INTERNATIONAL TRADE

THEORY
ECN 308 / INB 302
Aminur Rahman
Head of the Department of Economics
Independent University, Bangladesh

Absolute Advantage & Comparative Advantage

Absolute Advantage

Food

USA

UK

Clothing Advantage
4 in the Production
6
USA: Absolute
of food

UK: Absolute Advantage in the Production of Clothing

Comparative Advantage
USA

UK

Food

Clothing

International Trade

Comparative Advantage
USA:

Wheat
Brazil: Coffee

Gains From Trade

INTRODUCTION TO
NEOCLASSICAL TRADE THEORY
(CHAPTER 3)

CH-3 MC P:44

As indicated in panel (a), in autarky the partner country produces and consumes at
point e. With trade it now faces the international price ratio (Ps/Py)2, which is
flatter than its internal relative prices in autarky. Consequently, production of the
relatively more expensive good Y expands and production of good X contracts,
until further adjustment is no longer profitable at point e. Consumers now find
good X relatively less expensive and adjust their consumption expenditures by
moving from point e to point e. The opening of trade allows the country to
consume outside the PPF on the higher indifference curve W2, thus demonstrating
the gains from trade (the difference between W1 and W2). Note that, with trade,
both countries face the same set of relative product prices, (Px/Py)2.

OBSERVATION
1.
2.
3.
4.
5.

T/T Autarkic prices of two countries

T/T Sw= Dw in both commodity markets
Better off Higher indifference curve
No complete specialization
Free trade equalizes opportunity

OFFER CURVES
Determination of International Equilibrium
Offers of a country at Alternative terms of trade
Relative Price of Food = Imports of clothing
Exports of foods
A: Gains from trade
B: Derivation of Demand Curve: A
C: Derivation of Demand Curve: B
D: International equilibrium
Equilibrium terms of trade
TOT USA offer is smaller than Britains offer (Ux)
(USA not willing Fx) excess demand for food
PF : Excess

Sc Pc
Relative Price of Food => K

INTERNATIONAL EQUILIBRIUM

THE HECKSHER-OHLIN MODEL

(FACTOR ENDOWMENTS THEORY)

1.
2.

Two Premises:
Commodities differ in their factor endowments
Countries differ in their factor endowments

Hecksher-Ohlin: A country has a comparative

advantage in those commodities that
use its abundant factors intensively.

Major ingredients: Factors intensity and

factor abundance

BASIC ASSUMPTIONS
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

Two countries, Two commodities with homogenous factors of

production ( Labor and capital)
Technology: Same
Constant Returns to Scale
Strong Factor Intensity: Labor of Capital Intensives
Incomplete specialization
Perfect competition: Law of One Price
Factor mobility: Perfectly mobile within countries, immobile
between countries
Similarity of tastes: Similar but not Identical ( Same Social
Indifference Curve)
Free Trade
Transportation Costs: Zero

FACTOR INTENSITY
FIXED COEFFICIENT OF PRODUCTION
Labor Ratio and Capital Ratio
Cloth needs 6 labor and 2 capital and Steel nees 8 labor and 4 capital
Cloth is labor intensive relative to steel as cloth needs more unit of
labor than the production of steel.
Labor- Capital Ratio is higher in Cloth Production (6/2 > 8/4).
Steel is Capital Intensive as Capital-Labor ratio is (4/8 > 2/6)
S
6

Optimal
techniques

Capita
l
3
L/K = 0.5
_______________
1. Physical and
economic
abundance

E
S

W/R

W/R 3/4

2
3

FACTOR PRICE EQUILIBRIUM

THEOREM
Free trade equalizes factor rewards ( real rental)
between countries and thus serves as a
substitute for external factor mobility
Stopler Samuelson Theorem: An increase in the
relative price of a commodity raises in terms of
both commodities the real rewards of factor used
intensively in production of the commodity and
reduces, in terms of both commodities, the real
reward of the other factor
Relative price of cloth W/P in terms of cloth
and steel and lowers (W/P) real rental rate of
capital => C/S

THE RYBCZYNSKI THEOREM

When the coefficients of production are given and factor supplies are
fully employed, an expansion in the endowments of one factor of production
raises the output of the commodity that uses the expanded factor intensively
and reduces the output of the other commodity.

