UCL ECON1005. THE WORLD ECONOMY. Hugh Goodacre.

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UCL ECON1005. THE WORLD ECONOMY. Hugh
Goodacre. 6. CLASSICAL TRADE THEORY.
The gains from trade. Absolute advantage. Comparat
ive advantage. An application US-UK trade in
1937.
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Classical trade theory. i.e. Arguments in favour
of free trade / against tariffs and commercial
restrictions. Two stages Absolute advantage.
As in Adam Smith. Comparative advantage. As in
Ricardo.
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• The gains from trade. Example.
• Two countries England and Portugal.
• Two commodities Cloth and corn.
• One input Labour.
• Assumptions (NOTE Very restrictive!)
• International
• Completely free trade no subsidies or tariffs.
• No transport costs!
• Domestic
• Labour is fully mobile within each country.
• Frictionless transfer between sectors, i.e.
• No hiring and firing costs.
• No retraining costs, etc.

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Technology matrix to show mutually beneficial
trade
Labour input per unit of cloth (unit 1 yd)
Labour input per unit of corn (unit 1 cwt)
Portugal
England
Opportunity cost Cost measured in terms of the
best alternative foregone. Here Cost is labour
input. The alternatives are cloth production and
corn production.
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Labour input per unit of cloth (unit 1 yd)
Labour input per unit of corn (unit 1 cwt)
5
2
Portugal
2
4
England
Prices in the absence of trade Would be
determined by relative input costs within each
country, i.e. English price of unit of cloth
would be 0.5 units of corn. Portuguese price
would be 2.5 units of corn.
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Labour input per unit of cloth (unit 1 yd)
Labour input per unit of corn (unit 1 cwt)
5
2
Portugal
2
4
England
Potential gains from trade England gains from
trade if can sell unit of cloth for gt 0.5 units
of corn, i.e. more than the English
price. Portugal gains from trade if can buy a
unit of cloth for lt 2.5 units of corn, i.e. for
less than the Portuguese price.
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• Adam Smith (1776)
• It is the maxim of every prudent master of a
  family never to attempt to make at home what it
  will cost him more to make than to buy.
• The tailor does not attempt to make his own
  shoes, but buys them of the shoemaker, etc.
• All of them find it for their interest to employ
  their whole industry in a way in which they have
  some advantage over their neighbours
• What is prudence in the conduct of every private
  family can scarce be folly in that of a great
  kingdom.

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Labour input per unit of cloth (unit 1 yd)
Labour input per unit of corn (unit 1 cwt)
5
2
Portugal
2
4
England
Mutually beneficial trade kind of exchange
rate in units of corn. any rate between 0.5 1
and 2.5 1 ? both countries would gain from
trade.
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Mutually beneficial trade
Input per yd of cloth
Input per cwt of corn
Pre-trade price of cloth in corn units
Would benefit if price was
5
2
Portugal
2
4
England
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Indirect production With trade, England can
consume more corn without consuming less
cloth. As though it had produced more corn by
indirect method. Conversely for Portugal /
corn. Generalizing Specialisation is better
than self-sufficiency. BUT Remember the very
restrictive assumptions Complete absence of
international and intersectoral friction.
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The theory of comparative advantage
What matters is the relative cost of producing
the goods within each country, not the absolute
level of cost as compared between the two
countries.
Labour input per unit of cloth (unit 1 yd)
Labour input per unit of corn (unit 1 cwt)
Spain
2
4
England
Spain is less efficient in producing both
commodities, but can still benefit from trade.
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The theory of comparative advantage
Input per yd of cloth
Input per cwt of corn
Pre-trade price of cloth in corn units
Would benefit if price was
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Spain
2
4
England
There still remains a range of corn exchange
rates where both countries gain from trade, i.e.
between 0.5 and 2.5. This is because Spains
productivity dis-advantage remains less in one
commodity (corn) than the other (cloth), so that
it can still benefit from indirect production
of cloth. Analogy Specialization in professions.
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Hypothetical special case relative costs are
equal
Input per yd of cloth
Input per cwt of corn
Pre-trade price of cloth in corn units
Would benefit if price was
3
0.5
lt 0.5
Italy
2
4
gt 0.5
0.5
England
Only case in which no mutually beneficial trade
is possible. Any alternative exchange rate
would harm the interest of one of the two
countries. Very hypothetical!
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An application US-UK trade in 1937.
An application US-UK trade in 1937.
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Note US has productivity advantage over UK in
all exports. Vertical intercept where advantage
schedule is positive.
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(No Transcript)
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Mutually beneficial trade (with matrix inverted)
Portugal
England
Labour input per unit of cloth (unit 1 yd)
Labour input per unit of corn (unit 1 cwt)
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Mutually beneficial trade formalistic version
Economy 1
Economy 2
Labour input per unit of M
L1M
Labour input per unit of A
L1A
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Case 1 Mutually beneficial trade
Economy 1
Economy 2
Labour input per unit of M
Labour input per unit of A
Ec. 1 is more efficient in producing M L1M
L2M Ec. 2 is more efficient in producing
A L2A L1A ? Both economies gain
from trade.
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Case 2 Comparative advantage
Economy 1
Economy 2

Labour input per unit of M
L1M
L2M
Labour input per unit of A
L1A
L2A
Ec. 1 is more efficient in producing both M and
A L1M L2M and L1A lt L2A Yet Ec. 2s
cost of home-produced M i.t.o. A is more than
cost of importing from Ec. 1 L2M / L2A L1M
/ L2A ? Ec. 2 still benefits from trade.
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Case 3 (hypothetical) Mutually beneficial trade
not possible
Economy 1
Economy 2
Labour input per unit of M
L1M
L2M
Labour input per unit of A
L1A
L2A
L2M / L2A L1M / L1A ? Mutually beneficial
trade not possible.
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James Mill, 1821 When a country say Economy 2
can either import a commodity say M or produce
it at home, it compares the cost i.e.
opportunity cost of producing at home
, with the cost of procuring from abroad if
the latter cost is less than the first, it
imports. The cost at which a country can import
M from abroad depends not upon the cost i.e.
the opportunity of not producing an alternative,
say A at which the foreign country produces the
commodity but upon what the
commodity costs which it sends in exchange
, compared with the cost which it must be at
to produce the commodity in question
, if it did not import it. Note James Mill was
a populariser of the theories of Ricardo.
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Summary / themes / preview Classical trade
theory in favour of free trade / against
tariffs and restrictions / gains from trade. Two
stages Absolute advantage. As in Comparative
advantage. As in Note What TCA does not say
convergence, equal benefit.
BUT NOTE Extremely restrictive and unrealistic
assumptions Completely free trade no subsidies,
tariffs, or commercial restrictions. Frictionless
inter-sectoral transfer of labour. Preview
Debates on realistic application of trade theory
largely centre around consequences of lifting
these assumptions.
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• Themes.
• Micro modelling (including contemporary
  elaborations) can only be as realistic as the
  assumptions upon which it is based.
• Keynesian critique of classical (micro / S-side)
  economics (applicable to a special case only).
• History of economic ideas is essential to
  assessing their analytical power.