RICARDO-1.ppt it tells information theory

Classical theory of
International trade

2.1 Introduction
 Historical Approach to Examine the
Development of International Trade
Theory (Mercantilism, Absolute
Advantage, Comparative Advantage)
 Three Basic Questions
 Basis for Trade
 Gains from Trade
 Patterns of Trade

2.3 Trade Based on Absolute
Advantage: Adam Smith
 Absolute Advantage
 Illustration of Absolute Advantage
 Main Views on Trade
 Comments
 Conclusion

 Adam Smith(1723-90)
Absolute advantage theory was proposed by Adam
Smith (1723-90) . With The Wealth of Nations Adam
Smith installed himself as the fountainhead of
contemporary economic thought . Adam Smith was born
in a small village in Kirkcaldy, Scotland. There his
widowed mother raised him until he entered the University of Glasgow at
age fourteen, as was the usual practice, on scholarship. He later
attended Balliol College at Oxford, graduating with an extensive
knowledge of European literature and an enduring contempt for English
schools. He returned home, and after delivering a series of well-received
lectures, was made first chair of logic (1751), then chair of moral
philosophy (1752), at Glasgow University.

 Introduction
Adam Smith coined (创新) the term "mercantile system" to describe the
system of political economy that sought to enrich the country by
restraining imports and encouraging exports. This system dominated
western European economic thought and policies from the sixteenth to the
late eighteenth century. The goal of these policies was, supposedly, to
achieve a "favorable" balance of trade that would bring gold and silver into
the country. In contrast to the agricultural system of the physiocrats(自然
拥护者), or the laissez-faire of the nineteenth and early twentieth centuries,
the mercantile system served the interests of merchants and producers
such as the British East India Company, whose activities were protected
or encouraged by the state.

 Illustration of Absolute Advantage
 No Trade
U.S. U.K.
Wheat (bushels/man-hour) 6 1
Cloth (yards/man-hour) 4 5
 With Trade
U.S. U.K.
 After Trade
Output wheat increases 5 units(12-7,before trade)
Output cloth increases 1 unit (10-9, before trade);
The world output increases 5 units wheat and 1 unit cloth.
U.S. gains 2 units wheat while U.K. gains 4 units cloth.

 Main Views on Trade
Under the heavy pressure of high smuggling and created variety of
products during the industrial revolution, by 1860 England had
removed the last vestiges of the mercantile era .
Adam Smith's insight that free trade leads to international specialization
of labor and, usually, to greater economic well-being for all nations.
What do nations trade? (two-win games)
What the gains from trade? ( the greater economic well-being)
What is the pattern of trade? (import and export)
(supposing with two nations, two products and one factor “labor” world.
One nation should export the more efficient product and import the less
efficient product compared with the other nation. In other words, the
nation should export the less cost product and import the higher cost
product)

2.4 Trade Based on Comparative
Advantage: David Ricardo
 The Law of Comparative Advantage
 The Gains from Trade
 Exception to the Law of Comparative
Advantage
 Comparative Advantage with Money
 Comments
 Conclusion

 Introduction
 Countries engage in international trade for two basic
reasons:
• They are different from each other in terms of climate,
land, capital, labor, and technology.
• They try to achieve scale economies in production.
 The Ricardian model is based on technological differences
across countries.
• These technological differences are reflected in
differences in the productivity of labor.

 David Recardo (1772-1823)
David Ricardo was one of those rare people who
achieved tremendous success and lasting fame.
After his family disinherited him for marrying outside
his Jewish faith, Ricardo made a fortune as a
stockbroker and a loan broker. When he died, his
estate was worth over $100 million in today's dollars.
At age twenty-seven, after reading Adam Smith's The Wealth of Nations,
Ricardo got excited about economics. He wrote his first economics
article at age thirty-seven and then spent only fourteen years—his last
ones—as a professional economist. His Principles of Political Economy
and Taxation was published in 1817, in which he presented the law of
comparative advantage, one of the most important and still unchallenged
laws of economics, with many practical applications.

