Section

International
Economics I
(Econ 3081)
B.A. Degree in
Economics International Economics I
Mengesha (Econ 3081)
Yayo
(Ph.D.)
B.A. Degree in Economics
Classical
Trade
Theories
Adam Mengesha Yayo (Ph.D.)
Smith’s
Principle of
Absolute
Advantage
David AAU, Department of Economics
Ricardo’s
Theory of Nov, 2021
Compara-
tive
Advantage
Contents
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical 1 Classical Trade Theories

Trade
Theories Adam Smith’s Principle of Absolute Advantage
Adam David Ricardo’s Theory of Comparative Advantage
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
The Classical Trade Theories
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Classicals
Mengesha
Yayo The forerunners
(Ph.D.) David Hume
Richard Cantillon
Classical Adam Smith (Philosophy On Division of Labour, Public Finance, Wealth)
Trade
Theories David Ricardo (Rent and the Law of Diminishing Returns, Profits and the
Adam Theory of Distribution, Theory of Value and Price, The Theory of
Smith’s
Principle of Comparative Cost)
Absolute Thomas Robert Malthus ( The Theory of Gluts)
Advantage
David Bentham, Say, and Mill (Jeremy Benthamm, Jean Baptiste Say, John
Ricardo’s Stuart Mill)
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Adam Smith (1723 – 1790) provided the basic building block for the
Economics
construction of the classical theory of international trade. He
Mengesha enunciated the theory in terms of what is called Absolute Advantage
Yayo
(Ph.D.) model.
Another well known classiest, David Ricardo (1722 – 1823),
Classical articulated it and expanded it further into what is called
Trade
Theories Comparative Advantages model.
Adam The models of Smith and Ricardo together constitute what is
Smith’s
Principle of sometimes referred to as the supply version of the classical theory of
Absolute
Advantage trade, because Smith and Ricardo paid almost exclusive attention to
David considerations of supply or production costs in the determination of
Ricardo’s
Theory of terms of trade and the gains from trade.
Compara- The modern version of the classical theory of trade, however, treats
tive
Advantage supply and demand with equal weight.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
John Stuart Mill (1806 -1873), another renowned classical economist, was
Mengesha the first to indicate that demand considerations must be incorporated into
Yayo Comparative advantage model. But Mill was not very clear or articulate.
(Ph.D.)
The vagueness in Mill’s principle of Reciprocal Demand was
removed in the 19th century, first by F.Y.
Classical
Trade Edgeworth and later by Alfred Marshall.
Theories
Both Marshal and Edgeworth are credited with originating and
Adam
Smith’s developing the theory of offer curves, which is a geometric technique
Principle of of demonstrating the theory of reciprocal demand.
Absolute
Advantage All these contributions of Smith, Ricardo, Mill, Edgeworth and Marshall,
David put together, would constitute the modern version of the classical theory
Ricardo’s of comparative advantage, which is the oldest and the most famous model
Theory of
Compara- of international trade.
tive
Advantage
The Classical Trade Theories:Adam Smith’s Principle of Absolute Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Adam Smith (1723 – 1790)

Yayo Although Adam Smith was the founder of the classical school, David
(Ph.D.) Ricardo was the leading figure in further developing the ideas of that
school.
Classical
Trade Adam Smith is regarded as the patriarch of economics. His major
Theories works (books) were:
Adam i. An Enquiry into the Nature and Causes of the Wealth of
Smith’s
Principle of Nations (1776)==>This is his most important work (his
Absolute masterpiece) which in short is known as ‘the Wealth of
Advantage Nations’.
David ii. The Theory of Moral Sentiments (1759).
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I Adam Smith (1723 – 1790)
(Econ 3081) Adam smith challenged the mercantilists views on what constituted the
B.A. Degree in
Economics wealth of Nations, and what contributed to "nation building" or increasing
the wealth and welfare of nations.
Mengesha
Yayo Smith was the first economist to show that goods, rather than gold (or
(Ph.D.) treasure), were the true measure of the wealth of a nation.
He argued that the wealth of a nation would expand most rapidly if
Classical the government would abandon mercantilist controls over foreign
Trade trade.
Theories
Adam Smith also exploded the mercantilist myth that in international trade one
Smith’s country gains at the cost of other countries.
Principle of
Absolute He showed how all countries would gain from international trade
Advantage through the international division of labor.
David
Ricardo’s Adam Smith, in his Wealth of nations (1776), argued that a country could
Theory of certainly gain by trading with other nations.
Compara-
tive Just as a tailor does not make his own shoes but exchanges a suit
Advantage for shoes, and hence both the tailor and the shoe maker gain by
trading, in the same manner, Smith argued that a country as a
whole would gain by having trade relations with other countries.
International Adam Smith (1723 – 1790)-Assumptions

Economics I
(Econ 3081) 1 There are constant returns to scale in the production of both goods in the
B.A. Degree in two countries (i.e. constant marginal opportunity cost conditions).
Economics
2 The production possibilities are such that both countries can produce both
Mengesha the goods if they wish.
Yayo
(Ph.D.) 3 The countries are endowed with X amounts of factors of production such
that:
Classical a) With X factors of production country A can produce either 100
Trade units of rubber or 50 units of textile, or any other mix of rubber and
Theories
textile, that satisfies the opportunity cost ratio of 2:1
Adam
Smith’s b) With X factors of production country B can produce either 50
Principle of units of rubber or 100 units of textile, or some other combinations
Absolute of rubber and textile subject to the opportunity cost ratio of 1:2
Advantage
David From the above production possibilities (or supply conditions), it is
Ricardo’s quite clear that country A has an absolute advantage in the
Theory of production of rubber, and country B has an absolute advantage in
Compara-
tive the production of textile.
Advantage This means there is symmetrical factor distribution between the two
countries so that there is scope for specialization in production and
also a scope for establishing mutually beneficial trade between the
two countries.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Adam Smith started with the simple truth that for two nations to trade
with each other voluntarily, both nations must gain.
Mengesha
Yayo If one nation gained nothing or lost, it would simply refuse to trade.
(Ph.D.) The question is “how does this mutually beneficial trade take place,
and from where do these gains from trade come?”
Classical According to Adam Smith, trade between two nations is based on absolute
Trade advantage.
Theories
Adam When one nation is more efficient than (or has an absolute
Smith’s advantage over) another in the production of one commodity but is
Principle of less efficient than (or has an absolute disadvantage with respect to)
Absolute
Advantage the other nation in producing a second commodity,
David Then both nations can gain by each specializing in the
Ricardo’s production of the commodity of its absolute advantage and
Theory of
Compara- exchanging part of its output with the other nation for the
tive commodity of its absolute disadvantage.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics By this process, resources are utilized in the most efficient way and the
Mengesha output of both commodities will rise.
Yayo This increase in the output of both commodities measures the gains
(Ph.D.) from specialization in production available to be divided between the
two nations through trade.
Classical
Trade For example,
Theories because of climatic conditions, Canada is efficient in growing wheat
Adam but inefficient in growing bananas .
Smith’s
Principle of On the other hand, Nicaragua is efficient in growing bananas but
Absolute inefficient in growing wheat.
Advantage Thus, Canada has an absolute advantage over Nicaragua in the
David cultivation of wheat but an absolute disadvantage in the cultivation
Ricardo’s
Theory of of bananas.
Compara- The opposite is true for Nicaragua.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Under these circumstances, both nations would benefit if each specialized
Mengesha in the production of the commodity of its absolute advantage and then
Yayo traded with the other nation.
(Ph.D.) Canada would specialize in the production of wheat (i.e., produce
more than needed domestically) and exchange some of it for
Classical (surplus) bananas grown in Nicaragua.
Trade As a result, both more wheat and more bananas would be grown
Theories
Adam and consumed, and both Canada and Nicaragua would gain.
Smith’s Unlike the Mercantilists, Adam Smith (and the other classical economists
Principle of
Absolute who followed him) believed that all nations would gain from free trade and
Advantage strongly advocated a policy of laissez-faire.
David Implication of trade based on absolute advantage
Ricardo’s
Theory of Free trade would cause world resources to be utilized most efficiently
Compara- and would maximize world welfare.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
There were to be only a few exceptions to this policy of laissez-faire and
Mengesha free trade.
Yayo
(Ph.D.) One of these was the protection of industries important for national
defense.
Classical In view of this belief, it seems paradoxical that today most nations
Trade impose many restrictions on the free flow of international trade.
Theories Trade restrictions are invariably rationalized in terms of national
Adam welfare.
Smith’s
Principle of Trade restrictions are advocated by the few industries and
Absolute their workers who are hurt by imports.
Advantage
Trade restrictions benefit the few at the expense of the many
David
Ricardo’s (who will have to pay higher prices for competing domestic
Theory of goods).
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) Illustration of Absolute Advantage
Table 2.1: Absolute Advantage
Classical
Trade US Uk
Theories
Adam Wheat( bushels/hour) 6 1
Smith’s Cloth (yard/hour) 4 5
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Table 2.1 shows that

Yayo One hour of labor time produces six bushels of wheat in the United
(Ph.D.) States but only one in the United Kingdom.
On the other hand, one hour of labor time produces five yards of
Classical cloth in the United Kingdom but only four in the United States.
Trade Thus,
Theories
Adam The United States is more efficient than, or has an absolute
Smith’s advantage over, the United Kingdom in the production of
Principle of
Absolute wheat,
Advantage Whereas the United Kingdom is more efficient than, or has an
David absolute advantage over, the United States in the production
Ricardo’s of cloth.
Theory of
Compara-
tive
Advantage
International
Economics I With trade,
(Econ 3081)
B.A. Degree in The United States would specialize in the production of wheat and
Economics exchange part of it for British cloth.
Mengesha British would specialize in the production of cloth and exchange part
Yayo of it for United States wheat.
(Ph.D.) If the United States exchanges six bushels of wheat (6W) for six
yards of British cloth (6C),
Classical the United States gains 2C or saves 1/2 hour or 30 minutes of
Trade labor time (since the United States can only exchange 6W for
Theories
4C domestically).
Adam
Smith’s Similarly, the 6W that the United Kingdom receives from the
Principle of United States is equivalent to or would require six hours of
Absolute labor time to produce in the United Kingdom.
Advantage
David These same six hours can produce 30C in the United Kingdom (6
Ricardo’s hours times 5 yards of cloth per hour).
Theory of
Compara- By being able to exchange 6C (requiring a little over one hour to
tive produce in the United Kingdom) for 6W with the United States, the
Advantage United Kingdom gains 24C, or saves almost five labor - hours.
The fact that the United Kingdom gains much more than the
United States is not important at this time.
International
Economics I
(Econ 3081)
B.A. Degree in According to Smith, if one country has an absolute advantage over
Economics
another in one line of production, and the other country has an absolute
Mengesha advantage over the first country in another line of production, then both
Yayo countries would gain by trading.
(Ph.D.)
A. Autarky (closed economy) situation
Classical The table to the right implies that country A produces and
Trade consumes 50 units of rubber and 25 units of textile with the given
Theories production technology and input supply.
Adam The total production, GDP, is 75 units and this is the
Smith’s
Principle of maximum consumption level if we assume that saving is zero.
Absolute Country B produces 25 units of rubber and 50 units of textile
Advantage
with its given technology and input supplies.
David
Ricardo’s The total production of country B is 75 units and total
Theory of consumption will also be 75 units if savings are assumed to be
Compara- zero. For our simple world of two countries, therefore, world
tive
Advantage production and consumption will be 150 units.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in The case of open economy
Economics
Opening trade provides the two countries an opportunity to
Mengesha specialize in production.
Yayo
It will lead to production and consumption gains.
(Ph.D.)
These effects can be seen in the following table.
Classical Country A will specialize in the production and export of
Trade rubber and B will specialize in the production and export of
Theories
textile.
Adam
Smith’s Trade will enable the countries to realize production and
Principle of consumption gains.
Absolute After trade both countries become richer by 25 units than
Advantage
David their situation without trade and this is due to production
Ricardo’s gain from international trade.
Theory of The world GNP has also increased from 150 to 200 units.
Compara- Country A has specialized in the production of rubber and
tive
Advantage country B has specialized in the production of textile.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Production Gain in an open economy

Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I What about consumption gains?
(Econ 3081)
B.A. Degree in
After trade, have the consumer in the two countries been happier as
Economics a result of their countries becoming richer and more specialized in
terms of production? This depends on how the gains from
Mengesha
Yayo production are distributed between the two countries.
(Ph.D.) In other worlds consumption gains to the two countries depend up
on the terms of trade (TOT) i.e. how many units of rubber
Classical exchanged for one unit of textile between country A and B.
Trade Case 1. Trade at TOT = 1:1
Theories
Adam At this TOT country A agree with country B to exchange 1 unit of
Smith’s rubber for 1 unit of textile.
Principle of
Absolute Then depending up an the taste pattern in the two countries
Advantage and up on how much or how little they want to trade each
David other’s goods, the consumption gains can be determined.
Ricardo’s If the two countries want to consume all that they have
Theory of
Compara- produced, it mean that their consumers have no taste for the
tive product of the other country then, there will be no trade
Advantage between countries.
But if each country wants to consume some mix of both
goods; then the countries will trade each other’s goods.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Country A could export, say; 40 units of rubber for 40 units of textile
Mengesha import from country B (at terms of trade 1:1). The result of this trade
Yayo can be depicted in table 3 below.
(Ph.D.)
Country A, after trade, has produced 100 units of rubber (see table 2)
Classical consumers in country A want to consume 60 of rubber, which means that
Trade this country can export 40 units of rubber to country B in exchange for 40
Theories units textile imports.
Adam
Smith’s As a result, their consumption will increase by a total of 25 units
Principle of than the case without trade (see table 1).
Absolute Similarly, country B’s consumption level will also increase by 25
Advantage
David units than the situation without trade However, if the terms of trade
Ricardo’s is equal to the cost ratio of country A, all the gains from trade will
Theory of be attributed to country B.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo Conversely, if the term of trade is equal to the cost ratio of county
(Ph.D.) B, all the gains from trade will be attributed to country A.
Classical
Any other terms of trade between the cost ratios of the two
Trade countries may lead to unequal gains to country A and B.
Theories
Adam The country whose domestic cost ratio is larger by small amount
Smith’s than the TOT will gain the smaller share and vice versa i.e.
Principle of
Absolute if TOT closer to the domestic opportunity cost ratio of country
Advantage
David
A, country A will gain the smaller and B will gain larger.
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Case 2: Trade at TOT =Domestic opportunity cost ratio of country A =
2:1
Mengesha
Yayo All the consumption gains from international trade go to country B
(Ph.D.) because the TOT is equal to the domestic opportunity cost ratio of
country A.
Classical Thus such a TOT is favorable to country B but does not
Trade bring any change in welfare level of A.
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Case 3: Trade at TOT =Domestic opportunity cost ratio of country B =
1:2
Mengesha
Yayo All the consumption gains from international trade go to country A
(Ph.D.) because the TOT is equal to the domestic opportunity cost ratio of
country B. Thus such a TOT is favorable to country A. It does not
Classical bring any change in the consumption level of country B.
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive The welfare of country B before and after trade remains constant.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Case 4: Trade at TOT = 2:3
Mengesha
Yayo Most of the consumption gains from international trade go to
(Ph.D.) country A because the TOT is closer to the domestic opportunity
cost ratio of country B than country A. Thus such a TOT is more
Classical favorable to country A than country B.
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Case 5: Trade at TOT = 3:2
Mengesha Most of the consumption gains from international trade go to
Yayo country B because the TOT is closer to the domestic opportunity
(Ph.D.) cost ratio of country A than country B. Thus such a TOT is more
favorable to country B than country A.
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Case 5: Trade at TOT = 3:2
Mengesha It is important to note that production gains alone are not sufficient
Yayo to determine the profitability of international trade from the
(Ph.D.) standpoint of an individual member country.
The consumption gains (welfare gains) are also equally important.
Classical How the consumption gains are determined is crucial in
Trade determining whether the economic well being (standard of
Theories
Adam living measured by consumption gains) of a member country
Smith’s has gone up as a result of international trade.
Principle of International TOT, therefore, plays a very important part in
Absolute determine the welfare gains from trade.
Advantage
David International trade would be beneficial and profitable for a
Ricardo’s country if it results in consumption gains.
Theory of
Compara- Production gains alone do not bring profitable trade from the stand
tive point of the country concerned, but it may from world point of view.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Limitation of Absolute advantage

Yayo Absolute advantage, however, can explain only a very small part of world
(Ph.D.)
trade today, such as some of the trade between developed and developing
countries.
Classical
Trade Most of world trade, especially trade among developed countries, could
Theories not be explained by absolute advantage.
Adam
Smith’s It remained for David Ricardo, with the law of comparative advantage, to
Principle of truly explain the basis for and the gains from trade.
Absolute
Advantage Absolute advantage will be seen to be only a special case of the more
David general theory of comparative advantage.
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Exercise
Yayo Suppose there are two regions in Ethiopia which produce two products
(Ph.D.) (Salt and Wheat).
Classical The differences in productivity (given in table below) could be caused by

Trade differences in labour skills, weather, or soil quality.
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) Exercise
Questions
Classical Calculate and fill the opportunity cost of producing the two products
Trade for each region in the space provided in the above table
Theories
Adam Identify the product that each region can have Absolute e advantage
Smith’s Identify the product that each region can have comparative
Principle of advantage
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
The Classical Trade Theories:David Ricardo’s Theory of Comparative Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha In 1817, Ricardo published his Principles of Political Economy and

Yayo Taxation, in which he presented the law of comparative advantage.
(Ph.D.) This is one of the most important and still unchallenged laws of
economics, with many practical applications.
Classical
Trade Ricardo, in relation to Adam Smith’s absolute cost advantage model of
Theories international trade, went farther, and argued that even if the countries did
Adam not have absolute advantage in any line of production over the others,
Smith’s international trade would be beneficial; leading to gains from trade to all
Principle of
Absolute the participating countries.
Advantage
Ricardo’s model is termed as comparative advantage model.
David
Ricardo’s Ricardo’s modal is a further refinement of Smiths’ model.
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo A ssumptions of the basic Ricardian Model
(Ph.D.) 1.Each country has a fixed endowment of resources, and all units of
each particular resource are identical.
Classical 2. The factors of production are completely mobile between
Trade alternative uses within a country. This assumption implies that the
Theories
prices of factors of production also are the same among these
Adam
Smith’s alternative uses.
Principle of 3. The factors of production are completely immobile externally;
Absolute that is, they do not move between countries. Therefore, factor
Advantage
David prices may be different between countries prior to trade.
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha A ssumptions of the basic Ricardian Model

Yayo
(Ph.D.) 4. A labor theory of value is employed in the model. Thus, the
relative value of a commodity is based solely on its relative labor
Classical content. From a production standpoint, this implies that
Trade (a) no other inputs are used in the production process, or
Theories
(b) any other inputs are measured in terms of the labor
Adam
Smith’s embodied in their production, or
Principle of (c) the other inputs/labor ratio is the same in all industries.
Absolute
Advantage In simple terms, this assumption means that a good embodying two
David hours of labor is twice as expensive as a good using only one hour.
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081) A ssumptions of the basic Ricardian Model
B.A. Degree in
Economics 5. The level of technology is fixed for both countries, although the
technology can differ between them.
Mengesha
Yayo 6 Unit costs of production are constant. Thus, the hours of labor
(Ph.D.) per unit of production of a good do not change, regardless of the
quantity produced. This means that the supply curve of any good is
Classical horizontal.
Trade 7. There is full employment.
Theories 8. The economy is characterized by perfect competition. No single
Adam consumer or producer is large enough to influence the market;
Smith’s
Principle of hence, all are price takers. All participants have full access to
Absolute market information, there is free entry to and exit from an industry,
Advantage and all prices equal the marginal cost of production.
David 9. There are no government-imposed obstacles to economic activity.
Ricardo’s
Theory of 10. Internal and external transportation costs are zero.
Compara- 11. The analysis is confined to a two-country, two-commodity
tive “world” to simplify the presentation. This simplification will be
Advantage
dropped later to make the model more realistic.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) Assumption of Ricardo’s Model
12. Both countries can produce both goods if they wish ( i.e.,
Classical dependence on each other is not mandatory)
Trade 13. Constant returns to scale in production of both goods in the
Theories two countries (constant marginal opportunity cost condition)
Adam 14. One country’s comparative advantage is grater in one line of
Smith’s
Principle of production and the other country’s comparative disadvantage is
Absolute smaller in the other line of production.
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Ricardian Comparative Advantage

Yayo Ricardo began by noting that Smith’s idea of absolute advantage
(Ph.D.) determined the pattern of trade and production internal to a
country when factors were perfectly mobile.
Classical Theories of why trade occurs can be grouped into three categories:
Trade
Theories Market size and distance between markets determine how
Adam much countries buy and sell. These transactions benefit both
Smith’s buyers and sellers.
Principle of Differences in labor, physical capital, natural resources and
Absolute
Advantage technology create productive advantages for countries.
David Economies of scale (larger is more efficient) create productive
Ricardo’s advantages for countries.
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) The Ricardian model says differences in productivity of labor between
countries cause productive differences, leading to gains from trade.
Classical Differences in productivity are usually explained by differences in
Trade technology.
Theories
Adam The Heckscher-Ohlin model says differences in labor, labor skills, physical
Smith’s capital and land between countries cause productive differences, leading to
Principle of
Absolute gains from trade.
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics The Ricardian model uses the concepts of opportunity cost and
Mengesha comparative advantage.
Yayo The opportunity cost of producing something measures the cost of
(Ph.D.) not being able to produce something else.
A country faces opportunity costs when it employs resources to
Classical produce goods and services.
Trade
Theories For example, a limited number of workers could be employed to produce
Adam either roses or computers.
Smith’s
Principle of The opportunity cost of producing computers is the amount of roses
Absolute not produced.
Advantage The opportunity cost of producing roses is the amount of computers
David not produced.
Ricardo’s
Theory of A country faces a trade off: how many computers or roses should it
Compara- produce with the limited resources that it has?
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha The Law of Comparative Advantage