Cloth production

Steel =>
capital released to
match with
expanded cloth
production

Ls

Capit
al

Clot
h
V

Labou
r
H

Steel
Once constraints become binding JEH is the PPF

STOPLER- SAMUELSON
THEOREM
Q

Clot
h

Production at Qx with tariff

G

Steel
RICARDO: Free Trade Benefits all
S-sProtection hurts everyone

Disagreed Cheap Labor (Foreign) for protection

Technology: Cloth
Steel

Labor
4
2

Capital
1
2

Magnification effect: W/P Rental

Relative price of cloth => for steel (Q-Q)
Reorganziation of the structure of Production technology MPLK
change

FACTOR PRICE EQUALIZATION

THEOREM
As labor becomes cheaper compared to capital W/R labor intensive

commodities become cheaper relative to the capital intensive commodity

M

S
S
c1

Steel

Cloth

Unit Cost ( Save

100) of each
product

When W steel S1 and Cloth C1

Cloth Cheaper relative to steel as C1 lies on lower isocost less than S1
F
W/
R

W
America

PC
/P
S

E
B

R
P
O

Autarky price
USA: OS
BRITAIN: OD
ON= Common Commodity
Price Ratio

ALTERNATIVE TRADE THEORIES

AND EMPIRICAL TESTING

MAC Dougall- Balassa- Steru

1937

Wage in the USA twice as high as UK

OUTPUT PER WORKER MORE THAN TWICE US MONEY

COST LOWER COST ADVANTAGE FOR US OVER UK.

TWICE => NO COST ADVANTAGE

Less than twice: UK AOUT

TESTING OF HYPOTHESIS:

EXPORT RATIO: US ex to UK ex

PRODUCTIVITY RATIO: output per US worker to UK worker

WHEN PRODUCTIVITY RATIO WAS HIGHER THAN 2, then US

had a larger share of EXPORT market and when lower UK
had this.

THE LEONTIEF PRADOX

IMPORT COMPETING PRODUCTION REQUIRED 30% MORE
CAPITAL PER WORKER THAN US EXPORT PRODUCTION
- JUST OPPOSITE OF HECKSCHER-OHLIN THEOREM
EXPLANATION OF PARADOX
1. FACTOR INTENSITY REVERSALS SEPARATE US FROM
REST OF THE WORLD- INVALIDATE H-O THEOREM
2. BY PROTECTING US INDUSTRIES THAT ARE RELATIVELY
INTENSIVE IN UNSKILLED LABOR- US TARIFF AND NONTARIFF BARRIER TO INTERNATIONAL TRADE EXCLUDE
LABOR INTENSIVE IMPORTS
3. SCARCITY OF NATURAL RESOURCES IN USA -> IMPORT
CAPITAL INTENSIVE PRODUCT
4. US EXPORT INDUSTRY USES SKILLED LABOR
5. CONSUMPTION BIAS towards capital intensive good
- But on the contrary it is toward labor intensive goods

SPECIFIC FACTOR MODEL

COMPARATIVE ADVANTAGE Relative abundance of specific
factor
SPECIFIC FACTOR USE P Better off and other factor worse off
Specific factor ( Small economy) OUTPUT OUTPUT OF OTHER
COMMODITY
Mobile factor output of both commodity Mobile factor worse off
specific factor better off
J*

Cor
n

B
A

N
H* H

I
Steel

Linders Thesis: COUNTRY EXPORTS THOSE MANUFACTURED GOODS FOR WHICH THERE IS BROAD LOCAL
MARKET

NO BIG SUPPORT

TECHNOLOGICAL GAP THEORY IS BASED ON THE SEQUENCE OF INNOVATION AND IMITATION.

USA ADVANTAGE IN R&D
Export Technologically Advanced Product

DECREASING OPPORTUNITY
COSTS
U
- ALL
GAINS
: EU CASE
2
S
R

Aut
o

T
N

Plant

E= Before trade production point

for US vs UK at UV
After trade
USA = V and Consumes A, UK U
and B
Both gain even though no
difference
GF
T/T

GROWTH AND TRADE

CAPITAL ACCUMULATION:
CAPITAL DEEPENING
(CAPITAL STOCK POPULATION HIGHER Y AND STANDARD OF
LIVING
ENDOGENOUS
I S CAPITAL STOCK
TECHNICAL PROGRESS
CLASSIFICATION --? NEUTRAL (NT)
LABOR SAVING (LS)
HICKSIAN DEFINITION CAPITAL SAVING (CS)
b

