2. WHY DO WE TRADE?- Part I: 2. WHY DO WE TRADE? - Part I


Index of Openness*: Index of Openness* Some trade extensively, others very little. How can this activity be understood and explained? * Ratio of exports to GDP multiplied by 100


Why Do We Trade?: Why Do We Trade? The classical theory of international trade is concerned with the following three questions: 1. What are the gains from trade? In other words, if countries benefit from international trade, where do the gains come from, and how are they divided among the trading countries?


Why Do We Trade? continued: Why Do We Trade? continued 2. What is the structure/pattern of trade? In other words, which goods/services are exported, and which are imported What are the fundamental laws that govern international allocation of resources and the flow of trade? 3. What are the terms of trade? In other words, at what prices are the exported and imported goods exchanged?


Understanding the Gains from International Trade: Understanding the Gains from International Trade Nations (or firms in different nations) trade with each other because they benefit from it! We can divide the different trade theories in four categories...


The Different Trade Theories: The Different Trade Theories 1. Early Trade Theory: Mercantilists 2. Classical Trade Theory: Ricardian Model (section 2.1) 3. Modern Trade Theory: Heckscher-Ohlin Model (section 2.2) 4. New Approaches to Trade Theory (section 2.3)


1. Early Trade Theory: Mercantilists: 1. Early Trade Theory: Mercantilists Until mid-eighteenth century, it was believed that the purpose of international trade was to keep exports greater than imports and pile up gold, and when/if deficits were created they believed that imports had to be restricted Mercantilists assumed trade to be a zero-sum game since they assumed that fixed amounts of goods and of gold existed in the world and that trade merely determined their distribution among the various nations


Mercantilists continued: Mercantilists continued But in the 1740s, David Hume explained that as quantity of money (gold) changes, so also does the price level, and the nation's real wealth is unaffected In 1770s, Adam Smith argued that import restrictions would reduce the gains from specialization and make a nation poorer Theories 2 - 4 will be now discussed in more detail ...


2. Why Do We Trade? continued: 2. Why Do We Trade? continued 2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage 2.2 Modern Trade Theory: Heckscher-Ohlin Model 2.3 Alternative Trade Theories: Results from Practical Evidence


Economic Basis for Trade: Economic Basis for Trade What are the factors that determine how countries will specialize in international trade? David Ricardo (1817) developed the theory of comparative advantage...


Economic Basis for Trade continued: Economic Basis for Trade continued Specialization and free trade will benefit (= real wages will rise) all trading partners, even those that may be absolutely less efficient producers. According to this theory,


Absolute vs. Comparative Advantage: Absolute vs. Comparative Advantage Although comparative advantage is a simple concept, experience shows that it is a surprisingly hard concept for many people to understand (or accept).


Absolute vs. Comparative Advantage continued: Absolute vs. Comparative Advantage continued Indeed, Paul Samuelson — the Nobel laureate economist who did much to develop the model of international trade — has described comparative advantage as the best example he knows of an economic principle that is undeniably true yet not obvious to intelligent people.


Definition: Absolute Advantage: Definition: Absolute Advantage The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does.


Absolute Advantage - an Illustration: Absolute Advantage - an Illustration Suppose country A and country B produce wheat, but that A's climate is more suited to wheat and its labor is more productive. Country A will therefore produce more wheat per acre than country B and use less labor in growing it and bringing it to the market. Country A thus enjoys an absolute advantage over country B in the production of wheat.


Definition: Comparative Advantage: Definition: Comparative Advantage The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other goods than it could be in the other country.


Comparative Advantage - an Illustration: Comparative Advantage - an Illustration Suppose that countries C and D both produce wheat and corn and that C enjoys an absolute advantage in the production of both - that is, C's climate is better than D's, and fewer of C's resources are needed to produce a given quantity of both wheat and corn C and D each need to choose between planting land with wheat and corn


Comparative Advantage - an Illustration continued: Comparative Advantage - an Illustration continued To produce more wheat, either country must transfer land from corn production and vice versa Suppose that in country C, a bushel of wheat has an opportunity cost of two bushels of corn. At the same time, suppose that producing a bushel of wheat in country D requires to give up only one bushel of corn D enjoys a comparative advantage in producing wheat


Example 1: Gains from Mutual Absolute Advantage: Example 1: Gains from Mutual Absolute Advantage Assume a) two countries with fixed amount of land (100 acres) and land yields given in the table below b) only two products produced (wheat and cotton), c) preferences for food and clothing are such that both countries consume equal amounts of wheat and cotton. PPF:s Before trade:


