lecture 3 trade theoryaof

8/10/2019 Lecture 3 TRADE TheoryAoF

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Lecture 3

Classical and

Neoclassical Theories



Mercantilist Theory

• To export is good, to import is to be avoided

• When you exported, you receive payment –currency based on gold standard

•

Best thing to do is export as much as possibleto gain as much gold as possible

• Problem with this theory is that excludes thefact that in some cases it is good to import

• If you completely refuse to import, thepopulation will have to do without certainconsumer items



Hecscher!"hlin Theory #H!"$

• While trade is partly explained by di%erences inlabor productivity, it also can be explained bydi%erences in resources across countries&

•

The Hecscher!"hlin theory argues thatinternational di%erences in labor, labor sills,physical capital or land #factors of production$create productive di%erences that explain whytrade occurs& –

'ountries have relative abundance of factors ofproduction&

– Production processes use factors of production withrelative intensity.



Two (actor Hecscher!"hlin )odel

*& +abor and land are resources important for production&

& The amount of labor and land varies across countries,and this variation in-uences productivity&

.& The supply of labor and land in each country is

constant&/& "nly two goods are important for production and

consumption0 cloth and food&

1& 'ompetition allows factors of production to be paid a2competitive3 wage, a function of their productivitiesand the price of the good that it produces, and allowsfactors to be used in the industry that pays the highestwage4rate&

5& "nly two countries are modeled0 domestic and foreign



Classical Economics: Political Economy

The pursuit of economic growth and development as a

socially desirable goal is contemporaneous with the rise ofcapitalism as an economic system (and with the

emergence of the industrial revolution!

Two o"#ectives of classical political economists ineconomic in$uiry are:

1. to explain the reasons for rapid economicexpansion of total economic wealth thataccompanied industrialization

2. to explain the enigma of the extreme of wealthand poverty that attended this process

Who are the classical (political) economists?

• 6dam 7mith

• Thomas )althus

• 8avid 9icardo

•

:ohn 7tuart )ill• ;arl )arx



*<

• The classical assumed that capitalism represented thehighest achievement of human development and it wasa “natural order.” – except for )arx and )ill

• Neoclassical economists (after the 1870s – 6gainst the radical implications of )arx –

shifted the emphasis from the broadermacroeconomics of growth and development to anarrower concern with the allocation of a =xed>uantity of scarce resources to their best use withgiven institutions&

– e?ciency as the focus of economics –

more static and marginalist perspective foreconomics – interest in the >uestion of growth and development

has disappeared from view for >uite some time&



%dam &mith !n in"uiry into the Nature and #auses of the$ealth of Nations% 177&

• Analyzes the newly emerging economic system capitalismor the mar!et economy

• "i!ens its operation to the “invisible hand”

As every individual# ..# endeavors as much as he can both toemploy his capital in the support of the domestic industry#and so to direct that industry that its produce may be ofgreatest value$ every individual necessarily labors to renderthe annual revenue of society as great as he can. %e

generally# indeed# neither intends to promote the publicinterest# nor !nows how much he is promoting it ...heintends only his own gain# and he is in this# as in manyother cases# led by an invisible hand to promote an endwhich was no part of his intention. (&mith '* +,*$ -/'01)



&mith's iews onEconomic )evelopment

Basic tenets of 'apitalist production thatfosters @rowth and 8evelopmentaccording to 7mith0

• -ompetition• /ivision of labor

• 2echnological progress

• 3ree trade• 2he law of capital accumulation



Thomas Malthus !n 'ssay on the rinciple of opulation% 17)8

• Population grows in a geometric progression, while

• 6gricultural output can only increase inarithmetic progressionA such that

• (eeding the population would becomeincreasingly more e4pensive a tas

•

This would mean misery for a ma5ority ofthe population who are poor

• The system (capitalism) would end up in acrisis



)avid *icardorinciples of olitical 'conomy and*axation% 1817

• the law of eventually diminishing returns

#implications similar to )althus in terms of thedilemmas of the capitalist growth proces$A yet

•

the theory comparative advantage#implies free trade through open economies wouldhelp to escape the dilemmas posed by the law ofdiminishing returns&$

Theory which suggests that unrestrictedexchange +etween countries will increasetotal world output if each country tends tospecialize in those goods that it can produce

at relatively lower costs compared to its potential trading partners.



*icardo's Theory of Comparative %dvantage% numerical e+ample to e+plain the virtues of free trade

Cloth

laborhrs

perunit

,ine

laborhrs perunit

oppurtunitycost of Cloth

in terms of Wineforegone

opportunitycost of ,ine

in terms of'loth foregone

England

<hrs

+'C

*<hrs

+WC

<&D1<

+'C4 +WC

<&D1 additional wines producedper each unit of reduced cloth

production

*&...