Yayo
(Ph.D.) According to the law of comparative advantage, even if one nation is
less efficient than (has an absolute disadvantage with respect to)
the other nation in the production of both commodities, there is still
Classical
Trade a basis for mutually beneficial trade.
Theories The first nation should specialize in the production and export of
Adam the commodity in which its absolute disadvantage is smaller (this is
Smith’s the commodity of its comparative advantage) and
Principle of
Absolute The other nation should import the commodity in which its absolute
Advantage disadvantage is greater (this is the commodity of its comparative
David disadvantage).
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics How countries will benefit from international trade in a situation where
one country has a larger comparative advantage in the production of one
Mengesha
Yayo good and the other country has a smaller comparative disadvantage in the
(Ph.D.) production of the other good
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Absolute advantage
Mengesha Country A has absolute advantage in the production of both textile
Yayo and rubber over country B.
(Ph.D.) Country B has absolute disadvantage in the production of both
goods over country A.
Classical Relative (comparative) advantage
Trade
Theories Country A’s comparative advantage over country B is greater in the
Adam production of Ruber (3:1) as compared to Textile (1.5:1)
Smith’s Country B’s comparative disadvantage, in relation to country A, is
Principle of
Absolute lower in the production of Textile (1:1:5) as against Rubber (1:3)
Advantage In addition, country B can produce rubber at a far higher cost
David
Ricardo’s of production than textile.
Theory of For country B, the cost of producing 1 unit of rubber equals
Compara- the cost of producing 2 units of textile.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Hence,
Yayo Country A would specialize in product of rubber and country B in
(Ph.D.) production of textile.
The theory of comparative advantage suggests that a country
Classical should specialize in the production and export of those goods in
Trade which either its comparative advantage is greater or its comparative
Theories
disadvantage is smaller.
Adam
Smith’s It should import those goods, in the production of which its
Principle of comparative advantage is smaller or its comparative
Absolute
Advantage disadvantage is greater there by a country would be able to
David maximize its production (GNP) and consumption (economic
Ricardo’s welfare) gains from trade.
Theory of
Compara-
tive
Advantage
International
Economics I Case 1 Autarky Situation
(Econ 3081)
B.A. Degree in Table 9 indicates that country a produces and consumes 80 units of rubber
Economics
and 40 units of textile with the given production technology and input
Mengesha supply.
Yayo
The total production, GDP, is 120 units and this is the maximum
(Ph.D.)
consumption level if we assume that saving is zero.
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
Case 1 Autarky Situation
(Ph.D.)
Country B produces 20 units of rubber and 40 units of textile with its
Classical given technology and input supplies.
Trade The total production of country B is 60 units and total consumption will
Theories
Adam also be 60 units if savings are assumed to be zero.
Smith’s For our simple world of two countries, therefore, world production and
Principle of
Absolute consumption will be 180 units.
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
After trade country B becomes richer by 20 units than the autarky
Mengesha situation and the world GNP increases from 180 units to 200 units. This is
Yayo due to the fact that trade enables country A to specialize in the
(Ph.D.) production of Rubber, for which it has a greater comparative advantage,
and country B has specialized in the production of textile for which it has
Classical a smaller comparative disadvantage.
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
As in the case of Smith’s model, the distribution of production gains from
Mengesha
Yayo international trade among trading countries for consumption depends on
(Ph.D.) the terms of trade.
The following tables illustrate the distribution of consumption gains at
Classical different terms of trade.
Trade
Theories The gains are equally distributed to country A and B at TOT = 3:4.
Adam This TOT is exactly half way between internal cost ratios of country
Smith’s A (1:1) and country B (1:2).
Principle of From table 10 and 11, we observe that, although the production
Absolute
Advantage gains are obtained entirely by country B, the consumption gains are
David distributed equally between country A and B.
Ricardo’s
Theory of This is due to the equitable terms of trade.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam All the gains in consumption are appropriated by country B due to the
Smith’s reason that TOT is equal to the internal opportunity cost ratio of country
Principle of
Absolute A.
Advantage In this situation, country A will not gain anything from international trade,
David because the cost of importing the good is the same as the cost of
Ricardo’s
Theory of producing that good domestically.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s All the gains in consumption are appropriated by country A due to the
Principle of
Absolute reason that TOT is equal to the internal opportunity cost ration of
Advantage country B.
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo Law of Reciprocal Demand Offer curve Analysis
(Ph.D.) The Principle of Reciprocal Demand was developed by J.S. Mill in
1848 when he wrote his book: Principles of Political Economy.
Classical Later offer curve technique was developed by Edgeworth and
Trade Marshall.
Theories
Adam The offer curve tries to show how the terms of trade are
Smith’s determined by the interaction of demand and supply.
Principle of Their merit lies in the fact that they resolve the problem of
Absolute determining the exact terms of trade that emerge in trade
Advantage
David equilibrium.
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Assumptions
Mengesha
Yayo Simple model of the world with two countries A and B,
(Ph.D.) Country A specializes in the production of textile and B in the
production of rubber.
Classical The TOT, then according to the law of reciprocal demand, are
Trade determined by A’s demand for B’s product and B’s demand for A’s
Theories product.
Adam
Smith’s In other words, the TOT are determined by the intensity of
Principle of domestic demand for foreign goods (offer curve of the country
Absolute A) and of the foreign demand for domestic good (offer curve
Advantage
David of the other country B).
Ricardo’s The equilibrium TOT is determined at the point where the
Theory of offer curves of the two countries intersect.
Compara-
tive
Advantage
International
Economics I
(Econ 3081) Table 14 indicates that textile is country A’s exportable product, and
B.A. Degree in rubber is its importable product.
Economics
Country A has completely specialized in the production of textile, because
Mengesha it has an absolute or comparative advantage in this line of production.
Yayo
(Ph.D.) If consumers in country A want to consume rubber, it can be fulfilled only
by importing it from country B, which has achieved complete
Classical specialization in rubber production.
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Initially when country A does not have any rubber to consume at all, it is
Economics willing to export 25 units of textile in exchange for 5 units of rubber
Mengesha implying trade takes place at 5:1 terms of trade.
Yayo This is the highest TOT in table 5 and as trade continues between A and
(Ph.D.) B, the TOT declines.
The reason is, initially the marginal utility of rubber for country A is so
Classical high that it is willing to offer 5 units of textile (export) in exchange for 1
Trade
Theories unit of rubber (import).
Adam But as trade continues and country A consumes more and more of the
Smith’s
Principle of imported product (rubber), the marginal utility from additional
Absolute consumption of rubber goes down.
Advantage
David This is explained by the decrease in the TOT ratios in column 3 of table
Ricardo’s 10 from 5:1 to 1:1.
Theory of
Compara- This follows from the law of diminishing marginal utility where the
tive consumer is willing to pay higher price per unit of utility initially, but only
Advantage lower and lower price for subsequent unit that he/she buys.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo In the same way the price that a country is willing to pay per unit of
(Ph.D.) imports decrease as the imports increase in quantity.
The TOT in column 3 of table 14 are potential terms of trade, which only
Classical indicate country A’s propensity to trade more and more at different
Trade
Theories possible terms of trade.
Adam That is, as TOT decreases what country A want to export and import will
Smith’s also increase as indicated in columns 1 and 2 of table 14.
Principle of
Absolute We can plot the information in table 10 and draw the offer curve of
Advantage country A as shown below.
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
The continuous line which is drawn from the point of origin connecting all
Mengesha
Yayo the five points, 1,2,3,4, and 5 is the offer curve of country A.
(Ph.D.) It is designated as OA. It has a positive slope and it is non-linear.
Its positive slope derives from country A’s desire to trade more and more,
Classical though at different terms of trade.
Trade
Theories Up to point 5 its slope continues to be positive.
Adam
Smith’s At point 5, country A is willing to offer 100 units of textiles in exchange
Principle of for 100 units of rubber imports.
Absolute
Advantage Beyond point 5, however, the offer curve has a negative slope.
David This indicates that at point 5 where country A exports 100 units, its desire
Ricardo’s
Theory of or the capacity to export more textiles is exhausted.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo At point 6 in the diagram, country A is willing to accept or import 120
(Ph.D.) units of rubber at a price of only 90 units of textile exports.
This will not be acceptable to country B; because, for country B it is
Classical
Trade better to sell 100 units of rubber and receive100 units of textiles at point 5
Theories than trading at point 6.
Adam This means country A would be willing to trade with country B even
Smith’s
Principle of beyond point 5, but this will not be acceptable by country B.
Absolute
Advantage Therefore, trade virtually cannot take place beyond point 5.
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Properties of offer curve of a country.
Classical i. The relevant portion of the offer curve is positively sloped
Trade Only the positively sloping portion of the offer curve is relevant for
Theories
trade equilibrium.
Adam
Smith’s The negative portion of the other offer curve is an irrelevant range.
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Properties of offer curve of a country.
Mengesha ii. The offer curve is not a straight line, it is a non-linear curve.
Yayo This property follows from the law of diminishing marginal utility for
(Ph.D.) the purchased goods.
For a given unit of imported commodity, country A is willing
Classical
Trade to offer less and less price as it goes on importing more and
Theories more quantity.
Adam The rays which are drawn from the point of origin across
Smith’s points 1, 2, 3, 4, 5 and 6 represent potentially acceptable
Principle of
Absolute terms of trade from the standpoint of country A.
Advantage They all have different slopes suggesting that the price of
David rubber, payable in terms of the number of units of textiles per
Ricardo’s
Theory of unit of rubber imported, goes on decreasing as country A
Compara- imports lager and larger quantities of imports.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Properties of offer curve of a country.
Mengesha
Yayo iii. The offer curve is a composite curve (both demand and supply)
(Ph.D.) Each point on the offer curve represents the demand of the country
for imports and supply of the country (exports).
Classical The offer curve of a country has an affinity with the potential terms of
Trade
Theories trade.
Adam The question then is where the actual terms of trade are?
Smith’s
Principle of This cannot be known until the other country’s offer curve is
Absolute known.
Advantage It is unnecessary to repeat the whole explanation, because the
David same principles apply to country B’s offer curve as those of
Ricardo’s
Theory of country A’s offer curve.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics The only point to emphasize for contrast would be that country A’s
Mengesha importable product would be country B’s exportable.
Yayo Once we know the offer curve of country A and country B, we can see
(Ph.D.) where the actual terms of trade are.
Figure 2.2 demonstrates where the terms of trade are actually settled
Classical
Trade between the two countries.
Theories OA and OB are the two offer curves of country A and country B.
Adam Both intersect at point 1, country A is willing to offer (export) Oa
Smith’s
Principle of quantity of textiles in exchange for Ob quantity of rubber imports.
Absolute This perfectly matches with country B’s trading propensity as well,
Advantage because at point 1, country B is willing to offer (export) Ob
David quantity of rubber in exchange for Oa quantity of textile imports.
Ricardo’s
Theory of In other words, A’s demand for B’s product exactly coincides with
Compara- B’s demand for A’s product at point 1.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics The straight line starting from the point of origin and going through point
Mengesha 1 is the equilibrium terms of trade line, Oe.
Yayo The slope of this line represents the international terms of trade
(Ph.D.) (i.e., the price of rubber in terms of textile).
The two countries can trade as much or as little as they wish along
Classical the terms of trade line Oe, but beyond point 1 on the Oe line they
Trade
Theories will have no incentive to trade further.
Adam The equilibrium size of trade is represented by the triangle Oal or
Smith’s Ob1 i.e., when Oa exports of country A (or bl imports of country B)
Principle of are matched by al imports of country a (or Ob exports of country B).
Absolute
Advantage Beyond point 1, there will be no incentive for trade between the two
David countries.
Ricardo’s
Theory of By the same token, an incentive to trade will not stop until the two
Compara- countries reach point 1 on the Oe line. Why ?
tive
Advantage
International Take for instance a point such as point 2 on the terms of trade line Oe.
Economics I At point 2 there is:
(Econ 3081)
B.A. Degree in Excess offer of C3C1 amount of rubber by country B to country A,
Economics
and
Mengesha Excess offer of C2C4 amount of textiles by country A to country B.
Yayo Both the countries accept this excess offers and their trade volumes
(Ph.D.) increase.
This process of trade expansion will go on until the excess offers by
Classical the two countries are eliminated.
Trade Such a point is reached when both countries arrive at point 1, where
Theories
Adam country A’s offer is exactly equal to what country B is asking for,
Smith’s and country B’s offer is also exactly equal to what country A is
Principle of willing to accept.
Absolute
Advantage We say that at point 1 the reciprocal demands of the two
David countries are in exact balance and trade equilibrium point is
Ricardo’s reached.
Theory of
Compara- This has taken place at a point where the two offer curves
tive intersect.
Advantage The size of international trade corresponding to this equilibrium
position is Oa of textile exports plus b1 of rubber imports for
country A that equals a1 textile imports plus Ob rubber exports of
country B at Oe terms of trade.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Changes in Terms of Trade

Yayo The offer curve of a country is both a demand curve and a supply
(Ph.D.) curve.
It is a demand curve to the extent that it represents domestic
Classical
Trade demand for foreign goods.
Theories It is also a supply curve in sofar as it represents quantities of
Adam exportable goods offered in exchange for imported good.
Smith’s
Principle of An offer curve of a country, therefore, is a composite curve,
Absolute representing demand for importable goods and supply of exportable
Advantage goods.
David
Ricardo’s This applies to offer curves of both (or all) the countries.
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Changes in Terms of Trade
Mengesha When the offer curves of two countries intersect at a point such as 1
Yayo in figure 2.2 we have equilibrium terms of trade in the static sense.
(Ph.D.) But the conditions underlying demand and supply in the home and
the foreign country do not remain static forever.
Classical
Trade Many dynamic changes are possible.
Theories For example, the domestic demand for foreign goods may
Adam change due to changes in tastes, incomes, foreign prices of the
Smith’s goods etc.
Principle of
Absolute Similarly, the supplies of exportable goods may change on
Advantage account of changes in domestic cost conditions or demand
David conditions.
Ricardo’s
Theory of In the same way there could be changes affecting foreign
Compara- country’s offer curve as well.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Changes in Terms of Trade
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha This would shift the trade equilibrium position from point 1 to point 2 as
Yayo shown in figure 2.3.
(Ph.D.) Such a shift causes terms of trade to improve for country B and
worsen for country A.
Classical Country A is now able to import a smaller quantity of rubber in
Trade exchange for a given quantity of textile exports.
Theories
Adam This is suggested by the fact that the new terms of trade line, Ob, is
Smith’s steeper than the original terms of trade line Oe.
Principle of As the terms of trade line becomes steeper, and keeps moving closer
Absolute
Advantage to the vertical axis (where we measure country A’s export product)
David the terms of trade would go on worsening for country A and
Ricardo’s improving for country B.
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha A shift from point 1 to point 2 causing terms of trade deterioration for
Yayo country A has, in this case come about due to adverse changes in country
(Ph.D.) B for country A’s export product. This may have been as a result of
several factors like:
Classical A drop in the taste in country B for the product of country A.
Trade
Theories Country B might have diverted its trade direction away from country
Adam A to some other country in the world.
Smith’s
Principle of This will reduce country B’s demand for country A’s product.
Absolute Country B might have launched a program of import substitution as
Advantage a result of which it has started’ producing country A’s product
David
Ricardo’s domestically within country B itself.
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in It is also possible for terms of trade to worsen for country A even though
Economics there are no adverse changes in country B towards the product of country
Mengesha A.
Yayo For instance, starting from point 1 we could end up at point 3 in figure 2.3.
(Ph.D.)
This will also shift the terms of trade line from Oe to Ob.
Note, however, that this time the worsening of terms of trade is a
Classical
Trade result of a leftward shift in country A’s offer curve from OA1 to OA2.
Theories Such a shift is due to changes that have taken place within
Adam country A itself.
Smith’s
Principle of These internal changes could be:
Absolute Increase in export production in country A leading to fall in
Advantage
David the price of export product.
Ricardo’s A technological revolution in the export production has
Theory of considerably cut costs of producing textiles in country A.
Compara-
tive This would mean that country A has become a more efficient
Advantage producer and exporter of its product to country B.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) In this way it is possible to visualize number of changes in supply condition
in country A that will have the effect of shifting its offer curve from OA1
Classical to OA2.
Trade Compare now the effects on terms of trade on country A as a result of
Theories
Adam going from point 1 to point 2 and going from point 1 to point 3.
Smith’s In either case, of course, there has been the same degree of deterioration in
Principle of
Absolute terms of trade affecting country A adversely. But there are differences too.
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International These differences are:

