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1505 Topic 1 Essay

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UKEA3094 INTERNATIONAL TRADE
THEORY AND POLICY

Topic 1: The Ricardian Trade Model

Carbaugh, R. J. (2006). International Economics
(9th ed.). Ohio: South-Western-Chapter 2
201505

After studying this topic, you should be
able to understand:
1.1 Historical development on Modern Trade
Theory
1.2 Trade based on absolute advantage
1.3 Trade based on comparative advantage
1.4 Production possibilities schedules
1.5 Trading under constant cost conditions
1.6 Trading under increasing cost conditions
1.7 Community indifference curves, terms of
trade, and offer curves

1.1 Historical Development of Modern
Trade Theory

The mercantilists
David Hume
Adam Smith
David Ricardo

The Mercantilists
 An economic theory and practice, dominant in
Europe from the 16th to the 18th century.
 The world’s wealth is fixed (static).
 Concern: Regulation of domestic and
international affairs to promote national
interests.
 Solution: Strong foreign-trade sector.
 Favorable trade balance.
 Advocated government regulation of trade.

David Hume
 The Price-specie-Flow doctrine is a logical
mechanism created by David Hume which
dispeled the Mercantilist (1700-1776) notion
that a nation can have a continuously favorable
balance of trade.
 Favorable trade balance possible only in the
short run; over time it would automatically be
eliminated.

Suppose England were to achieve a trade
surplus that resulted in an inflow of gold and
silver
increase the amount of money in
circulation,
rise in England’s price level
relative to foreign price
rise in the demand
for foreign goods
rise in import and a
decline in export,
trade surplus would
eventually be eliminated.

Adam Smith
 Adam Smith’s “The Wealth of Nations”- the first
modern work of Economics.
 Challenged the static view of wealth
(Mercantilists).
 Dynamic view- Smith maintained that with free
trade, international specialization of resources in
production leads to an increase in world output
which can be shared by both trading partners.

All nations simultaneously can enjoy gains
from trade in terms of production and
consumption.
The principles of absolute advantage.

David Ricardo
 Ricardo’s comparative advantage theory takes
Smith’s work one step further.
 Smith did not believe that a nation could gain
from trade if they had either an absolute
advantage or absolute disadvantage in both
goods. This was the shortcoming in Smith’s
theory.

However, Ricardo based advantage on relative
cost differences instead of absolute, measuring
the cost of the good in terms of opportunity
costs, not absolute labor costs, both nation
could trade based on the principle of
comparative advantage.

That is, a nation could have absolute
disadvantage in both goods and still gain from
trade if the could produce one good at a lower
opportunity cost (as measured by units of the
other good given up) than the other nation (the
principle of comparative advantage).

1.2 Trade Based on Absolute Advantage
Principle of absolute advantage- Adam Smith
 Smith’s concept of cost was f...

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Keywords

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