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Chapter 3

The Classical Model

of International Trade

Topics to be Covered

• Mercantilism

• Classical Trade Model Assumptions

•Smith’s Absolute Advantage

• Ricardo’s Comparative Advantage

Recall: Seven Assumptions

1. Rational behavior

2. Only 2 countries & 2 goods

3. No money illusion

4. Factor endowments are fixed and technology isconstant

5. Perfect competition

6. Factor of production are perfectly mobile

7.Community preferences in consumption can be

represented by consistent set of CIC

Mercantilism

• A system of government institutions and

policies designed to restrict international trade

•The source of a country’s wealth is gold ormoney.

• Two means of increasing a country’s wealth are

colonialism and international trade.

• A country must export more and import less.

Adam Smith

• Attacked the mercantilist system

• Advocated free international trade

• Emphasized advantages of specialization andinternational division of labor whereby

nations specialize in the production of only a

few goods

Additional Assumptions

• Assumption 8—Resources cannot move

between countries.

Assumption 9—There are no trade barriers.• Assumption 10—Exports must pay for

imports.

Assumptions of the Classical Model

• Assumption 11—Labor is the only relevant

resource.

– Labor Theory of Value states that the pre-trade

price of a good is determined by the amount of

labor it took to produce it.

• Assumption 12—Constant returns to scale

between labor and output prevails.

– Constant returns implies a fixed ratio between the

labor used and the output level produced.

Illustration of Absolute Advantage

• Table of labor requirements for two goods

TABLE 3.1 Absolute Advantage as a Basisfor Trade1

1Numbers in the table denote labor required to produce one unit.

What Causes Each Country to Follow Its Absolute

Advantage?

• Market forces combined with free trade

• Given that the labor cost equals the wage

rate (W) times the amount of labor input:(refer to Table 3.1) P S W

A hours

P S / P

T in A (W

A 3 ) / (W

A 6) 3 / 6 1 / 2

Absolute Advantage (cont.)

• In country B:

P S / P

T in B (W

B 1 2 ) / (W

B 4) 12 / 4 3

Since P S / P T in A < P S / P T in B, A is the lower (opportunity) cost producer

of good S and has absolute advantage in S.

Summary of Smith’s Principle

• For various reasons such as differenttechnologies and climate, countries willproduce different goods.

•World output will increase if countriesspecialize in their absolute advantageproducts.

• This situation is the natural outcome of

market forces combined with free trade. Agood is cheapest in the country that hasabsolute advantage in its production.

David Ricardo

What If One Country Has Absolute Advantage in Both

Goods?

• David Ricardo’s Law of Comparative

Advantage—countries should specialize where

they have their greatest absolute advantage (if

they have absolute advantage in both goods) or

in their least absolute disadvantage (if they

have absolute advantage in neither good).

TABLE 3.3 Comparative Advantage as

a Basis for Trade1

1Numbers in the table denote labor hours per unit of output.

From Table 3.3

• Country A has absolute advantage in both goods S and T.

• A is 4x more efficient than B in production of good S (compare

3 hours with 12 hours).

• A is only (4/3)x more efficient than B in production of good T.

• Thus, A has comparative advantage in S.

• With trade, A will completely specialize in S.

• Do likewise for country B!

FIGURE 3.1 Production Possibility Frontiers for Country

A and Country B

International Terms of Trade

• Terms of Trade (TOT)—the relative price at

which trade occurs between countries.

The TOT will lie between the autarky prices ofthe two countries; in our example,

½ (A’s price) < TOT < 3/2 (B’s price)

Post-trade Equilibrium

• The country with a lower autarky price of agood has comparative advantage in that good.

• With constant opportunity cost (straight-line

PPF), the country will completely specialize inits comparative advantage product once tradebegins.

• With trade, the country will now consume onthe TOT line which represents its ConsumptionPossibility Frontier.

FIGURE 3.3 Posttrade Equilibriums for

Country A and Country B

Trade Triangle

• Trade Triangle—a geometric device that

shows the amounts a country is willing to

trade at a particular world price.

• The trade triangle shows the desired exports

and imports of a country given the terms of

trade.

• In international trade equilibrium, the

countries’ trade triangles are congruent.

How Can Trading Equilibrium Be

Attained?

• By reciprocal demand

• Reciprocal demand—the process of

interaction of international demand andsupply necessary to produce an equilibrium

world price.

Summary of Ricardo’s Model

• It is not necessary for a country to possess absolute advantagein order to participate in trade. What is required iscomparative advantage in production.

• A country will specialize in and export that good in which its

has comparative advantage, i.e., has a lower pre-trade relativeprice than in the other country.

• The terms of trade or world price will settle between theautarky prices of the two countries and is determined byreciprocal demand.

Key words

Mercantilism

Absolute advantage

Comparative advantage

Trade triangle

Given the input-output relationships in the table below:

Countries

A BGoods

(a) Which country has absolute advantage in which good and why?

(b) Which country has comparative advantage in which good and

Answer:

(a) B (A) has absolute advantage in both

(neither).

(b) A (B) has comparative advantage in X (Y).

What_are_the_differences_

between_absolute_advantage_and _comparative_advantage?

COMPARE AND CONTRAST

ABSOLUTE ADVANTAGE COMPARATIVE ADVANTAGE

SIMILARITIES

1.TWO BASIC CONCEPTS IN INTERNATIONAL

TRADE.

2. THEY ARE IN CLASSICAL MODEL.

Absolute Advantage Comparative Advantage

1.One country can produce more

output per unit of productiveinput than another.

One country has an advantage in

every type of output that benefitfrom specializing and exporting

those product.

2. It can produce goods at lower

It can produce goods at lower

opportunity cost.

3.It is not mutually beneficial. It is mutually beneficial to

another country.

DIFFERENCES

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