+WC4+'C

*&.. additional cloth producedper each unit of reduced wine

production

Portug

al

<hr

s +'P

E<hrs

+WP

*&*1

+'P4 +WP

<&EEE

+WP 4+'P



*icardo's Theory of Comparative %dvantage:% numerical e+ample to e+plain the virtues of free trade

%ssume: -oth E and P have 3../... la"or hours to start with0 andPre1trade "oth divide their time e$ually "etween cloth and wine production

Portugal England

-efore Trade: Cloth ,ine Cloth ,ine

Production 2Consumption

*555 *ED1 *555 *1<

%fter Trade:

Production < .D1< .... <

Trade @ets*555

@ives *555 @ives *555 @ets *555

Consumption *555 <E. *55D *555

ains fromTrade:Country

< F<E F* F /*5

ains fromTrade:,orld

Pre trade wine0 .*1

Post trade wine0 .D1<

Pre trade cloth0 .*55

Post trade cloth0 .*55



*E

4ree Trade according to Comparative %dvantage-ene5ts %ll 666 Criti$ue of the Comparative%dvantage Theory of 4ree Trade

• Gery static analysis which assumes that overtime, the terms of trade between wine and clothwill remain the same&

– "n the contrary, historically what happenedwith C and P was that the terms of trade verymuch favored clothA such that C had a de=nitetrade advantage&

– P stuc with wine production and importing

cloth, was put in a position of ever increasingtrade de=cit&

• dynamic or created comparative advantage asopposed to static comparative advantage

– the 6sian tigers&



7arl Mar+#apital% 18&7% 188,% 18)-

• does not assume capitalism to be immutable ornatural order of society, rather one stage of asocietys historical development

• capitalism will also ultimately brea down andevolve into a di%erent system

• agrees with 7miths analysis of capitalism as animmensely dynamic system driven by the law ofcapital accumulation, characteried by division oflabor and technological progress

• yet is critical of the one sided distribution

#2exploitation of labor by capital3$ that results inthe capitalist growth process• a relatively high!level of income per capita in a

capitalist economic environment is a preconditionfor the evolution of a new future economic

system



Traditional Theory of International Trade

• 'omparative advantage – specialiation

• 9elative factor endowments and

international specialiation0 theJeoclassical model – 9icardo and )ill #static model$

–

Hecscher and "hlin #factor endowmenttheory$• 8i%erent products re>uire productive factors in

di%erent ratios

• 'ountries have di%erent endowments of factors of

production



Trade with Gariable (actor Proportionsand 8i%erent (actor Cndowments



Trade with Gariable (actor Proportions and8i%erent (actor Cndowments #continued$



'opyright K <<Pearson 6ddison!Wesley&6ll rights reserved&

*!/


• )ain conclusion of the neoclassical modelis that all countries gain from trade

• World output increases with trade• 'ountries will tend to specialie in

products that use their abundantresources intensively

• International wage rates and capital costswill gradually tend toward e>ualiation

• 9eturns to owners of abundant resourceswill rise relatively

• Trade will stimulate economic growth




• Trade theory and 8evelopment0 The Traditional 6rguments

– Trade stimulates economic growth

– Trade promotes international and domestice>uality

– Trade promotes and rewards sectors ofcomparative advantage

– International prices and costs of production

determine trading volumes – "utward!looing international policy is

superior to isolation



The 'riti>ue of Traditional (ree!Trade Theory inthe 'ontext of 8eveloping!'ountry Cxperience

• The following assumptions of theJeoclassical model must bescrutinied0 – (ixed resources, full employment, and

international factor immobility

– (ixed, freely available technology and

consumer sovereignty – Internal factor mobility and perfect

competition

– @overnmental non!interference in trade




– Balanced trade and international priceadLustments

– Trade gains accruing to nationals




• (ixed 9esources, (ull Cmployment,and the International Immobility of

'apital and 7illed +abor – 'hallenged by Jorth!7outh trade models

– )ichael Porters 'ompetitive 6dvantage

theory – Gent for 7urplus theory




• (ixed, (reely 6vailable Technologyand 'onsumer 7overeignty –

'hallenged by the Product 'ycle theory – 8evelopment of synthetic substitutes for

developing country exports




• International (actor )obility, Perfect'ompetition, and Mncertainty0 Increasing9eturns, Imperfect 'ompetition, and Issues

in 7pecialiation – 7tructural realities in developing countries

– Increasing returns and exercise of monopolisticcontrol over world marets

– 9is and uncertainty inherent in internationaltrading arrangements




• The 6bsence of Jational@overnments in Trading 9elations – 8e=nite role for 7tate

– Industrial policy is crafted bygovernments

– 'ommercial policies instruments #tari%s,>uotas$ are state constructs

– International policies can result inuneven distribution of gains from trade




• Balanced Trade and InternationalPrice 6dLustments

– Mnrealistic #oil price hies of the D<s$




• Trade gains accruing to nationals – Cnclave economies are promoted by

trade – 8i%erence between @8P and @JI

becomes important



7ome 'onclusions on Trade Theory andCconomic 8evelopment 7trategy

• Trade can lead to rapid economic growthunder some circumstances

• Trade seems to reinforce existing incomeine>ualities

• Trade can bene=t +8's if they can extracttrade concessions from developed

countries• +8's generally must trade

• 9egional cooperation may help +8's

lecture 3 trade theoryaof

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