Economics I Movement from point 1 to point 2 has resulted in contraction of the
(Econ 3081) volume of world trade; but in respect of the movement from point 1
B.A. Degree in
Economics to point 3 there has been an expansion in trade volume.
Movement from point 1 to point 2 is the result of an adverse
Mengesha demand shift in the foreign country (country B) causing terms of
Yayo
(Ph.D.) trade decline for country A.
Country A may suffer trading losses on account of such terms of
Classical trade deterioration. In the case of a movement from point 1 to point
Trade 3, however, there is decline in terms of trade for country A; but this
Theories term of trade decline may not amount to a trading loss as such.
Adam Because, this movement has resulted from favorable supply shifts in
Smith’s the home country (country A) itself, such as for example
Principle of
Absolute technological progress or efficiency in export production leading to
Advantage reduced input costs.
David Country B, in this case benefits from such technological progress in
Ricardo’s
Theory of country A, because country A can now sell its product at a lower
Compara- price to country B.
tive Country A can increase country B’s welfare without suffering any
Advantage
loss of welfare itself.
In this way the benefits of progress in one country (country d A in
this case) can be transmitted to other countries (country B) in the
form of reduced export prices.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics The classical economists had these advantages of trade in their mind; they
Mengesha thought that international trade would act as a "transmission belt" in
Yayo which the benefits of growth, productivity and efficiency in one country
(Ph.D.) will be passed on to other countries through the mechanism of trade.
The reality of the world today may appear to be quite puzzling.
Classical Advanced industrial countries have experienced remarkable progress in
Trade
Theories technology and productivity in the last several years, but this does not
Adam seem to have resulted in reduced prices of their products to the developing
Smith’s countries.
Principle of
Absolute Examples are not lacking.
Advantage
David According to a United Nations’ report, 25 tons of rubber exports
Ricardo’s could earn enough foreign exchange for a less developed country to
Theory of buy 6 tractors from an advanced industrial country in 1960; but in
Compara- 1975, the same 25 tons of rubber can buy only 2 tractors.
tive
Advantage
International Technological breakthrough in rubber production has reflected in rubber

Economics I
(Econ 3081) price reduction by rubber exporting countries (i.e. the LDCs), but the
B.A. Degree in industrial countries have not reduced their tractor prices in spite of a much
Economics
more spectacular technological progress in all fields of industrial
Mengesha production.
Yayo This is quite contrary to what the classical economists had hoped about
(Ph.D.)
benevolent trade between countries.
Classical Where have the productivity gains, resulting from technological progress in
Trade the industrial countries, gone then? They have gone in the form of higher
Theories wages, profits and standards of living in those countries themselves.
Adam
Smith’s The benefits of technological progress in the LDCs have gone to the
Principle of industrial countries in the form of reduced prices of primary goods, which
Absolute the LDCs export to the industrial countries.
Advantage
David This would only suggest that trade is benefiting the rich countries
Ricardo’s and not the poor countries.
Theory of
Compara- Productivity gains are going from the poor to the rich countries, while rich
tive countries themselves are retaining their productivity gains by improving
Advantage
their wage and profit levels.
LDCs are quite bitter about such kind of trade relationship existing in the
world today.
International
Economics I Let us now take another situation where the offer curve of country B, rich
(Econ 3081)
B.A. Degree in country, is a straight line and the offer curve of country A, poor country,
Economics not as shown in the following figure 2.4.
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) To whatever direction the offer curve of country A shifts, the terms of
trade remains constant and equal to the offer curve of country B.
Classical
Trade From this it should be realized that a small country could exercise no
Theories influence in changing the course of international terms of trade.
Adam A small country, like country A in this case, is essentially price taker than
Smith’s
Principle of a price-maker.
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo The Case of No Comparative Advantage
(Ph.D.) There is one (not very common) case where there is no comparative
advantage. This occurs when the absolute disadvantage that one nation
Classical has with respect to another nation is the same in both commodities.
Trade
Theories
USA UK US-opp.cost UK-opp.cost
Adam
Smith’s
Principle of Wheat (bushels/hour) 6 6 0.6 0.6
Absolute Cloth ( yards/hour) 4 4 1.6 1.6
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081) A One Factor Ricardian Model
B.A. Degree in
Economics The simple example with roses and computers explains the intuition
Mengesha behind the Ricardian model.
Yayo We formalize these ideas by constructing a slightly more complex one
(Ph.D.) factor Ricardian model using the following simplifying assumptions:
Labor is the only resource important for production.
Classical Labor productivity varies across countries, usually due to differences
Trade
Theories in technology, but labor productivity in each country is constant
Adam across time.
Smith’s The supply of labor in each country is constant.
Principle of
Absolute Only two goods are important for production and consumption:
Advantage wine and cheese.
David Competition allows laborers to be paid a “competitive” wage, a
Ricardo’s function of their productivity and the price of the good that they
Theory of
Compara- can sell, and allows laborers to work in the industry that pays the
tive highest wage.
Advantage Only two countries are modeled: domestic and foreign.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
A One Factor Ricardian Model
Mengesha Because labor productivity is constant, define a unit labor requirement as
Yayo the constant number of hours of labor required to produce one unit of
(Ph.D.)
output.
Classical aLW is the unit labor requirement for wine in the domestic country.
Trade For example, if aLW = 2, then it takes 2 hours of labor to produce
Theories one liter of wine in the domestic country.
Adam aLC is the unit labor requirement for cheese in the domestic
Smith’s
Principle of country. For example, if aLC = 1, then it takes 1 hour of labor to
Absolute produce one kg of cheese in the domestic country.
Advantage A high unit labor requirement means low labor productivity.
David
Ricardo’s Because the supply of labor is constant, denote the total number of labor
Theory of hours worked in the domestic country as a constant number L.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
A One Factor Ricardian Model
Mengesha The production possibility frontier (PPF) of an economy shows the
Yayo
maximum amount of a goods that can be produced for a fixed amount of
(Ph.D.)
resources.
Classical If QC represents the quantity of cheese produced and QW represents the
Trade quantity of wine produced, then the production possibility frontier of the
Theories domestic economy has the equation:
Adam
Smith’s
Principle of aLC QC + aLW QW = L ← Tota amount of labour resourcel
Absolute
Advantage aLC =Labor required for each unit of cheese production, QC =Total unites
David
Ricardo’s of Cheese, aLW =La bour required for each of wine production , QW =Total
Theory of units of wine production
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha aLC QC + aLW QW = L

Yayo
(Ph.D.)
QC = L/aLC when QW = 0
Classical QW = L/aLW when QC = 0
Trade QW = L/aLW – (aLC /aLW )QC: the equation for the PPF, with a slope
Theories
Adam equal to – (aLC /aLW )
Smith’s When the economy uses all of its resources, the opportunity cost of cheese
Principle of
Absolute production is the quantity of wine that is given up (reduced) as QC
Advantage increases: (aLC /aLW ) When the economy uses all of its resources, the
David opportunity cost is equal to the absolute value of the slope of the PPF,
Ricardo’s and it is constant when the PPF is a straight line.
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
To produce an additional kg of cheese requires aLC hours of work.
Mengesha
Yayo Each hour devoted to cheese production could have been used to produce
(Ph.D.) a certain amount of wine instead, equal to 1 hour/(aLW hours/liter of
wine) = (1/aLW) liter of wine For example, if 1 hour is moved to cheese
Classical production, that additional hour of labor could have produced 1 hour/(2
Trade hours/liter of wine) = 1/2 liter of wine.
Theories
Adam The trade-off is the increased amount of cheese relative to the decreased
Smith’s amount of wine: aLC /aLW.
Principle of
Absolute In general, the amount of the domestic economy’s production is defined by
Advantage aLCQC + aLWQW ≤ L
David This describes what an economy can produce, but to determine what
Ricardo’s
Theory of the economy does produce, we must determine the prices of goods.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Production, Prices and Wages
Mengesha Let PC be the price of cheese and PW be the price of wine. Because of
Yayo competition, hourly wages of cheese makers are equal to the market value
(Ph.D.) of the cheese produced in an hour:
Pc /aLC hourly wages of wine makers are equal to the market value of the
Classical
Trade wine produced in an hour: PW /aLW Because workers like high wages,
Theories they will work in the industry that pays a higher hourly wage.
Adam If PC /aLC > PW/aLW workers will make only cheese. If PC /PW > aLC
Smith’s
Principle of /aLW workers will only make cheese.
Absolute The economy will specialize in cheese production if the price of cheese
Advantage
David relative to the price of wine exceeds the opportunity cost of producing
Ricardo’s cheese.
Theory of
Compara- If PC /aLC < PW /aLW workers will make only wine.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Production, Prices and Wages
Mengesha If PC /PW < aLC /aLW workers will only make wine. If PW /PC > aLW
Yayo /aLC workers will only make wine.
(Ph.D.)
The economy will specialize in wine production if the price of wine relative
to the price of cheese exceeds the opportunity cost of producing wine.
Classical
Trade If the domestic country wants to consume both wine and cheese (in the
Theories absence of international trade), relative prices must adjust so that wages
Adam are equal in the wine and cheese industries.
Smith’s
Principle of If PC /aLC = PW /aLW workers will have no incentive to flock to either
Absolute
Advantage the cheese industry or the wine industry, thereby maintaining a positive
David amount of production of both goods. PC /PW = aLC /aLW Production
Ricardo’s (and consumption) of both goods occurs when relative price of a good
Theory of
Compara- equals the opportunity cost of producing that good.
tive
Advantage
International
Economics I Trade in the Ricardian Model
(Econ 3081)
B.A. Degree in Suppose that the domestic country has a comparative advantage in cheese
Economics
production: its opportunity cost of producing cheese is lower than it is in
Mengesha the foreign country.
Yayo aLC /aLW < a*LC /a*LW
(Ph.D.)
where “*” notates foreign country variables
Classical When the domestic country increases cheese production, it reduces wine
Trade production less than the foreign country does because the domestic unit
Theories labor requirement of cheese production is low compared to that of wine
Adam production.
Smith’s
Principle of Suppose the domestic country is more efficient in wine and cheese
Absolute production.
Advantage
David It has an absolute advantage in all production: its unit labor requirements
Ricardo’s for wine and cheese production are lower than those in the foreign country:
Theory of
Compara- aLC < a*LC and aLW < a*LW A country can be more efficient in
tive producing both goods, but it will have a comparative advantage in only
Advantage one good—the good that uses resources most efficiently compared to
alternative production.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Trade in the Ricardian Model

Yayo
(Ph.D.) Even if a country is the most (or least) efficient producer of all goods, it
still can benefit from trade.
Classical To see how all countries can benefit from trade, we calculate relative
Trade prices when trade exists.
Theories
Adam Without trade, relative price of a good equals the opportunity cost of
Smith’s producing that good.
Principle of
Absolute To calculate relative prices with trade, we first calculate relative quantities
Advantage of world production: (QC + Q*C )/(QW + Q*W)
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International Relative Supply and Relative Demand

