EXTENSIONS AND TESTS

OF THE CLASSICAL
MODEL
OF TRADE

Chapter- 4
15/IMB/004
The classical model
in money terms

Chapter- 4
 The classical model in money terms
This is a logical extension because most economic transactions, even
in Ricardo's time, were based on money prices and not barter. This
monetization will be accomplished by assigning a wage rate to each
country. The domestic value of each good is then found by multiplying
the labor requirement per unit by the appropriate wage rate. This
valuation procedure does not change the internal prices under autarky
because the relative labor content—the underlying basis for relative
value—is still the same..
 The classical model in money terms
It does, however, provide a set of money prices in each country that
can be used to determine the attractiveness of buying or selling
abroad. Because each country's price is now stated in its own
currency, however, money prices cannot be used until a link between
the two currencies is established. The link is pro-
vided by specifying an exchange rate, which is the number of units of
one currency that exchange for one unit of a second currency. Once
the exchange rate is established, the value of all goods can be stated
in terms of one currency
 The classical model in money terms
To demonstrate comparative advantage in a monetized Ricardian
model, let us examine an example
In this example, England has the absolute advantage in both goods
Cloth and wine . Table 1 contains data on wages per hour and the
money price of each commodity based on the labor needed to
produce 1 unit of each good in each country. Assume that the fixed
exchange rate is 1 escudo (esc) = El.
 The classical model in money terms

The pattern of trade now responds to money price differences. Cloth

will be purchased in England because the price of cloth in either
currency is less in England than in Portugal. Wine, however, is
cheaper in Portugal, so consumers will buy Portuguese wine. This
result is the same as that reached in the examination of relative labor
efficiency between the two countries (i.e., England should export cloth
and import wine because 1/2 < 3/4).
 The classical model in money terms

In the monetized version of the Classical model, a country exports a

product when it can produce it the most inexpensively, given wage rates
and the exchange rate. The export condition—the cost conditions
necessary for a country to export a good—can be stated in
the following manner for any country 1 (England in our example)

a1jW1e < a2jW2

 The classical model in money terms
where: a1j = the labor requirement/unit in country 1 for
commodity j
WI = the wage rate in country 1 in country 1 's currency
e = the country 2 currency/country 1 currency exchange rate, or
the number of units of country 2's currency required to purchase 1
unit of country 1 's currency
a2j= the labor requirement/unit in country 2 for commodity j
W2 = the wage rate in country 2 in country 2's currency
 The classical model in money terms
It is clear that England (country 1) should export cloth since (1 hr) X
(El/hr) X (1 esc/E1) < (2 hr) X (0.6 esc/hr). This condition does not,
however, hold for wine, because (3 hr) X (El/hr) X (1 esc/El) > (4 hr)
X (0.6 esc/hr). Thus, England should export cloth and import wine.
In a two-country, two-commodity framework, once the export and
import goods are known for one country, the import and export
pattern for the trading partner is also determined: England's exports
are Portugal's (country 2's) imports, and England's imports are
Portugal' s exports.
Wage rate and
exchange rate
limits
Chapter- 4
 Wage rate and exchange rate limits

wage rate limits—the endpoints of the range within which the wage
can vary without eliminating the basis for trade
Limits for Portugal are 0.5 esc/hr and 0.75 esc/hr.
At 0.5 esc/hr, the prices of cloth are equal, and at a wage rate of 0.75
esc/hr, the prices of wine are equal. However, if the Portuguese wage
rate were 0.4 esc/hr, then cloth in Portugal would cost 0.8 esc (EO.8)
and wine in Portugal would cost 1.6 esc (El .6). Portugal
would then be able to export both goods to England
 Wage rate and exchange rate limits
Similarly, there are exchange rate limits. Using the wage levels in the
England Portugal example (see Table l), it is obvious that an
exchange rate of 1.2 esc/El will cause the price of cloth to be the
same in both countries. On the other hand, an exchange rate of
0.8 esc/El will cause wine prices to be the same in both countries.
For trade to take place, the exchange rate must lie within these limits.
The closer it lies to 1.2 esc/El, the more the terms of trade benefit
England. The closer the exchange rate lies to 0.8 esc/El, the more the
terms of trade benefit Portugal.
 Multiple
Commodities
Chapter- 4
 Multiple Commodities
Up to this point, it has been assumed that trade was taking place within
a two-country, two-commodity world, but in the real world countries
produce and trade more than two products. Suppose that two countries
have labor requirements per unit of production and wages as described
in Table 2 and that the exchange rate is 0.8 pound/ I euro or €0.8/€1. In
this situation, the relative labor requirements, a1j/a2j, must be less than
w2/21e in order for Spain (country l) to export the good
 Multiple Commodities
If Spain's relative labor requirements are greater than the relative
wage cost (expressed in a common currency), then Spain should
import the good from the United Kingdom. With only two countries,
once imports and exports are determined for one country, they are
automatically determined for the other. The way to solve this
problem is to place the commodities in ascending order
according to their relative labor requirements (a1j/a2j) and then
position the relative wage cost in the appropriate place in the goods
spectrum. The following array of goods will then appear:
 Multiple Commodities
The pattern of trade is thus clear: Spain should specialize in and
export cloth, wine, and wheat while importing cheese, hardware, and
cutlery from the United Kingdom. (In this example, each country
exports three goods, but there is no a priori reason for two trading
partners to import and export the same number of goods.) To verify
that indeed each country's exports are in fact the lowest price goods,
the array of goods prices is as follows:
 Multiple
Countries
Chapter- 4
 Multiple Countries
In a two-country framework, the pattern of trade has always been
unambiguous. With two commodities, the pattern of trade was
determined by comparative advantage based on relative unit labor
requirements. In the monetized, multicommodity model, the trade
pattern was uniquely determined by relative labor costs and relative
wages. When several countries are taken into account, however, the
specification of the trade pattern is less straightforward.
 Multiple Countries
Returning to our two-good world to simplify the analysis, let us
examine the case for trade between three countries in order to make
generalizations about the pattern of trade. Table 5 shows a clear basis
for trade because the autarky prices are different among the
potential trading partners. The incentive for trade will be greatest
between the two countries with the greatest difference in autarky
prices.
 Multiple Countries
The potential gains from trade initially are the greatest between
Sweden and France; that is, the autarky price ratios are the most
different. The equilibrium terms of trade will settle somewhere
between IC:2.5F and IC:4F. Sweden has the comparative advantage
in the production of cutlery (10/20 < 4/5), France
has the comparative advantage in fish, and the trade pattern between
the two countries is
Thank you
Chapter- 4