Ricardo first gained notice among economists over the "bullion
controversy." In 1809 he wrote that England's inflation was the
result of the Bank of England's propensity to issue excess bank
notes. In short, Ricardo was an early believer in the quantity theory
of money, or what is known today as monetarism.
In his Essay on the Influence of a Low Price of Corn on the Profits of
Stock (1815), Ricardo articulated what came to be known as the law of
diminishing returns. One of the most famous laws of economics, it holds
that as more and more resources are combined in production with a
fixed resource—for example, as more labor and machinery are used on
a fixed amount of land—the additions to output will diminish.
Ricardo also opposed the protectionist Corn Laws(谷物法), which
restricted imports of wheat. In arguing for free trade, Ricardo formulated
the idea of comparative costs, today called comparative advantage
(LTV: Labor Theory of Value). Comparative advantage—a very subtle
idea—is the main basis for most economists' belief in free trade today.
The idea is this: a country that trades for products that it can get at lower
cost from another country is better off than if it had made the products at
home.

 The Concept of Law of Comparative Advantage
In a two-nation and two-commodity world economy, even if one nation
is less efficient than the other nation in the production of both
commodities, there is still a basis for mutually beneficial trade. The first
nation should specialize in the production of and export the commodity in
which its absolute disadvantage is smaller (the commodity of its
comparative advantage) and import the commodity in which its absolute
disadvantage is greater (the commodity of its comparative disadvantage).
Note that in a two-nation, two-commodity world, once it is determined
that one nation has a comparative advantage in one commodity, then the
other nation must necessarily have a comparative advantage in the other
commodity.

 Assumptions of the model:
• Only two countries and two commodities in the world (Home and
Foreign)
• Free Trade
• Perfect mobility of labor within each nation but immobility
between the two nations
• Constant costs of production
• No transportation cost
• No technical change
• The labor theory of value

 The Illustration of Comparative Advantage
Without Trade
U.S. U.K.
Explanation: US has an absolute advantage of both wheat and
cloth with respect to UK, but the absolute advantage is greater in
wheat(6:1) than cloth (4:2), US has a comparative advantage in
wheat. On the contrary , UK’s comparative advantage in cloth
( smaller absolute disadvantage).

 The Gains from Trade
If the trade exchange rate is equal to the domestic exchange
rate , no trade happens. Only trading partners can gains by
each specializing in the production and exporting the
commodity of its comparative advantage, international trade
happens.
E.G. (page table 2.2)
With Trade (specialization)
U.S. U.K.
Explanation: If US exports 6w for 4c from UK, and UK exports 2c
for 1w from US, no trade happens since it is the same with
domestic exchange without trade .

 The comparative advantage can be expressed in terms of
currency of either nation (Price difference)
E.G. See table 2.2
U.S. U.K.
Wheat (bushels/man-hour) 6 ($1) 1($2)
Cloth (yards/man-hour) 4 ($1.5) 2 ($1)
Suppose that the wage rate in US is $6 dollar per hour, since one
man-hour produces 6w in US, the price of a bushel of wheat is Pw
= $1, Pc=$1.5; Suppose UK 1pound per hour, Pw=1pound,
Pc=0.5pound. If the exchange rate 1pound =$2, Pw=$2, Pc=$1
Business people would buy the lower price of wheat in US and sell them
in UK; on the contrary buying the lower price of cloth in UK and sell
them in US.

 The exchange rate influences the international trade
E.G. If 1 pound = $1, in UK Pw=$1 and Pc=$0.5
No trade happens in Wheat from US to UK, and UK would
export more cloth to US. Trade would be unbalanced in favor of the
UK, and the exchange rate between the dollar and the pound would
have to rise.
E.G. If 1 pound =$3, in UK Pw=$3 and Pc=$1.5( the same with US)
No trade happens in Cloth from UK to US, and US would export
more wheat to UK. Trade surplus in UK would decrease while US
trade deficit would decrease, and imbalance trade between the two
countries would decrease.
Therefore , each country need pay attention to its own currency
exchange rate to other nation’s.