Economics I
(Econ 3081) The quantity of cheese supplied by all countries relative to the quantity of
B.A. Degree in
Economics wine supplied by all countries at each relative price of cheese, Pc /PW.
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Relative Supply and Relative Demand
Mengesha There is no supply of cheese if the relative price of cheese falls below aLC
Yayo /aLW . Why? because the domestic country will specialize in wine
(Ph.D.) production whenever PC /PW < aLC /aLW And we assumed that aLC
/aLW < a*LC /a*LW so foreign workers won’t find it desirable to produce
Classical cheese either.
Trade
Theories When PC /PW = aLC /aLW , domestic workers will be indifferent between
Adam producing wine or cheese, but foreign workers will still produce only wine.
Smith’s When a*LC /a*LW > Pc /PW > aLC /aLW , domestic workers specialize
Principle of
Absolute in cheese production because they can earn higher wages, but foreign
Advantage workers will still produce only wine. When a*LC /a*LW = PC / PW,
David foreign workers will be indifferent between producing wine or cheese, but
Ricardo’s
Theory of domestic workers will still produce only cheese. There is no supply of wine
Compara- if the relative price of cheese rises above a*LC /a*LW
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) Relative Supply and Relative Demand
Relative demand of cheese is the quantity of cheese demanded in all
Classical countries relative to the quantity of wine demanded in all countries at
Trade each relative price of cheese, PC /PW.
Theories
Adam As the relative price of cheese rises, consumers in all countries will tend to
Smith’s purchase less cheese and more wine so that the relative quantity of cheese
Principle of demanded falls.
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081) Relative Supply and Relative Demand
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081) Relative Supply and Relative Demand
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Gains From Trade

Yayo Gains from trade come from specializing in production that use resources
(Ph.D.) most efficiently, and using the income generated from that production to
buy the goods and services that countries desire.
Classical where “using resources most efficiently” means producing a good in
Trade
Theories which a country has a comparative advantage.
Adam Domestic workers earn a higher income from cheese production because
Smith’s
Principle of the relative price of cheese increases with trade.
Absolute Foreign workers earn a higher income from wine production because the
Advantage
David relative price of cheese decreases with trade (making cheese cheaper) and
Ricardo’s the relative price of wine increases with trade.
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Gains From Trade
Mengesha Think of trade as an indirect method of production or a new technology
Yayo that converts cheese into wine or vice versa.
(Ph.D.) Without the technology, a country has to allocate resources to produce all
of the goods that it wants to consume.
Classical
Trade With the technology, a country can specialize its production and trade
Theories (“convert”) the products for the goods that it wants to consume.
Adam
Smith’s We show how consumption possibilities expand beyond the production
Principle of possibility frontier when trade is allowed.
Absolute
Advantage Without trade, consumption is restricted to what is produced.
David With trade, consumption in each country is expanded because world
Ricardo’s
Theory of production is expanded when each country specializes in producing the
Compara- good in which it has a comparative advantage.
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Gains From Trade
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I Trade expands consumption possibilities
(Econ 3081)
B.A. Degree in International trade allows home foreign to consume anywhere within
Economics the colored lines, which lie outside the countries production
Mengesha possibility frontiers.
Yayo Numerical example
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Trade expands consumption possibilities

Yayo
(Ph.D.) The domestic country is more efficient in both industries, but it has
a comparative advantage only in cheese production.
Classical The foreign country is less efficient in both industries, but it has a
Trade comparative advantage in wine production.
Theories Quick quiz: what is its opportunity cost of producing wine? what is
Adam its opportunity cost of producing cheese?
Smith’s
Principle of With trade, the equilibrium relative price of cheese must be between
Absolute aLC /aLW = 1/2 and a*LC /a*LW = 2 Suppose that PC /PW = 1
Advantage in equilibrium. In words, one kg of cheese trades for one liter of
David wine.
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Trade expands consumption possibilities

Yayo
(Ph.D.) If the domestic country does not trade, it can use one hour of labor
to produce 1/aLW = 1/2 liter of wine. If the domestic country does
trade, it can use one hour of labor to produce 1/aLC = 1 kg of
Classical
Trade cheese, sell this amount to the foreign country at current prices to
Theories obtain 1 liter of wine.
Adam If the foreign country does not trade, it can use one hour of labor to
Smith’s produce 1/a*LC = 1/6 kg of cheese.
Principle of
Absolute If the foreign country does trade, it can use one hour of labor to
Advantage produce 1/a*LW = 1/3 liter of wine, sell this amount to the
David domestic country at current prices to obtain 1/3 kg of cheese.
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Relative wages
Economics
Relative wages are the wages of the domestic country relative to the wages
Mengesha in the foreign country.
Yayo
(Ph.D.) Although the Ricardian model predicts that relative prices equalize across
countries after trade, it does not predict that relative wages will do the
Classical same.
Trade Productivity (technological) differences determine wage differences in the
Theories
Adam Ricardian model. A country with absolute advantage in producing a good
Smith’s will enjoy a higher wage in that industry after trade.
Principle of
Absolute Suppose that PC = $12/kg and PW = $12/L Since domestic workers
Advantage specialize in cheese production after trade, their hourly wages will be
David (1/aLC)PC = (1/1)$12 = $12 Since foreign workers specialize in wine
Ricardo’s
Theory of production after trade, their hourly wages will be (1/a*LW)PW =
Compara- (1/3)$12 = $4 The relative wage of domestic workers is therefore $12/$4
tive =3
Advantage
International
Economics I Relative wages
(Econ 3081)
B.A. Degree in The relative wage lies between the ratio of the productivities in each
Economics
industry.
Mengesha The domestic country is 6/1 = 6 times as productive in cheese
Yayo
production, but only 3/2 = 1.5 times as productive in wine production.
(Ph.D.)
The domestic country has a wage rate 3 times as high as that in the
Classical foreign country. These relationships imply that both countries have a cost
Trade advantage in production.
Theories
Adam The cost of high wages can be offset by high productivity.
Smith’s The cost of low productivity can be offset by low wages.
Principle of
Absolute Because foreign workers have a wage that is only 1/3 the wage of
Advantage domestic workers, they are able to attain a cost advantage (in wine
David production), despite low productivity.
Ricardo’s
Theory of
Compara- Because domestic workers have a productivity that is 6 times that of
tive
Advantage foreign workers (in cheese production), they are able to attain a cost
advantage, despite high wages.
The Classical Trade Theories:Opportunity Costs and Comparative Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo Do Wages Reflect Productivity?
(Ph.D.) In the Ricardian model, relative wages reflect relative productivities of the
two countries.
Classical
Trade Is this an accurate assumption?
Theories
Some argue that low wage countries pay low wages despite growing
Adam
Smith’s productivity, putting high wage countries at a cost disadvantage.
Principle of But evidence shows that low wages are associated with low
Absolute productivity.
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I Do Wages Reflect Productivity?
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) Do Wages Reflect Productivity?
Other evidence shows that wages rise as productivity rises. In 2000, South
Classical Korea’s labor productivity was 35% of the US level and its average wages
Trade were about 38% of US average wages.
Theories
Adam After the Korean War, South Korea was one of the poorest countries in
Smith’s the world, and its labor productivity was very low. In 1975, average wages
Principle of in South Korea were still only 5% of US average wages.
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I Misconceptions About Comparative Advantage
(Econ 3081)
B.A. Degree in Free trade is beneficial only if a country is more productive than foreign
Economics
countries. But even an unproductive country benefits from free trade by
Mengesha avoiding the high costs for goods that it would otherwise have to produce
Yayo domestically.
(Ph.D.)
High costs derive from inefficient use of resources.
Classical The benefits of free trade do not depend on absolute advantage, rather
Trade they depend on comparative advantage: specializing in industries that use
Theories resources most efficiently.
Adam
Smith’s Free trade with countries that pay low wages hurts high wage countries.
Principle of
Absolute While trade may reduce wages for some workers, thereby affecting the
Advantage distribution of income within a country, trade benefits consumers and
David other workers.
Ricardo’s
Theory of Consumers benefit because they can purchase goods more cheaply (more
Compara- wine in exchange for cheese).
tive
Advantage Producers/workers benefit by earning a higher income (by using resources
more efficiently and through higher prices/wages).
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Misconceptions About Comparative Advantage
Mengesha
Yayo Free trade exploits less productive countries. While labor standards in
(Ph.D.) some countries are less than exemplary compared to Western standards,
they are so with or without trade.
Classical Are high wages and safe labor practices alternatives to trade?
Trade Deeper poverty and exploitation (e.g., involuntary prostitution) may result
Theories
Adam without export production.
Smith’s Consumers benefit from free trade by having access to cheaply (efficiently)
Principle of
Absolute produced goods.
Advantage
David Producers/workers benefit from having higher profits/wages—higher
Ricardo’s
Theory of compared to the alternative.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Comparative Advantage With Many Goods
Mengesha Suppose now there are N goods produced, indexed by i = 1,2,. . . N. The
Yayo
(Ph.D.) domestic country’s unit labor requirement for good i is aLi, and that of the
foreign country is a*Li
Classical Goods will be produced wherever it is cheaper to produce them.
Trade Let w represent the wage rate in the domestic country and w* represent
Theories
Adam the wage rate in the foreign country.
Smith’s If waL1 < w*a*L1 then only the domestic country will produce good 1,
Principle of
Absolute since total wage payments are less there.
Advantage Or equivalently, if a*L1 /aL1 > w/w* If the relative productivity of a
David
Ricardo’s country in producing a good is higher than the relative wage, then the
Theory of good will be produced in that country.
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Comparative Advantage With Many Goods

Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International Comparative Advantage With Many Goods

Economics I If w/w* = 3, the domestic country will produce apples, bananas, and
(Econ 3081)
B.A. Degree in caviar, while the foreign country will produce dates and enchiladas.
Economics The relative productivities of the domestic country in producing
Mengesha apples, bananas and caviar are higher than the relative wage.
Yayo If each country specializes in goods that use resources productively and
(Ph.D.) trades the products for those that it wants to consume, then each benefits.
If a country tries to produce all goods for itself, resources are “wasted”.
Classical The domestic country has high productivity in apples, bananas, and caviar
Trade
Theories that give it a cost advantage, despite its high wage.
Adam The foreign country has low wages that give it a cost advantage, despite
Smith’s
Principle of its low productivity in dates.
Absolute How is the relative wage determined? By the relative supply and relative
Advantage
(derived) demand for labor services.
David
Ricardo’s The relative (derived) demand for domestic labor services falls when w/w*
Theory of rises.
Compara-
tive As domestic labor becomes more expensive relative to foreign labor, goods
Advantage produced in the domestic country become more expensive, and demand for
these goods and the labor to produce them falls.
Fewer goods will be produced in the domestic country, further reducing
the demand for domestic labor.
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo Comparative Advantage With Many Goods
(Ph.D.) Suppose w/w* increases from 3 to 3.99: The domestic country would
produce apples, bananas, and caviar, but the demand for these goods and
Classical the labor to produce them falls as the relative wage rises.
Trade
Theories Suppose w/w* increases from 3.99 to 4.01: Caviar is now too expensive to
Adam produce in the domestic country, so the caviar industry moves to the
Smith’s foreign country, causing a discrete (abrupt) drop in the demand for
Principle of domestic labor.
Absolute
Advantage Consider similar effects as w/w* rises from 0.75 to 10.
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Comparative Advantage With Many Goods
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I Comparative Advantage With Many Goods
(Econ 3081)
B.A. Degree in Finally, suppose that relative supply of labor is independent of w/w* and
Economics
is fixed at an amount determined by the populations in the domestic and
Mengesha foreign countries.
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
The Classical Trade Theories : Production Possibilities Schedule and Comparative
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Ricardo’s law of comparative advantage suggested that specialization and
Economics trade can lead to gains for both nations. His theory, however, depended on
Mengesha the restrictive assumption of the labor theory of value, in which labor was
Yayo assumed to be the only factor input.
(Ph.D.) In practice, labor is only one of several factor inputs. Recognizing the
shortcomings of the labor theory of value, modern trade theory provides a
Classical more generalized theory of comparative advantage.
Trade
Theories It explains the theory using a production possibilities schedule, also called
Adam a transformation schedule.
Smith’s
Principle of This schedule shows various alternative combinations of two goods that a
Absolute nation can produce when all of its factor inputs (land, labor, capital,
Advantage entrepreneurship) are used in their most efficient manner.
David
Ricardo’s The production possibilities schedule thus illustrates the maximum output
Theory of possibilities of a nation.
Compara-
tive Note that we are no longer assuming labor to be the only factor input, as
Advantage Ricardo did.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in This figure (Figure 2) illustrates hypothetical production possibilities
Economics schedules for the United States and Canada.
Mengesha By fully using all available inputs with the best available technologyWith
Yayo constant opportunity costs, a nation will specialize in the product of its
(Ph.D.) comparative advantage.
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha The principle of comparative advantage implies that with specialization