LS:

a
A

B
C

L
Labor is saved per unit of capital
employed
At W R ratio shown by the slope of

OB TO OA

b
a
L

CLOT
H

CLOT
H
U

V V

V V

STEEL

BALANCED GROWTH
NEUTRAL PRODUCTION EFFECT.
WELFARE CONSTANT

CLOT
H U

Labor
growth
worse off

STEEL

Labor Supply
Labor Intensive good
Less capital to work with
Negative

Capital
Growth

BETTER
E
OFF

V STEELV
Effects on Small Country

CLOT
H

CLOT
H

CLOT
H

E
E

STEEL

WORSE

STEEL

BETTER OFF

STEEL

THE THEORY OF TARIFF

TYPES: IMPORT DUTY, EXPORT DUTY,
AD VALOREM, SPECIFIC, COMPOUND
1. Consumption effect: GC
2. Production effect: KH
( Protective effect)
3. Trade effect: JF
4. Revenue effect: JHGF
5. Redistribution effect
Consumer surplus
( Area 1,2,3 and 4)
Area 1 -> Producer
Area 2 and 4: dead weight loss
GENERAL EQUILIBRIUM ANALYSIS
EFFECT ON DOMESTIC PRICE
EFFECT ON PRODUCTION
EFFECT ON VALUE OF PRODUCTION AND WELFARE
EFFECT ON CONSUMPTION
DISTRIBUTION OF INCOME : TARIFF REVENUE
VOLUME OF TRADE

EFFECT ON LARGE COUNTRY

TERMS OF TRADE EFFECT
EFFECTS OF TARIFF ON DOMESTIC PRICES
METZLERS PARADOX
TARIFF AND WELFARE
TARIFF WORLD OUTPUT
SUBOPTIMAL ALLOCATION OF
COMMODITIES AMONG CONSUMERS

TARIFF IMPROVES LARGE COUNTRY TERMS OF TRADE

SMALL COUNTRY TARIFF VOLUME OF TRADE ( POINT D)

MONOPOLY- MONOPOLY POWER

USA DESIRED VOLUME OF TRADE CONTRACTS ( OEo OD)

SUPPLY BY S1So

DEMAND FOR CLOTH C1Co

STEEL MARKET MONOPOLIST

CLOTH MARKET- MONOPSONIST

RESTRICTS SUPPLY TO RAISE PRICE

RESTRICTS DEMAND TO BUY IT AT

LOWER PRICE

RELATIVE PRICE OF STEEL

TOT

TARIFF AND WORLD WELFARE

TARIFF INTERFERES WITH THE MAXIMIZATION
OF WELFARE
(a) TARIFF REDUCES THE WORLD OUTPUT OF
COMMODITIES BY REVERSING THE PROCESS
OF INTERNATIONAL DIVISION OF LABOR,
WHICH IS DICTATED BT THE LAW OF
COMPARATIVE ADVANTAGE MRTA MRTB
(b) THE TARIFF FORCES A SUBOPTIMAL
ALLOCATION OF COMMODITIES AMONG THE
CONSUMERS
Commodity price equation FREE TRADE MRSA
MRSB
TARIFF MRSA MRSB AS PRICE DIVERGENCE
OCCURS

TARIFF AND DOMESTIC PRICE

LARGE COUNTRY: TARIFF MAKES IMPORTED
COMMODITY RELATIVELY CHEAPER IN
THE REST OF THE WORLD
PARADOX? METZLER
TARIFF CAUSES the price of the imported
commodities to fall more than the tariff
WHY? (a) the foreign demand for imports is
inelastic
(b) the tariff levying countrys MPI is very
low the protection provided to the import
competing industries is negative

EFFECTIVE RATE OF PROTECTION

ERP = V-V
V
V Value added at domestic prices
V Value added at world prices
Stopler- Samuelson theorem
AM relative price of a commodity or of
factor used intensively in its production