Example 1: Continued: Example 1: Continued Wheat Cotton New Zealand (150, 150) Cotton Australia Wheat (150, 150) When there is no trade the allocation of resources will be such that both countries will produce 150 bushels of wheat and 150 bales of cotton. W: 25 acres x 6 bu/acre C: 75 acres x 2 bales/acre W: 75 acres x 2 bu/acre C: 25 acres x 6 bales/acre PPF


Example 1: Continued: Example 1: Continued Expanded possibilities after trade: If countries realize that they should specialize (Australia in cotton and New Zealand in wheat) and trade, both countries could gain Both are now specializing:


Example 1: Continued: Example 1: Continued Cotton Australia Wheat (300, 300) Wheat Cotton New Zealand (300, 300) In this situation 300 bushels of wheat is traded for 300 bales of cotton:


Example 1: Continued: Example 1: Continued Trade enables both countries to move beyond their previous resource and productivity constraints both countries (after trade) can consume beyond their production possibilities (PPFs)!


Example 2: Gains from trade when one country has a double absolute advantage: Example 2: Gains from trade when one country has a double absolute advantage Production Possibilities and Consumption in a Closed Economy (same assumptions as before):


Example 2: Continued: Example 2: Continued When countries realize that they can benefit from specialization and trade:


Example 2: Continued: Example 2: Continued Consumption after trade: Stage 3 When countries specialize they will maximize their combined output and use resources more efficiently: both countries are better off than they were before the trade both have moved beyond their own production possibilities If 100 bu of wheat from NZ is traded to 200 bales of cotton from Australia


International Equilibrium with Increasing Costs: International Equilibrium with Increasing Costs Next we will extend the classical model of trade to the more general case of increasing opportunity costs and introduce demand by means of social indifference curves Increasing Opportunity Cost Food Clothing PPF Indifference Map and Consumer Equilibrium Food Clothing I’’ I’ I’’’ a) Product specific factors. b) Different industries use factors in different proportions.


General Equilibrium in a Small Open Economy: General Equilibrium in a Small Open Economy


Specialization Based on Comparative Advantage and the Resulting Gains from Trade: Specialization Based on Comparative Advantage and the Resulting Gains from Trade America Britain Figure 1 (a) Figure 1 (b) Assume such a domestic price ratios that E (in US) and E* (in UK) are the consumption and production in autarky.


Specialization Based on Comparative Advantage and the Resulting Gains from Trade continued: Specialization Based on Comparative Advantage and the Resulting Gains from Trade continued Figure 1: Specialization based on comparative advantage, and the resulting gains from trade. In autarky, America produces and consumes at E, And Britain at E*. With trade, America shifts production from E to Q and consumes at S by exporting VQ units of food to Britain in exchange for VS units of British clothing. America is better off with trade because S lies on a higher indifference curve than E. Indeed, in our illustration, America consumes more food and more clothing at S than at E. Britain shifts production from E* to Q* and consumption from E* to S*. Britain’s welfare increases also. Trade triangles SVQ and Q*V*S* are identical.


Same Production Technique in Both Countries, Trade Based on Different Taste: Same Production Technique in Both Countries, Trade Based on Different Taste Food Clothing America Britain Figure 2


Trade Based on Different Taste continued: Trade Based on Different Taste continued Figure 2: Trade based on different tastes. America and Britain share the same production frontier MN. In autarky, America produces and consumes at A, and Britain at B. With free trade, both countries produce at Q, but America consumes at A’ and Britain at B’. Trade triangles A’VQ and QSB’ are identical.


2. WHY DO WE TRADE?: 2. WHY DO WE TRADE? 2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage 2.2 Modern Trade Theory: Heckscher-Ohlin Model 2.3 Alternative Trade Theories: Results from Practical Evidence


What are the ultimate determinants of comparative advantage?: What are the ultimate determinants of comparative advantage? Ricardo did not bother to answer this question He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology), but he did not explain the basis for these differences. Implicit reason in his example was climate...


What are the ultimate determinants of comparative advantage? continued: What are the ultimate determinants of comparative advantage? continued It remained to Heckscher and Ohlin to offer an explanation for comparative advantage And this theory has become, since 1930s, the orthodox explanation of the ultimate cause of international trade


What are the ultimate determinants of comparative advantage? continued: What are the ultimate determinants of comparative advantage? continued Their basic idea is: 1. Commodities differ in their factor requirements 2. Countries differ in their factor endowments


What are the ultimate determinants of comparative advantage? continued: What are the ultimate determinants of comparative advantage? continued A country has comparative advantage in those commodities that use its abundant factors intensively. This is why labor-abundant countries, such as India, China and Korea export footwear, rugs, textiles, and other labor intensive commodities; and land-abundant countries, such as Argentina, Australia, and Canada, export meat, wheat, wool, and other land-intensive commodities