Yayo and free trade, a nation enjoys production gains and consumption gains.
(Ph.D.)
A nation’s trade triangle denotes its exports, imports, and terms of trade.
Classical In a two-nation, two-product world, the trade triangle of one nation equals
Trade that of the other nation; one nation’s exports equal the other nation’s
Theories
imports, and there is one equilibrium terms of trade.
Adam
Smith’s During a given time period, the United States can produce either 60
Principle of bushels of wheat or 120 autos or certain combinations of the two products.
Absolute
Advantage Similarly, Canada can produce either 160 bushels of wheat or 80 autos or
David certain combinations of the two products.
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo Just how does a production possibilities schedule illustrate the concept of
(Ph.D.) comparative cost?
The answer lies in the slope of the production possibilities schedule,
Classical which is referred to as the marginal rate of transformation (MRT).
Trade
Theories The MRT shows the amount of one product a nation must sacrifice to get
Adam one additional unit of the other product:
Smith’s
Principle of △Wheat
Absolute MRT =
Advantage △Autos
David
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics This rate of sacrifice is sometimes called the opportunity cost of a product.
Mengesha Because this formula also refers to the slope of the production
Yayo possibilities schedule, the MRT equals the absolute value of the
(Ph.D.) production possibilities schedule’s slope.
In Figure 2 , the MRT of wheat into autos gives the amount of wheat that
Classical must be sacrificed for each additional auto produced.
Trade
Theories Concerning the United States, movement from the top endpoint on its
Adam production possibilities schedule to the bottom endpoint shows that the
Smith’s relative cost of producing 120 additional autos is the sacrifice of 60
Principle of
Absolute bushels of wheat.
Advantage This sacrifice means that the relative cost of each auto produced is
David 0.5 bushel of wheat sacrificed 60 120 0 5 ; the MRT 0 5.
Ricardo’s
Theory of Similarly, Canada’s relative cost of each auto produced is two bushels of
Compara-
tive wheat; that is, Canada’s MRT 2 0.
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Trading Under Constant -Cost Conditions

Yayo
(Ph.D.) This section illustrates the principle of comparative advantage under
constant opportunity costs.
Classical Although the constant-cost case may be of limited relevance to the real
Trade world, it serves as a useful pedagogical tool for analyzing international
Theories trade.
Adam
Smith’s The discussion focuses on two questions.
Principle of
Absolute First, what are the basis for trade and the direction of trade?
Advantage Second, what are the potential gains from trade, for a single nation
David and for the world as a whole?
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I Trading Under Constant -Cost Conditions
(Econ 3081) Referring to Figure 2.1, notice that the production possibilities schedules
B.A. Degree in
Economics for the United States and Canada are drawn as straight lines.
Mengesha The fact that these schedules are linear indicates that the relative
Yayo costs of the two products do not change as the economy shifts its
(Ph.D.) production from all wheat to all autos or anywhere in between.
For the United States, the relative cost of an auto is 0.5 bushels of
Classical wheat as output expands or contracts; for Canada, the relative cost
Trade of an auto is 2 bushels of wheat as output expands or contracts.
Theories There are two reasons for constant-costs.
Adam
Smith’s First, the factors of production are perfect substitutes for each
Principle of other.
Absolute Second, all units of a given factor are of the same quality.
Advantage
David As a country transfers resources from the production of wheat into
Ricardo’s the production of autos, or vice versa, the country will not have to
Theory of
Compara- resort to resources that are inadequate for the production of the
tive good.
Advantage Therefore, the country must sacrifice exactly the same amount of
wheat for each additional auto produced, regardless of how many
autos it is already producing.
Advantage
International
Economics I Basis for Trade and Direction of Trade
(Econ 3081)
B.A. Degree in Let us examine trade under constant-cost conditions.
Economics Referring to Figure 2, assume that in autarky (the absence of trade)
Mengesha the United States prefers to produce and consume at point A on its
Yayo production possibilities schedule, with 40 autos and 40 bushels of
(Ph.D.) wheat.
Assume also that Canada produces and consumes at point A on its
Classical production possibilities schedule, with 40 autos and 80 bushels of
Trade wheat.
Theories
The slopes of the two countries’ production possibilities schedules
Adam
Smith’s give the relative cost of one product in terms of the other.
Principle of The relative cost of producing an additional auto is only 0.5 bushels
Absolute of wheat for the United States but it is 2 bushels of wheat for
Advantage
David Canada.
Ricardo’s According to the principle of comparative advantage, this situation
Theory of provides a basis for mutually favorable specialization and trade
Compara-
tive owing to the differences in the countries’ relative costs.
Advantage As for the direction of trade, we find the United States specializing
in and exporting autos and Canada specializing in and exporting
wheat.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Production Gains from Specialization

Yayo
(Ph.D.) The law of comparative advantage asserts that with trade, each
country will find it favorable to specialize in the production of the
Classical good of its comparative advantage and will trade part of this for the
Trade good of its comparative disadvantage.
Theories In Figure 2.1, the United States moves from production point A to
Adam production point B, totally specializing in auto production.
Smith’s
Principle of Canada specializes in wheat production by moving from production
Absolute point A to production point B in the figure.
Advantage Taking advantage of specialization can result in production gains for
David both countries.
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Production Gains from Specialization
Mengesha We find that prior to specialization, the United States produces 40
Yayo autos and 40 bushels of wheat.
(Ph.D.)
But with complete specialization, the United States produces
120 autos and no wheat.
Classical
Trade As for Canada, its production point in the absence of specialization
Theories is at 40 autos and 80 bushels of wheat,
Adam
Smith’s whereas its production point under complete specialization is
Principle of at 160 bushels of wheat and no autos.
Absolute
Advantage Combining these results, we find that both nations together have
David experienced a net production gain of 40 autos and 40 bushels of
Ricardo’s wheat under conditions of complete specialization.
Theory of
Compara- Table 2.4(a) summarizes these production gains.
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Production Gains from Specialization
Mengesha Because these production gains arise from the reallocation of
Yayo existing resources, they are also called the static gains from
(Ph.D.) specialization:
through specialization, a country can use its current supply of
Classical resources more efficiently and thus achieve a higher level of
Trade
Theories output than it could without specialization.
Adam Japan’s opening to the global economy is an example of the
Smith’s static gains from comparative advantage.
Principle of
Absolute Responding to pressure from the United States, in 1859 Japan
Advantage opened its ports to international trade after more than two hundred
David years of self-imposed economic isolation.
Ricardo’s
Theory of In autarky, Japan found that it had a comparative advantage in
Compara- some products and a comparative disadvantage in others.
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Production Gains from Specialization
For example, the price of tea and silk was much higher on world
Mengesha
Yayo markets than in Japan prior to the opening of trade, while the price
(Ph.D.) of woolen goods and cotton was much lower on world markets.
Japan responded according to the principle of comparative
Classical advantage: it exported tea and silk in exchange for imports of
Trade clothing.
Theories By using its resources more efficiently and trading with the rest of
Adam the world, Japan was able to realize static gains from specialization
Smith’s
Principle of that equaled eight to nine percent of its gross domestic product at
Absolute that time.
Advantage Of course the long-run gains to Japan of improving its productivity
David and acquiring better technology were several times this figure.5
Ricardo’s
Theory of However, when a country initially opens to trade and then trade is
Compara- eliminated, it suffers static losses, as seen in the case of the United
tive States.
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha Production Gains from Specialization

