strong merchant marines



The Mercantilist Period
Trade Policies:
Foreign trade policies:
Import duties, trade prohibitions
Encourage export of and import of.
Discourage export of .. and import of ..
Required all goods imported to be carried in either
English or colonial vessels




The Mercantilist Period
Mercantil
-ism
- Confuse wealth with
money
- Incoherent, clumsy means
- Cannot explain the pattern
of trade


- First development
economists
- Policies consistent with
nations priorities
- Aim to maximize national
wealth by trade
Advantages
Disadvantages
Adam Smith
The Wealth of Nations
Adam Smith The Wealth of Nations
The beginning of classical school of
economics
Economic growth depended upon
specialization and the division of labor
Advocate free trade
Do not oppose to restrictions imposed by
small states, or exceptions


Adam Smith The Wealth of Nations
Productivities of labor inputs:
Natural advantages: Climate, soil, mineral wealth
Acquired advantages: Special skills and
techniques


Adam Smith Absolute Advantage
Assumptions:
Factor of production: Labor
Homogeneous goods, prices depend on labor
required
2 goods, 2 countries


Adam Smith Absolute Advantage
The Wealth of Nations and economic
thought:
Absolute advantage:
Principle:
When one nation has an absolute cost advantage
that is, uses less labor to produce a unit of
output) in one good and the other nation has an
absolute cost advantage in the other good,
international specialization and trade will be
beneficial

Adam Smith Absolute Advantage
Vietnam Thailand
Rice (tons) 100 200
Coffee (tons) 300 200
Adam Smith Absolute Advantage
Vietnam Thailand
Units of labor/ A
ton of rice
2 1
Units of labor/ A
ton of coffee
0.5 1
Adam Smith Absolute Advantage
Vietnam Thailand
Rice (tone) 100 200
Coffee (tone) 150 200
Adam Smith Absolute Advantage
Absolute
advantage
- Unreal assumptions
- Cannot explain the pattern
of trade in some cases




- Explain the pattern of
international
specialization and trade
- A basic for modern trade
theories

Advantages
Disadvantages
The Ricardian Model
David Ricardos economic thought
Reinforce the case for free trade
International trade was first applied in the
field of political economy
Explain the pattern of international
specialization and trade based on
comparative advantage


The Ricardian Model
Assumptions:
2 nations, 2 commodities
Labor is the only input that can move freely
among industries, technology is fixed
Costs do not vary and are proportional to the
amount of labor used
Perfect competition in all markets


The Ricardian Model
Comparative advantage:
A country has a comparative advantage in
producing a good if the opportunity cost of
producing that good in terms of other goods is
lower in that country than it is in other countries
The opportunity cost of As in terms of Bs is the
number of Bs that could have been produced with
the resources used to produce a given number
of As
Depend on relative costs


The Ricardian Model
Vietnam Thailand
Rice (tons) 100 200
Coffee (tons) 300 200
David Ricardo Absolute Advantage
Comparative
advantage
- Cannot explain the terms
of trade
- Unreal assumptions
- Based only on supply side
-



- A supplement for Adam
Smiths theory
- Political economies are
mentioned

Advantages
Disadvantages
The Ricardian Model
United States Canada
Wheat 60 160
Autos 120 80
The Ricardian Model
The Gains from Trade:


The Ricardian Model
The Gains from Trade:


The Heckscher Ohlin
Theory
The HO Theory
Two factor economy model: 2 x 2 x 2
Two countries: Home and Foreign
Two goods: Cloth and Food
Two factors of production: Land and Labor
The HO Theory
Two factor economy model: 2 x 2 x 2
Two countries: Home and Foreign
Two goods: Cloth and Food
Two factors of production: Land and Labor
The HO Theory
Two factor economy model: 2 x 2 x 2
Assumptions:

: The ratio of labor to land used in production

>

The HO Theory
Two factor economy model: 2 x 2 x 2
PPF (without factor substitution)
a
TF
Q
F
+ a
TC
Q
C
T
a
LF
Q
F
+ a
LC
Q
C
L

The HO Theory
Two factor economy model: 2 x 2 x 2
PPF (without factor substitution)

The HO Theory
Two factor economy model: 2 x 2 x 2
PPF (with factor substitution)

The HO Theory
Two factor economy model: 2 x 2 x 2
Price and Production:
V = P
C
Q
C
+ P
F
Q
F
Q
F
= V/P
F
(P
C
/P
F
)Q
C
The slope of an isovalue line is (P
C
/P
F
)


The HO Theory
Two factor economy model: 2 x 2 x 2
Price and Production:


The HO Theory




The HO Theory
Resources and Production Possibilities:
Biased expansion of production possibilities:

The HO Theory
Resources and Production Possibilities:
Biased expansion of production possibilities:
An economy will tend to be relatively effective at
producing goods that are intensive in the factors with
which the country is relatively well endowed

The HO Theory
Assumptions:
Two countries: Home and Foreign
Same technology
Home has a higher ratio of labor to land than
Foreign does
Home is labor abundant
Foreign is land abundant



The HO Theory
Factors endowment:
Home is labor abundant
Foreign is land abundant
At any given price ratio of cloth to that of
food:
Home has a larger relative supply of cloth
Foreign has a larger relative supply of food


The HO Theory
Effects of International Trade:
P
C
D
C
+ P
F
D
F
= P
C
Q
C
+ P
F
Q
F

(D
F
Q
F
) = (P
C
/P
F
)(Q
C
D
C
)
This equation is the budget constraint for an
economy, and it has a slope of (P
C
/P
F
)
(D
F
Q
F
) (P
C
/P
F
)(Q
C
D
C
) = 0


The HO Theory
Relative prices and Pattern of Trade


The HO Theory
Relative prices and Pattern of Trade


The HO Theory
Relative prices and Pattern of Trade:
Countries tend to export goods whose
production is intensive in factors with which
they are abundantly endowed


The HO Theory
The Gains from Trade


The Gains from Trade
The Gains from Trade

The Gains from Trade

The Gains from Trade

End of chapter questions
How can trade theories explain the pattern
of international trade?
What are gains from trade?