The Basic Assumptions of the Heckscher-Ohlin Model:: The Basic Assumptions of the Heckscher-Ohlin Model: 1. Number of countries, factors, and commodities are all two (often referred to as the 2 x 2 x 2 model) 2. Technology is the same in both countries 3. Constant returns to scale 4. Strong factor intensity 5. Incomplete specialization


The Basic Assumptions of the Heckscher-Ohlin Model continued:: The Basic Assumptions of the Heckscher-Ohlin Model continued: 6. Perfect competition 7. Factors are perfectly mobile within each country but perfectly immobile between countries 8. Tastes are largely similar between countries 9. Free trade 10. Transportation costs are zero


Heckscher-Ohlin Theorem with a Single Technique: Heckscher-Ohlin Theorem with a Single Technique The structure of trade, in general, can be traced back to differences in factor endowments, technology and tastes Since Heckscher-Ohlin theory assumes that technology and tastes are similar between countries, it attributes the comparative advantage to differences in factor endowments


Heckscher-Ohlin Theorem with a Single Technique continued: Heckscher-Ohlin Theorem with a Single Technique continued In summary, the capital-abundant country exports the capital-intensive commodity, and the labor-abundant country exports the labor-intensive commodity.


Example 1: Factor Endowments and Production-Possibilities: Example 1: Factor Endowments and Production-Possibilities One country Required inputs per unit of output


Example 1: Continued: Example 1: Continued Steel Cloth 200 150 450 600 150 225 Labor constraint Capital Constraint E G M H 0 J V • • • • • • Figure 3


Example 1: Continued: Example 1: Continued Figure 3: Derivation of the production-possibilities frontier. If the economy had an unlimited supply of capital (labor), it would be able to produce along the labor constraint JG (capital constraint MH). When the supplies of both factors are limited, both constraints become binding and the production frontier coincides with the heavy kinked line JEH. Because steel is capital intensive relative to cloth, the capital constraint is steeper than the labor frontier.


Heckscher-Ohlin Theorem with a Single Technique: Heckscher-Ohlin Theorem with a Single Technique Figure 4 Steel Cloth Steel


Heckscher-Ohlin Theorem with a Single Technique: Heckscher-Ohlin Theorem with a Single Technique Figure 4: Production frontiers JQH and J*Q*H* reflect the fact that America is endowed with more capital than Britain, while Britain is endowed with more labor than America. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but shifts consumption to C*. Trade triangles CQV and Q*C*V* are identical. America exports steel, and Britain cloth.


Heckscher-Ohlin Theorem with Many Techniques: Heckscher-Ohlin Theorem with Many Techniques Figure 5 Steel Cloth


Heckcher-Ohlin Theorem with Many Techniques: Heckcher-Ohlin Theorem with Many Techniques Figure 5: Production frontier JH of America (the capital-abundant country) is skewed along the axis for steel (the capital-intensive commodity); and the production frontier J*H* of Britain (the labor-abundant country) is skewed along the axis for cloth (the labor-intensive commodity). Before trade, America produces and consumes at R, and Britain at R*. With free trade, America produces at Q and consumes at C, And Britain at Q* and C*, respectively. Trade triangles CQV and Q*C*V* are identical, America exports steel, and Britain cloth.


Derivation of Offer Curves and the International Equilibrium: Derivation of Offer Curves and the International Equilibrium Figure 6 (a) Figure 6 (b) Food America’s exports of food America’s imports of clothing Clothing


Derivation of Offer Curves and the International Equilibrium continued: Derivation of Offer Curves and the International Equilibrium continued Figure 6: Derivation of America’s offer curve. At the Autarkic relative price of food (p), assumed to be equal to 2, America produces and consumes at E in panel (a), and trades at the origin of panel (b). At p=3, America shifts production to Q and consumption to S in panel (a), and trades at S in panel (b). Similarly, at p=4, America produces at R and consumes at K in panel (a), and trades at K in panel (b). Trade triangles SVQ and KGR are identical to triangles SJO and KLO, respectively. The locus of all trade points (such as S and K) in panel (b) is America’s offer curve.


Derivation of Offer Curves and the International Equilibrium: Derivation of Offer Curves and the International Equilibrium Figure 7 Food America’s exports Britain’s imports Clothing America’s imports Britain’s exports


Derivation of Offer Curves and the International Equilibrium continued: Derivation of Offer Curves and the International Equilibrium continued Figure 7: International equilibrium International equilibrium occurs at K, where the offer curves intersect. America exports OL units of food to Britain and imports OL* units of clothing from Britain. The slope of terms-of-trade line TOT3 gives equilibrium terms of trade OL*/OL.


Slide53: End of Fun! On next lecture: 2. WHY DO WE TRADE? - Part II