Yayo In the early 1800s, Britain and France were at war.
(Ph.D.) As part of the conflict, the countries attempted to prevent the
shipping of goods to each other by neutral countries, notably the
Classical United States.
Trade This policy resulted in the British and French navies confiscating
Theories
Adam American ships and cargo.
Smith’s To discourage this harassment, in 1807, President Thomas Jefferson
Principle of ordered the closure of America’s ports to international trade:
Absolute
Advantage American ships were prevented from taking goods to foreign
David ports and foreign ships were prevented from taking on any
Ricardo’s cargo in the United States.
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Production Gains from Specialization
Mengesha The intent of the embargo was to inflict hardship on the British and
Yayo French, and discourage them from meddling in America’s affairs.
(Ph.D.) Although the embargo did not completely eliminate trade, the
United States was as close to autarky as it had ever been in its
Classical history.
Trade Therefore, Americans shifted production away from previously
Theories
exported agricultural goods (the goods of comparative advantage)
Adam
Smith’s and increased production of import-replacement manufactured
Principle of goods (the goods of comparative disadvantage).
Absolute The result was a less efficient utilization of America’s resources.
Advantage
David Overall, the embargo cost about eight percent of America’s gross
Ricardo’s national product in 1807.
Theory of It is no surprise that the embargo was highly unpopular among
Compara- Americans and, therefore, terminated in 1809.
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Consumption Gains from Trade
Mengesha
Yayo In the absence of trade, the consumption alternatives of the United
(Ph.D.) States and Canada are limited to points along their domestic
production possibilities schedules.
Classical The exact consumption point for each nation will be determined by
Trade the tastes and preferences in each country.
Theories But with specialization and trade, the two nations can achieve
Adam post-trade consumption points outside their domestic production
Smith’s
Principle of possibilities schedules;
Absolute that is, they can consume more wheat and more autos than
Advantage
David they could consume in the absence of trade.
Ricardo’s Thus, trade can result in consumption gains for both
Theory of countries.
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Consumption Gains from Trade
Mengesha The set of post-trade consumption points that a nation can achieve
Yayo is determined by the rate at which its export product is traded for
(Ph.D.) the other country’s export product.
This rate is known as the terms of trade.
Classical The terms of trade defines the relative prices at which two products
Trade
Theories are traded in the marketplace.
Adam Under constant-cost conditions, the slope of the production
Smith’s possibilities schedule defines the domestic rate of transformation
Principle of (domestic terms of trade) that represents the relative prices that
Absolute
Advantage two commodities can be exchanged at home.
David For a country to consume at some point outside its production
Ricardo’s possibilities schedule, it must be able to exchange its export good
Theory of
Compara- internationally at terms of trade more favorable than the domestic
tive terms of trade.
Advantage
Advantage
International
Economics I
(Econ 3081) Consumption Gains from Trade
B.A. Degree in
Economics Assume that the United States and Canada achieve a terms of trade ratio that permits both
trading partners to consume at some point outside their respective production possibilities
Mengesha schedules (Figure 2.1).
Yayo Suppose that the terms of trade agreed on is a 1:1 ratio, whereby 1 auto is exchanged for 1 bushel
(Ph.D.) of wheat.
Based on these conditions, let line tt represent the international terms of trade for both countries.
Classical This line is referred to as the trading possibilities line (note that it is drawn with a slope having an
Trade absolute value of one).
Theories Suppose now that the United States decides to export 60 autos to Canada.
Adam Starting at post-specialization production point B in the figure, the United States will slide along
Smith’s its trading possibilities line until point C is reached.
Principle of
Absolute At point C, 60 autos will have been exchanged for 60 bushels of wheat, at the terms of trade ratio
Advantage of 1:1.
David Point C thenrepresents the U.S. post-trade consumption point.
Ricardo’s Compared with consumption point A, point C results in a consumption gain for the United States
Theory of
of 20 autos and 20 bushels of wheat.
Compara-
tive The triangle BCD that shows the U.S. exports (along the horizontal axis), imports (along the
Advantage vertical axis), and terms of trade (the slope) is referred to as the trade triangle.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Consumption Gains from Trade
Economics
Does this trading situation provide favorable results for Canada?
Mengesha Starting at postspecialization production point B in the figure,
Yayo Canada can import 60 autos from the United States by giving up 60
(Ph.D.) bushels of wheat.
Canada would slide along its trading possibilities line until it reaches
Classical point C .
Trade
Theories Clearly, this is a more favorable consumption point than point A .
Adam With trade, Canada experiences a consumption gain of 20 autos and
Smith’s 20 bushels of wheat. Canada’s trade triangle is denoted by B C D .
Principle of
Absolute In our two-country model, the trade triangles of the United States and
Advantage Canada are identical; one country’s exports equal the other country’s
David imports that exchange at the equilibrium terms of trade.
Ricardo’s
Theory of One implication of the foregoing trading example is that the United States
Compara- produced only autos, whereas Canada produced only wheat—that is,
tive
Advantage complete specialization occurs.
Advantage
International
Economics I
(Econ 3081) Consumption Gains from Trade
B.A. Degree in
Economics
As the United States increases and Canada decreases the production of
autos, both countries’ unit production costs remain constant
Mengesha
Yayo . Because the relative costs never become equal, the United States does
(Ph.D.) not lose its comparative advantage, nor does Canada lose its comparative
disadvantage.
Classical The United States therefore produces only autos.
Trade
Theories Similarly, as Canada produces more wheat and the United States reduces
Adam its wheat production, both nations’ production costs remain the same.
Smith’s Canada produces only wheat without losing its advantage to the United
Principle of States.
Absolute
Advantage The only exception to complete specialization would occur if one of the
David countries, say Canada, is too small to supply the United States with all of
Ricardo’s
Theory of its need for wheat.
Compara- Canada would be completely specialized in its export product, wheat,
tive
Advantage while the United States (large country) would produce both goods;
however, the United States would still export autos and import wheat.
Advantage
International
Economics I Distributing the Gains from Trade
(Econ 3081)
B.A. Degree in Our trading example assumes that the terms of trade agreed to by the
Economics United States and Canada will result in both benefiting from trade.
Mengesha But where will the terms of trade actually lie?
Yayo A shortcoming of Ricardo’s principle of comparative advantage is its
(Ph.D.)
inability to determine the actual terms of trade.
Classical The best description that Ricardo could provide was only the outer limits
Trade within which the terms of trade would fall.
Theories
This is because the Ricardian theory relied solely on domestic cost ratios
Adam
Smith’s (supply conditions) in explaining trade patterns; it ignored the role of
Principle of demand.
Absolute
Advantage To visualize Ricardo’s analysis of the terms of trade, recall our
David trading example of Figure 2.1.
Ricardo’s
Theory of We assumed that for the United States the relative cost of producing an
Compara- additional auto was 0.5 bushels of wheat whereas for Canada the relative
tive cost of producing an additional auto was 2 bushels of wheat.
Advantage
Thus, the United States has a comparative advantage in autos,
whereas Canada has a comparative advantage in wheat.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Distributing the Gains from Trade
Economics
Figure 2.2 illustrates these domestic cost conditions for the two countries.
Mengesha However, for each country, we have translated the domestic cost
Yayo
ratio, given by the negatively sloped production possibilities
(Ph.D.)
schedule, into a positively sloped cost-ratio line.
According to Ricardo, the domestic cost ratios set the outer limits
Classical
Trade for the equilibrium terms of trade.
Theories If the United States is to export autos, it should not accept any
Adam terms of trade less than a ratio of 0.5:1, indicated by its domestic
Smith’s cost-ratio line.
Principle of
Absolute Otherwise, the U.S. post-trade consumption point would lie inside
Advantage its production possibilities schedule.
David The United States would clearly be better off without trade than
Ricardo’s
Theory of with trade.
Compara- The U.S.domestic cost-ratio line therefore becomes its
tive no-trade boundary.
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Distributing the Gains from Trade
Mengesha Similarly, Canada would require a minimum of 1 auto for every 2 bushels
Yayo of wheat exported, as indicated by its domestic cost-ratio line; any terms
(Ph.D.) of trade less than this rate would be unacceptable to Canada.
Thus, its domestic cost-ratio line defines the no-trade boundary line
Classical
Trade for Canada.
Theories For gainful international trade to exist, a nation must achieve a post-trade
Adam consumption location at least equivalent to its point along its domestic
Smith’s
Principle of production possibilities schedule.
Absolute Any acceptable international terms of trade has to be more favorable than
Advantage
David or equal to the rate defined by the domestic price line.
Ricardo’s Thus, the region of mutually beneficial trade is bounded by the cost
Theory of
Compara- ratios of the two countries.
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Figure 2.1
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo The supply-side analysis of Ricardo describes the outer limits within which
(Ph.D.) the equilibrium terms of trade must fall.
The domestic cost ratios set the outer limits for the equilibrium terms of
Classical
Trade trade.
Theories Mutually beneficial trade for both nations occurs if the equilibrium terms
Adam of trade lies between the two nations’ domestic cost ratios.
Smith’s
Principle of According to the theory of reciprocal demand, the actual exchange ratio at
Absolute
Advantage which trade occurs depends on the trading partners’ interacting demands.
David
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Equilibrium Terms of Trade
Mengesha As noted, Ricardo did not explain how the actual terms of trade
Yayo would be determined in international trade.
(Ph.D.) This gap was filled by another classical economist, John Stuart Mill
(1806–1873).
Classical By bringing into the picture the intensity of the trading partners’
Trade demands, Mill could determine the actual terms of trade for Figure
Theories
2.2.
Adam
Smith’s Mill’s theory is known as the theory of reciprocal demand.
Principle of This theory asserts that within the outer limits of the terms of
Absolute trade, the actual terms of trade is determined by the relative
Advantage
David strength of each country’s demand for the other country’s product.
Ricardo’s Simply put, production costs determine the outer limits of the terms
Theory of of trade, while reciprocal demand determines what the actual terms
Compara-
tive of trade will be within those limits.
Advantage
Advantage
International
Economics I Equilibrium Terms of Trade
(Econ 3081)
B.A. Degree in Referring to Figure 2.2, if Canadians are more eager for U.S. autos
Economics than Americans are for Canadian wheat, the terms of trade would
Mengesha end up close to the Canadian cost ratio of 2:1 Thus, the terms of
Yayo trade would improve for the United States.
(Ph.D.) However, if Americans are more eager for Canadian wheat than
Canadians are for U.S. autos, the terms of trade would fall close to
Classical the U.S. cost ratio of 0.5:1 and the terms of trade would improve for
Trade Canadians.
Theories
The reciprocal-demand theory best applies when both nations are of
Adam
Smith’s equal economic size, so that the demand of each nation has a
Principle of noticeable effect on market price. However, if two nations are of
Absolute unequal economic size, it is possible that the relative demand
Advantage
David strength of the smaller nation will be dwarfed by that of the larger
Ricardo’s nation.
Theory of In this case, the domestic exchange ratio of the larger nation will
Compara- prevail.
tive
Advantage Assuming the absence of monopoly elements working in the
markets, the small nation can export as much of the commodity as
it desires, enjoying large gains from trade.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Equilibrium Terms of Trade
Mengesha Consider trade in crude oil and autos between Venezuela and the
Yayo United States before the rise of the Organization of Petroleum
(Ph.D.)
Exporting Countries (OPEC). Venezuela, as a small nation,
accounted for only a very small share of the U.S.–Venezuelan
Classical market, whereas the U.S. market share was overwhelmingly large.
Trade
Theories Because Venezuelan consumers and producers had no influence on
Adam market price levels, they were in effect price takers. In trading with
Smith’s the United States, no matter what the Venezuelan demand was for
Principle of
Absolute crude oil and autos, it was not strong enough to affect U.S. price
Advantage levels.
David As a result, Venezuela traded according to the U.S. domestic price
Ricardo’s ratio, buying and selling autos and crude oil at the price levels that
Theory of
Compara- existed in the United States.
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Equilibrium Terms of Trade
Mengesha The example just given implies the following generalization:
Yayo If two nations of approximately the same size and with similar
(Ph.D.)
taste patterns participate in international trade, the gains
from trade will be shared about equally between them.
Classical However, if one nation is significantly larger than the other,
Trade
Theories the larger nation attains fewer gains from trade while the
Adam smaller nation attains most of the gains from trade.
Smith’s This situation is characterized as the importance of being
Principle of
Absolute unimportant.
Advantage What’s more, when nations are very dissimilar in size, there is a
David strong possibility that the larger nation will continue to produce its
Ricardo’s
Theory of comparative-disadvantage good because the smaller nation is unable
Compara- to supply all of the world’s demand for this product.
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Terms of Trade Estimates
As we have seen, the terms of trade affect a country’s gains from
Mengesha
Yayo trade. How are the terms of trade actually measured?
(Ph.D.) The commodity terms of trade (also referred to as the barter terms
of trade) is a frequently used measure of the international exchange
Classical ratio.
Trade It measures the relation between the prices a nation gets for its
Theories exports and the prices it pays for its imports.
Adam This is calculated by dividing a nation’s export price index by its
Smith’s
Principle of import price index, multiplied by 100 to express the terms of trade
Absolute in percentages:
Advantage Terms of Trade Export Price Index Import Price Index 100 T
David
Ricardo’s
Theory of EXPORT PRICE INDEX
Compara- TERMS OF TRADE = ∗ 100
IMPORT PRICE INDEX
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics An improvement in a nation’s terms of trade requires that the prices of its
Mengesha exports rise relative to the prices of its imports over the given time period.
Yayo A smaller quantity of export goods sold abroad is required to obtain a
(Ph.D.) given quantity of imports.
Conversely, deterioration in a nation’s terms of trade is due to a rise in its
Classical
Trade import prices relative to its export prices over a time period.
Theories The purchase of a given quantity of imports would require the sacrifice of
Adam a greater quantity of exports.
Smith’s
Principle of Table 2.5 gives the commodity terms of trade for selected countries.
Absolute
Advantage With 2005 as the base year (equal to 100), the table shows that by 2013
David the U.S. index of export prices rose to 124, an increase of 24 percent.
Ricardo’s
Theory of During the same period, the index of U.S. import prices rose by 27
Compara- percent, to a level of 127.
tive
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
Advantage
International Using the terms of trade formula, we find that the U.S. terms of trade
Economics I
(Econ 3081) worsened by 2 percent 124 127 100 98 over the period 2005–2013.
B.A. Degree in This means that to purchase a given quantity of imports, the United States
Economics
had to sacrifice 2 percent more exports; conversely, for a given number of
Mengesha exports, the United States could obtain 2 percent fewer imports.
Yayo
(Ph.D.) Although changes in the commodity terms of trade indicate the direction
of movement of the gains from trade, their implications must be
Classical interpreted with caution.
Trade Suppose there is an increase in the foreign demand for U.S. exports,
Theories
leading to higher prices and revenues for U.S. exporters.
Adam
Smith’s In this case, an improving terms of trade implies that the U.S. gains from
Principle of trade have increased. However, suppose that the cause of the rise in
Absolute
Advantage export prices and terms of trade is the falling productivity of U.S. workers.
David If these result in reduced export sales and less revenue earned from
Ricardo’s
Theory of exports, we could hardly say that U.S. welfare has improved.
Compara- Despite its limitations, however, the commodity terms of trade is a useful
tive
Advantage concept.
Over a long period, it illustrates how a country’s share of the world gains
from trade changes and gives a rough measure of the fortunes of a nation
in the world market.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Dynamic Gains from Trade
Economics
The previous analysis of the gains from international trade stressed
Mengesha specialization and reallocation of existing resources—the so called
Yayo static gains from specialization.
(Ph.D.) However, these gains can be dwarfed by the effect of trade on the
country’s growth rate and the volume of additional resources made
Classical available to, or utilized by, the trading country.
Trade These are known as the dynamic gains from international trade as
Theories
Adam opposed to the static effects of reallocating a fixed quantity of
Smith’s resources.
Principle of We have learned that international trade tends to bring about a
Absolute
Advantage more efficient use of an economy’s resources that leads to higher
David output and income.
Ricardo’s Over time, increased income tends to result in more saving and,
Theory of
thus, more investment in equipment and manufacturing plants.
Compara-
tive This additional investment generally results in a higher rate of
Advantage economic growth.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Dynamic Gains from Trade
Mengesha
Yayo Moreover, opening an economy to trade can lead to imported
(Ph.D.) investment goods such as machinery that fosters higher productivity
and economic growth.
Classical In a roundabout manner, gains from international trade grow larger
Trade over time.
Theories Empirical evidence shows that countries that are more open to
Adam international trade tend to grow faster than closed economies.
Smith’s
Principle of Free trade also increases the possibility that a firm importing a
Absolute capital good will be able to locate a supplier who will provide a
Advantage good that more closely meets its specifications.
David The better the match, the larger the increase in the firm’s
Ricardo’s
Theory of productivity, which promotes economic growth.
Compara-
tive
Advantage
Advantage
International
Economics I Dynamic Gains from Trade
(Econ 3081)
B.A. Degree in Economies of large-scale production represent another dynamic gain
Economics from trade. International trade allows small and moderately sized
Mengesha countries to establish and operate many plants of efficient size that
Yayo would be impossible if production were limited to the domestic
(Ph.D.) market.
For example, the free access that Mexican and Canadian firms have
Classical to the U.S. market, under the North American Free Trade
Trade Agreement (NAFTA), allows them to expand their production and
Theories
employ more specialized labor and equipment.
Adam
Smith’s These improvements have led to increased efficiency and lower unit
Principle of costs for these firms. Also, increased competition can be a source of
Absolute dynamic gains in trade.
Advantage
David For example, when Chile opened its economy to global competition
Ricardo’s in the 1970s, its exiting producers with comparative disadvantage
Theory of were about eight percent less efficient than producers that
Compara- continued to operate.
tive
Advantage The efficiency of plants competing against imports increased three
to ten percent more than in the domestic economy where goods
were not subject to foreign competition.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics Dynamic Gains from Trade
A closed economy shields companies from international competition
Mengesha
Yayo and permits them to pull down overall efficiency within an industry.
(Ph.D.) Open trade forces inefficient firms to exit the industry and allows
more productive firms to grow.
Classical Therefore, trade results in adjustments that raise average industry
Trade efficiency in both exporting and import-competing industries.
Theories Simply put, besides providing static gains rising from the
Adam reallocation of existing productive resources, trade can also generate
Smith’s
Principle of dynamic gains by stimulating economic growth.
Absolute Proponents of free trade note the many success stories of growth
Advantage through trade. However, the effect of trade on growth is not the
David same for all countries.
Ricardo’s
Theory of In general, the gains tend to be less for a large country such as the
Compara-
tive United States than for a small country such as Belgium.
Advantage
Advantage
International
Economics I How Global Competition Led to Productivity Gains for U.S. Iron Ore
(Econ 3081)
B.A. Degree in Workers
Economics The dynamic gains from international trade can be seen in the U.S.
Mengesha iron ore industry, located in the Midwest. Because iron ore is heavy
Yayo and costly to transport, U.S. producers supply ore only to U.S. steel
(Ph.D.) producers located in the Great Lakes region.
During the early 1980s, depressed economic conditions in most of
Classical the industrial world resulted in a decline in the demand for steel and
Trade thus falling demand for iron ore
Theories
. Ore producers throughout the world scrambled to find new
Adam
Smith’s customers.
Principle of Despite the huge distances and the transportation costs involved,
Absolute mines in Brazil began shipping iron ore to steel producers in the
Advantage
David Chicago area.
Ricardo’s The appearance of foreign competition led to increased competitive
Theory of pressure on U.S. iron ore producers.
Compara- To help keep domestic iron mines operating, American workers
tive
Advantage agreed to changes in work rules that increased labor productivity.
In most cases, these changes involved an expansion in the set of
tasks a worker was required to perform.
Advantage
International
Economics I
(Econ 3081) How Global Competition Led to Productivity Gains for U.S. Iron Ore
B.A. Degree in
Economics Workers
For example, the changes required equipment handlers to perform
Mengesha
Yayo routine maintenance on their equipment. Before, this maintenance
(Ph.D.) was the responsibility of repairmen.
Also, new work rules resulted in a flexible assignment of work that
Classical required a worker to occasionally do tasks assigned to another
Trade worker.
Theories In both cases, the new work rules led to the better use of a worker’s
Adam time.
Smith’s
Principle of Prior to the advent of foreign competition, labor productivity in the
Absolute U.S. iron ore industry was stagnant.
Advantage Because of the rise of foreign competition, labor productivity began
David to increase rapidly in the early 1980s; by the late 1980s, the
Ricardo’s
Theory of productivity of U.S. iron ore producers had doubled.
Compara- Simply put, the increase in foreign competitive pressure resulted in
tive American workers adopting new work rules that enhanced their
Advantage
productivity.
Advantage
International
Economics I Changing Comparative Advantage
(Econ 3081)
B.A. Degree in Although international trade can promote dynamic gains in terms of
Economics increased productivity, patterns of comparative advantage can and
Mengesha do change over time.
Yayo In the early 1800s, the United Kingdom had a comparative
(Ph.D.) advantage in textile manufacturing. Then that advantage shifted to
the New England states of the United States.
Classical Then the comparative advantage shifted once again to North
Trade Carolina and South Carolina.
Theories
Adam Now the comparative advantage resides in China and other
Smith’s low-wage countries. Let us see how changing comparative
Principle of advantage relates to our trade model.
Absolute
Advantage Figure 2.3 illustrates the production possibilities schedules for
David computers and automobiles, of the United States and Japan under
Ricardo’s conditions of constant opportunity cost.
Theory of
Compara- Note that the MRT of automobiles into computers initially equals
tive 1.0 for the United States and 2.0 for Japan.
Advantage The United States thus has a comparative advantage in the
production of computers and a comparative disadvantage in auto
production.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute If productivity in the Japanese computer industry grows faster than it does
Advantage in the U.S. computer industry, the opportunity cost of each computer
David produced in the United States increases relative to the opportunity cost of
Ricardo’s
Theory of the Japanese.
Compara- For the United States, comparative advantage shifts from computers
tive to autos.
Advantage
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Suppose both nations experience productivity increases in manufacturing
Economics
computers but no productivity change in manufacturing automobiles.
Mengesha Assume that the United States increases its computer manufacturing
Yayo
(Ph.D.) productivity by 50 percent (from 100 to 150 computers) but that Japan
increases its computer manufacturing productivity by 300 percent (from
40 to 160 computers).
Classical
Trade Because of these productivity gains, the production possibilities schedule
Theories of each country rotates outward and becomes flatter.
Adam
Smith’s More output can now be produced in each country with the same amount
Principle of of resources.
Absolute
Advantage Referring to the new production possibilities schedules, the MRT of
David automobiles into computers equals 0.67 for the United States and 0.5 for
Ricardo’s
Theory of Japan.
Compara- The comparative cost of a computer in Japan has thus fallen below that in
tive
Advantage the United States.
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha For the United States, the consequence of lagging productivity growth is
Yayo that it loses its comparative advantage in computer production. But even
(Ph.D.) after Japan achieves comparative advantage in computers, the United
States still has a comparative advantage in autos; the change in
Classical manufacturing productivity thus results in a change in the direction of
Trade
Theories trade.
Adam The lesson of this example is that producers who fall behind in research
Smith’s and development, technology, and equipment tend to find their
Principle of
Absolute competitiveness dwindling.
Advantage It should be noted, however, that all countries realize a comparative
David
Ricardo’s advantage in some product or service.
Theory of
Compara-
tive
Advantage
Advantage
International For the United States, the growth of international competition in