ARGUMENT FOR PROTECTION

OPTIMAL TARIFF

TWO CONFLICTING EFFECTS ON WELFARE:

i)IMPROVE TERMS OF TRADE
ii)VOLUME OF TRADE FALLS WELFARE
Max Welfare
Marginal T/T benefits = Marginal Volume of trade cost
Monopoly Monopsony Power
Brazil : Coffee Japan: Auto
Average and Marginal T/T
Volume of trade Max Welfare
MTT = Opp. Cost Domestic of exportable

ECONOMIC ARGUMENT FOR TARIFF

TARIFF FOR REVENUE PROTECTION

CHEAP FOREIGN LABOR
TARIFF TO MAINTAIN EMPLOYMENT
INDUSTRIAL POLICY

NON-ECONOMIC ARGUMENT
Political, cultural, and sociological goals
FOUR SPECIFIC OBJECTIVES
1. A CERTAIN LEVEL OF PRODUCTION ( MILITARY)
2. A CERTAIN LEVEL OF CONSUMPTION ( RESTRICTION
OF LUXURY GOODS)
3. SELF- SUFFICIENCY
4. EMPLOYMENT OF A FACTOR OF PRODUCTION
(LABOR)

CPT:9 INSTRUMENTS OF
COMERCIAL POLICY
EXPORT TAXES
EFFECTS OF EXPORT TAXES
(GRAPHICAL PRESENTATION)

D
6
0
PRICE 3
5
2
0

3
2

M
G
4 5
B
C
A

s
90

D
300

RICE

700

115
0

AT WORLD PRICE 60 =
DOMESTIC PRODUCTION 1150
90 CONSUMED (F)
WORL
D
1060 EXPORT (FG)
PRICE
T (DOMESTIC EXPORT TAX 25 P 35
DOMESTIC PRODUCTION
PRICE)
700 (C)
DOMESTIC CONSUMPTION
300
(B) EXPORT FALLS 400 (BC)
PRODUCTION SURPLUS 1 5
AREA 4 TAX REVENUE
1+2 = CONSUMER SURPLUS
3= OVER CONSUMPTION
5= UNDER PRODUCTION

II EXPORT SUBSIDY: NEGATIVE EXPORT

TAX
QUANTITATIVE RESTRICTIONS

RESTRICTION OF PHYSICAL VOLUME OF EITHER

EXPORT OR IMPORT
OPEN QUOTA OR IMPORT LICENSES
Specific amount from any where abnormal profit
PDOM
IMPORTERS AT COMPETITIVE
K PRICES?
Free
D

Pric
e
Import
tax or
quota
equivalen
ce

156
0
130
012
001
000
J
S
O

S
G

F
E

Trade
Supply
of
Export

40 5
0

D
IMPORT
DEMAND
Quantity/ import

QUOTA PD (13) (F) Lower PF (H)

A 30% IMPORT TAX --JK

III DIFFERENCE BETWEEN QUOTAS AND

IMPORT TAX
Revenue Effect, Certainty

QUOTA- LICENCE FEE CERTAIN UNCERTAINTIES

IMPORT TAX: REVENUE
EXPORT QUOTA : F. PRICE PD
VOLUNTARY EXPORT RESTRICTIONS
Voluntary cut of export otherwise import tax by IMPORTER
INTERNATIONAL CARTELS
D

MAX =>
CARTEL

S
G

P
P

E
F

DUMPING: PERSISTENT- PREDATORY- SPORADIC- GATT

CUSTOM UNION
Approaches of International Trade Liberalization
International Approach
Regional Approach
-Preferential Trading Club
-Free Trade Area
-Customs Union
- Common Market
- Economic Union
Reduce Tariff but keep original tariff with rest of the world
Abolish tariff but keep original tariff with rest of the world
Abolish Tariff but Common Tariff with rest of the world

COMMON MARKET
CUSTOM UNION + FREE MOVEMENTS OF ALL FACTOR
OF PRODUCTIONS
ECONOMIC UNION
COMMON MARKET + UNIFICATION OF DEMAND
MANAGEMENT POLICY + MONETARY UNION
SINGLE CURRENCY

TRADE CREATION
IMPROVES THE INTERNATIONAL MOVEMENT OF RESOURCES
BY SHIFTING THE NATIONAL FOCUS OF PRODUCTION FROM
HIGH COST TO LOW COST PRODUCER WELFARE
TRADE DIVERSION
DIVERSION OF TRADE FROM CHEAP PRODUCER TO HIGH
PRICE PRODUCER WELFARE INCREASING COST