360-3 - Chapter 3 Classical Model of International Trade We...

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Chapter 3 – Classical Model of International Trade We now have a model to answer question: How and why national engage in trade? CH 3 presents the classical theory of international trade going back to Adam Smith (1776) and David Ricardo (1819). Why Classical Model? 1. Based on timeless assumptions that apply even today. 2. Explains trade between developed, high-wage countries (U.S.) and developing, low-wage countries (India, China). 3. Illustrates the gains from international specialization of production. ABSOLUTE ADVANTAGE: ADAM SMITH Insight: Division of labor and specialization significantly increases output, e.g. pin factory (assembly line approach with 18 different specialized operations) vs. individual pin production. International division of labor , division of labor applied to global production, to increase global output and increase global standard of living. Mercantilism – government trade policies to increase exports and discourage imports, common during Smith’s time (18 th century). Protectionism through tariffs, quotas, subsidies, etc. Smith criticized mercantilism (lowered a country’s standard of living by discouraging or banning cheaper foreign imports) and advocated free trade policies. How does free trade promote prosperity? We return to our closed-economy model from CH 2, and extend it. Assumption 8: Factors of production (labor) cannot move between countries, to guarantee that the PPF won’t change after trade. Simplifies the model, doesn’t allow for immigration or MNCs. Assumption 9: No trade barriers, to allow for comparison of free trade vs. autarky. We examine trade barriers in CH 6-7. Assumption 10: Exports must pay for imports, trade must balance, X = M, rules out trade deficits and surpluses for now. Barter economy. 1
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Assumption 11: Labor is the only relevant factor of production, for simplification, and prices of goods are determined by the labor content – “labor theory of value.” Assumption 12 : Production exhibits constant returns to scale , instead of allowing for increasing or decreasing returns to scale, for simplification. Constant returns means that if you double inputs, you double output; assumes a fixed ratio between labor and output. If you double the number of workers (or hours worked), you double output of T or S. See example, bottom of p. 57. Absolute Advantage , see Table 3.1 on p. 58, labor hours required to produce 1 S or 1T in each country. A is more efficient at S, and B is more efficient at T, giving A (B) an absolute advantage at S (T). Smith: Specialization should take place internationally according to absolute advantage , A should specialize in Soybeans and B in Textiles. See Table 3.2 on p. 59: Country A reduces T by one unit, freeing up ______ hours, allowing A to produce _____ more units of S. Country B reduces S by one unit, freeing up _____ hours, allowing B to produce _____ more units of T. By specialization according to absolute advantage, world output increases by 1 S and
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360-3 - Chapter 3 Classical Model of International Trade We...

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