Economics I industries such as steel may make it easy to forget that the United States
(Econ 3081)
B.A. Degree in continues to be a major exporter of aircraft, paper, instruments, plastics,
Economics and chemicals.
Mengesha To cope with changing comparative advantages, producers are under
Yayo constant pressure to reinvent themselves.
(Ph.D.)
Consider how the U.S. semiconductor industry responded to competition
from Japan in the late 1980s. Japanese companies quickly became
Classical
Trade dominant in sectors such as memory chips. This dominance forced the big
Theories U.S. chip makers to reinvent themselves.
Adam Firms such as Intel, Motorola, and Texas Instruments abandoned the
Smith’s
Principle of dynamic-random-access-memory (DRAM) business and invested more
Absolute heavily in manufacturing microprocessors and logic products, the next
Advantage wave of growth in semiconductors.
David
Ricardo’s Intel became an even more dominant player in microprocessors, while
Theory of Texas Instruments developed a strong position in digital signal processors,
Compara-
tive the “brain” in mobile telephones. Motorola gained strength in
Advantage microcontrollers and automotive semiconductors.
A fact of economic life is that no producer can remain the world’s low-cost
producer forever. As comparative advantages change, producers need to
hone their skills to compete in more profitable areas.
Advantage
International
Economics I Trading Under Increasing -Cost Conditions
(Econ 3081)
B.A. Degree in The preceding section illustrated the comparative-advantage
Economics principle under constantcost conditions.
Mengesha In the real world, a good’s opportunity cost may increase as more of
Yayo it is produced. Based on studies of many industries, economists
(Ph.D.) think the opportunity costs of production increase with output
rather than remain constant for most goods.
Classical The principle of comparative advantage must be illustrated in a
Trade modified form. Increasing opportunity costs give rise to a production
Theories
possibilities schedule that appears bowed outward from the
Adam
Smith’s diagram’s origin.
Principle of In Figure 2.4, with movement along the production possibilities
Absolute schedule from A to B, the opportunity cost of producing autos
Advantage
David becomes larger in terms of wheat sacrificed.
Ricardo’s Increasing costs mean that the MRT of wheat into autos rises as
Theory of more autos are produced.
Compara- Remember that the MRT is measured by the absolute slope of the
tive
Advantage production possibilities schedule at a given point. With movement
from production point A to production point B, the respective
tangent lines
The Classical Trade Theories:Production Possibilities and Comparative Advantage
International
Economics I
(Econ 3081)
B.A. Degree in Transportation Costs and Non-traded Goods
Economics
The Ricardian model predicts that countries should completely specialize
Mengesha in production.
Yayo
(Ph.D.) But this rarely happens for primarily 3 reasons:
More than one factor of production reduces the tendency of
Classical specialization
Trade Protectionism
Theories
Transportation costs reduce or prevent trade, which may
Adam
Smith’s cause each country to produce the same good or service
Principle of Non-traded goods and services (e.g., haircuts and auto repairs) exist due
Absolute
Advantage to high transportation costs.
David Countries tend to spend a large fraction of national income on
Ricardo’s
Theory of non-traded goods and services.
Compara- This fact has implications for the gravity model and for models that
tive consider how income transfers across countries affect trade.
Advantage
International
Economics I Empirical Example
(Econ 3081)
B.A. Degree in Do countries export those goods in which their productivity is relatively
Economics high?
Mengesha The ratio of US to British exports in 1951 compared to the ratio of US to
Yayo British labor productivity in 26 manufacturing industries suggests yes.
(Ph.D.)
At this time the US had an absolute advantage in all 26 industries, yet the
ratio of exports was low in the least productive sectors of the US.
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International Summary
Economics I A country has a comparative advantage in producing a good if the
(Econ 3081)
B.A. Degree in
opportunity cost of producing that good is lower in the country than it is
Economics in other countries.
A country with a comparative advantage in producing a good uses its
Mengesha
Yayo resources most efficiently when it produces that good compared to
(Ph.D.) producing other goods.
The Ricardian model focuses only on differences in the productivity of
Classical labor across countries, and it explains gains from trade using the concept
Trade of comparative advantage.
Theories
When countries specialize and trade according to the Ricardian model; the
Adam
Smith’s relative price of the produced good rises, income for workers rises and
Principle of imported goods are less expensive for consumers.
Absolute Trade is predicted to benefit both high productivity and low productivity
Advantage
David countries, although trade may change the distribution of income within
Ricardo’s countries.
Theory of High productivity or low wages give countries a cost advantage that allow
Compara-
tive them to produce efficiently.
Advantage
Although empirical evidence supports trade based on comparative
advantage, transportation costs and other factors prevent complete
specialization in production.
International
Economics I
(Econ 3081)
B.A. Degree in Summary
Economics
Mengesha
Yayo
(Ph.D.)
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.) Summary
Classical
Trade
Theories
Adam
Smith’s
Principle of
Absolute
Advantage
David
Ricardo’s
Theory of
Compara-
tive
Advantage
References
International
Economics I
(Econ 3081)
B.A. Degree in
Economics
Mengesha
Yayo
(Ph.D.)
Tantau, Till et al.:
Appendix
The beamer class.
https://ctan.org/tex-archive/macros/latex/
contrib/beamer/doc/beameruserguide.pdf.

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International

Classical 1 Classical Trade Theories

Mengesha Adam Smith (1723 – 1790)

International Adam Smith (1723 – 1790)-Assumptions

Mengesha Table 2.1 shows that

Mengesha Production Gain in an open economy

Mengesha Limitation of Absolute advantage

Classical The differences in productivity (given in table below) could be caused by

Mengesha In 1817, Ricardo published his Principles of Political Economy and

Mengesha A ssumptions of the basic Ricardian Model

Mengesha Ricardian Comparative Advantage

Mengesha The Law of Comparative Advantage

Mengesha Changes in Terms of Trade

International These differences are:

International Technological breakthrough in rubber production has reflected in rubber

Mengesha aLC QC + aLW QW = L

Mengesha Trade in the Ricardian Model

International Relative Supply and Relative Demand

Mengesha Gains From Trade

Mengesha Trade expands consumption possibilities

Mengesha Trade expands consumption possibilities

Mengesha Comparative Advantage With Many Goods

International Comparative Advantage With Many Goods

Mengesha The principle of comparative advantage implies that with specialization

Mengesha Trading Under Constant -Cost Conditions

Mengesha Production Gains from Specialization

Mengesha Production Gains from Specialization

International For the United States, the growth of international competition in

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