A common talk point relating to international trade revolves around the basic
understanding of knowing that countries differ. There are two very famous models that help
us to explain and understand international trade further, these are the Ricardian and HOS
model. The Ricardian model looks at international differences in technology. This model is
all about how differences between countries in the technologies they use to produce goods
affect international trade. For example, if we were to consider two distinct countries, one
that was relatively rich and the other being a relatively poor country, we would be able to
infer that the richer country is likely to have more advanced technologies than the poorer
nation (who would use older technologies). On the contrast, the HOS model looks at
international differences in resources. It focuses on looking at how differences in between
countries in their factors of production (labour, capital) affect international trade.
In addition to both models assisting in the explanation of how international trade functions,
both these models share similar assumptions. The first key assumption is that both models
simplify international trade by considering two goods and two countries. secondly, we
assume perfect competition exists. This means that all firms sell an identical product and are
price takers. We also assume an increase in inputs causes the same proportional increase in
output – this is referred to as constant returns to scale. Another featured assumption is that
factors of production are mobile within countries but immobile internationally. The last key
assumption is that full employment exists in the factors of production and there is balanced
trade. In terms of differing assumptions, the Ricardian model considers only one factor of
production, whilst the HOS model looks at two. Furthermore, both models are inter-industry
trade models, however the Ricardian model looks at technology differences between
industries and countries, whilst the HOS model only looks at technology differences
between industries.
The production possibility frontier (PPF) helps plot the output pairs that can be produced by
a country. The PPF function is a different shape between the Ricardian and HOS models. In
the Ricardian model the shape of the PPF is linear, whilst in the HOS model the PPF is seen
to be bowed out. In the HOS model, a countries PPF is biased towards the axis of the
industry that intensively uses its abundant factor, this implies that a country has a
comparative advantage in the industry that intensively uses its abundant factor. For
example, country 1 has a comparative advantage in good Y if country 1 is capital abundant
and industry Y is capital intensive.
There are two key factors that can help us understand international trade further. These are
comparative advantage and absolute advantage. Comparative advantage relates to how the
opportunity cost of producing a good differs between countries. The Ricardian model
suggests that countries export the good in which they have the comparative advantage in.
For example the U.S. has a comparative advantage in computers, hence they will export
computers. The U.S. has a lower opportunity cost in making computers than China, hence
this leads to the result of the U.S. having the comparative advantage in computers. On the
other hand, we have absolute advantage, which refers to how output per worker differs
between countries. For example, considering two countries – France and Germany, we
would say that France has the absolute advantage if it has a higher output per worker than
,Germany. It is important to also mention that absolute advantage isn’t the greatest metric
at measuring trade pattern. This is because it the feature matters more for measuring living
standards as oppose to explaining international trade.
The HOS model is another model that helps to explain international trade. In this model we
say that a country is capital-abundant i.e. the endowment of capital relative to the other
factors of production is large in that particular country. Considering two countries, country 1
and 2, we can infer that if country 1 is capital -abundant implies that country 2 is labour-
abundant. Furthermore, we say an industry is capital-intensive if its capital to labour ratio is
higher than other industries.
Autarky (closed economy) Equilibria
An autarky refers to the state of self-reliance and its typically applied to an economic system
or nation characterised by self-sufficiency and limited trade. Under autarky, production and
consumption bundles coincide. What we’re saying here is if you’re a closed economy, then
the mix of goods that particular country consumes is determined by what the country can
produce. An example of a closed economy is North Korea, the country can only consume
what they produce as there is nowhere else to get goods from since they are a closed
economy. In a state of autarky, the aggregate budget constraint is given by the countries
PPF. This can be shown in the Ricardian model below:
The movement from a state of autarky to free trade is defined as trade liberisation. This
movement to a state of free trade means that can import and export goods without any
tariff barriers to trade. The result of this movement allows lower prices for consumers, a
wider variety of goods, increased exports and lastly, economies of scale.
, Trade libersaiton by a small country differs between the Ricardian and HOS models. Firstly,
considering trade liberisation by a small country in the Ricardian model, if the country
(small) has a comparative advantage/ lower opportunity cost in good X compared to the
rest of the world, then we can graphically illustrate this:
In the above graph, we can evidently see that specialisation in production under free trade
occurs. Here, the movement from autarky to free trade has resulted in complete
specialisation in product X. Complete specialisation means that the country will only
produce a particular product, in this example this is product X and the country does not
produce any of good Y. Specialisation occurs as the country can keep on selling and export
as much of good X as it wants at a constant world price and keep putting more workers into
the X industry and get the same output. Also, for the trade to remain balanced, good X is
exported to pay for the imports of good Y.
In terms of welfare, both aggregate and individual welfare increases from the result of trade
liberisation (autarky to free trade), this is due to the fact the indifference curve is now in a
higher position. This situation can also be described the pareto gain – a situation whereby
everyone becomes better off. In summary of the movement and comparison of autarky and
free trade by a small country in the Ricardian model, we notice that the small country
exports its comparative good and there is increased welfare for everyone.
On the contrast, the following details trade liberisation by a small country in the HOS model.
If relative to the small country, the rest of the world has a comparative advantage in good X,
then the following graph illustrates trade liberisation:
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