 Conclusion
 We examined the Ricardian model, the simplest model
that shows how differences between countries give rise
to trade and gains from trade.
 In this model, labor is the only factor of production and
countries differ only in the productivity of labor in
different industries.
 In the Ricardian model, a country will export that
commodity in which it has comparative (as opposed to
absolute) labor productivity advantage.

 Conclusion
 The fact that trade benefits a country can be
shown in either of two ways:
• We can think of trade as an indirect method of
production.
• We can show that trade enlarges a country’s
consumption possibilities.
 The distribution of the gains from trade
depends on the relative prices of the goods
countries produce.

 Conclusion
 Extending the one-factor, two-good model to a
world of many commodities makes it possible
to illustrate that transportation costs can give
rise to the existence of nontraded goods.
 The basic prediction of the Ricardian model-
that countries will tend to export goods in
which they have relatively high productivity-
has been confirmed by a number of studies.

2.5 Comparative Advantage and
Opportunity Costs
 Comparative Advantage and the Labor
Theory of Value
 The Opportunity Cost Theory
 The Production Possibility Frontier
under Constant Costs
 Opportunity Costs and Relative
Commodity Prices
 Comments
 Conclusion

 Production Possibility Frontier
It is a curve that shows the alternative combinations of the two
commodities that a nation can produce by fully utilizing all of its
resources with the best technology available to it.
See table 2.4 (page 42) to show:
1. US’s opportunity cost of wheat is two-thirds of a unit of cloth, while
the opportunity cost of cloth is one and one-second units of wheat;
2. UK’s opportunity cost of wheat is two units of cloth, while the
opportunity cost of cloth is one-second of a unit of wheat;

 Illustration of PPF
FIGURE 2-1 The Production Possibility Frontiers of the United States and
the United Kingdom.

 Conclusion
 To explain the basis for mutually beneficial trade
Labor theory of value (David Ricardo) →Opportunity
cost theory (marginalism) → (absolute) slope of
the production possibility frontier (Transformation
Curve)→ the relative price of the commodity (price
difference)→ trade basis
 Opportunity cost of a commodity is equal to the relative
price of that commodity and is given by the (absolute)
slope of the production possibility frontier.

 Conclusion
In the absence of trade, a nation’s production possibility
frontier is also its consumption frontier. With trade, each
nation can specialize in producing the commodity of its
comparative advantage and exchange part of its output with
the other nation for the commodity of its comparative
disadvantage. By so doing, both nations end up consuming
more of both commodities than without trade. With complete
specialization, the equilibrium-relative commodity prices will
be between the pretrade-relative commodity prices prevailing
in each nation.

2.7 Empirical Tests of the
Ricardian Model
 Examination of empirical tests of Ricardo Model
If we allow for different labor productivities in various industries in
different nations, Ricardo trade model does a reasonably good job at
explaining the patter of trade.
1. Mac Dougall in 1951 and 1952 using labor productivity and
export data for 25 industries in US and UK for the year 1937
Relative Labor Productivities and Comparative Advantage–United
States and United Kingdom.
Conclusion: Positive relationship between labor productivity and
exports, higher productivity more exports.
(see figure 2-4)

2.7 Empirical Tests of the
Ricardian Model
2. Golub study in 1995
The conclusion is that in general , relative unit labor costs( the ratio of
wages to unit labor productivity) and exports were inversely related.
That is to say, the lower labor costs more exports, and verse versa.
The color line shows a clear negative correlation between relative unit
labor costs and relative exports for the 33 industries . Supporting
Ricardo model.
(See figure 2-5)

Chapter Summary
 This chapter examined the development of trade theory
from the mercantilism to Smith, Ricardo, and Haberler and
sought to answer three basic questions: (1) what is the
basis for trade? (2) What are the gains from trade? (3) what
is the pattern of trade?
 Although Ricardo theory was confirmed by many empirical
studies, the model explains neither the reason for the
difference in labor productivity or costs across nations nor
the effect of international trade on the earnings of factors.

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