chapter 02 foundations of modern trade theory

8/11/2019 Chapter 02 Foundations of Modern Trade Theory

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Foundations of Modern Trade

Theory

Chapter TWO


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Chapters objectives

Why do nations export and import certain

products?

At what terms of trade are products

exchanged in the world market?

What are the gains from international trade?


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History The Mercantilists

1500-1800

Trade balance surplus to accumulate gold and silver

Use of tariffs and quotas

Thought was trade was only good for one side; one countrybenefits at the expense of the other country

Trade is a zero-sum game

The worlds wealth is fixed

David Hume

Price-specie flow mechanism

Permanent trade surplus is unsustainable (because you cant exportif no one wants to import)

There are still neo-mercantilists today!


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Adam Smith: Absolute Advantage

Labor theory of value

Lower L (labor)/Q (output) ratio means lower costs

Higher Q/L ratio (inverse)

Nations specialize A country exports goods in which it has an absolute cost

advantage

A country imports goods in which it has an absolute cost

disadvantage

World output increases when countries specialize

All nations can benefit from trade

Free trade increases competition


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An example of Absolute Advantage

Output per Labor Hour

Nation Wine Cloth

US 5

bottles

20 yards

UK 15

bottles

10 yards

Gains fromspecialization

Wine Cloth

US -5

(i.e., one

worker

moving

to cloth,

only -5

units)

+20

UK +15 -10

Total

gain

+10 +10


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David Ricardo: Comparative Advantage

What happens if a country is more efficient than

its trading partners in the production of all

goods?

The less efficient nation has a comparative

advantage in producing and exporting the good

in which its absolute disadvantage is least

The more efficient nation should specialize in

producing the good where its absolute

advantage is the greatest.


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Ricardian model

Two countries and two goods One input: laborfixed endowment, fully

employed, homogeneous

Labor can move freely between industries but not

between countries Fixed technology; technology is different across

countries (so gives different counties comparativeadvantage) Explains difference in Q/L across countries

TC = w*L (proportional to amount of labor used)

CRS: AC = (w*L)/Q = w/Productivity = constant

Perfect competition: P = MC


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Ricardian model

Free trade: no trade barriers

Transportation costs = 0

Firms maximize profits; consumers maximize satisfaction

No money illusion; only relative prices matter Price of good X, Px= $100 If theres a substitute good, Z, Pz=$1000

You can discern because you have a gauge for comparison;otherwise, you cannot discern whether something is priced highor low

Exports pay for imports and trade is balanced (becausethere is no borrowing)

There is no money; instead barter

No financial markets no savings and no borrowing


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Comparative Advantage

Output per Labor Hour

Nation Wine Cloth

United States 40 bottles 40 yards

United Kingdom 20 bottles 10 yards

US has absolute advantage in producing both goods

US has comparative advantage in producing cloth

because it is 4 times more efficient than UK

UK has comparative advantage in producing wine

because its absolute disadvantage is the smallest


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Wheat Autos Wheat Autos

Q/L OC Q/L OC Gains

US 60 2 120 0.5 -60 +120Canada 160 0.5 80 2 +160 -80

World +100 +40

Another Example:


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Production Possibilities Frontiers

60

120

160

80

Wheat Wheat

Autos Autos

United States Canada

MRT = slope = amount of one product a nation must sacrifice to get one

additional unit of the other product

MRT = Marginal Rate of Transformation = Opportunity cost

Autos

WheatMRT

MRT = 60/120 = 0.5MRT = 160/80 = 2


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Constant Opportunity Costs

Straight line Production Possibilities Frontier(or Schedule)

In US, the relative cost of an auto is 0.5 bushels of

wheat In Canada, the relative cost of an auto is 2 bushels

of wheat

Thus the US has a comparative advantage in

producing autos Under free trade the US will specialize in producing

autos and will export autos

The reverse will be true for Canada


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Production under autarky versus free

trade: Intersection of PPF and DD

60

120

160

80

Wheat Wheat

Autos Autos


MRT = 60/120 = 0.5

MRT = 160/80 = 2DD

DD

A A

DD = Demand Diagonal (what you would demand dependent on your income)

In autarky, the US prefers to produce and consume at point A while Canada

prefers to produce and consume at point A

With free trade the US produces 120 autos and zero wheat at point B, while

Canada produces 160 bushels of wheat and 0 auto at point B

40

40

80

40B

B


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Production gains from specializationBEFORE SPECIALIZATION

AUTOS WHEAT

UNITED STATES 40 40

CANADA 40 80

WORLD 80 120

AFTER SPECIALIZATION

AUTOS WHEAT

UNITED STATES 120 0

CANADA 0 160

WORLD 120 160

NET GAINS 40 40

Those net gains are due to the fact that resources are

used more efficiently; they are called static gains.


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Trading Possibilities Line or terms of

trade Line (tt)

60

120

160

80

Wheat Wheat

Autos Autos


MRT = 60/120 = 0.5

MRT = 160/80 = 2DD

DD

A A40

40

80

40B

B

The slope of the PPF represents the relative prices that two commodities can be

exchanged at home under autarky

The terms of trade (tt) define the relative prices at which two products trade in the

global market place

The tt line is also the Consumption Possibility Schedule (CPS) under free trade

The triangles BCD and BCD are called the trade triangles

C C

60

100

60

D

D

tt=1:1= slopett=1:1= slope


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Consumption gains from trade

BEFORE TRADE

AUTOS WHEAT

UNITED STATES 40 40

CANADA 40 80

WORLD 80 120

AFTER TRADE

AUTOS WHEAT

UNITED STATES 60 60

CANADA 60 100

WORLD 120 160

NET GAINS 40 40


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Distributing the gains from trade

Distribution of the gains depends on the slopeof the tt line.

The slope of the tt line is the world price

The slope of the tt line depends on demand

factors (Reciprocal demand - John Stuart Mill) The domestic cost ratios set the outer limits for

the equilibrium terms of trade; in our example:

0.5 < tt < 2

Such that the tt line (red line) lies outside the PPF(purple line)

Implying that more can be consumed under free trade thanunder no trade


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The importance of being unimportant

Small countries should benefit more from

trade than large countries

The slope of the tt line is close to the MRT of the

large country

Moreover a very large country may have to

continue producing its comparative-disadvantage

good


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Dynamic gains from trade The more efficient use of resources brings

about more output and income More income results in more savings

More savings results in more investment

More investment results in higher productivity and higher

economic growth

Additionally free trade increases the size ofthe market which leads to economies of scale

Moreover free trade increases competitionwhich improves efficiency and innovation

Those dynamic gains could be large but hardto measure


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Changing comparative advantage

100

80

40 160100 150

MRT = 1

MRT = 0.67

MRT = 2

MRT = 0.5

Productivity in the Japanese computer industry grows faster

than it does in the US computer industry. The OC of

producing computers in Japan is now lower than in the US.

US has lost its comparative advantage in computers and

gained comparative advantage in autos while Japan has now a

comparative advantage in producing computers.

Autos Autos

computers

US Japan

computers


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Moving from A to B the OC of producing autos becomes larger in terms of wheat sacrificed.

The MRT of wheat into auto rises from 1 to 4.

This is the case when inputs are imperfect substitutes for each other.

The PPF is concave when viewed from the diagrams origin 21

Production possibilities schedule; increasing-cost conditionsFIGURE 2.4


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Increasing cost Trading case

Production &

consumption

under autarky

Consumption

under free trade

Production

under free trade

TOTWheat

Autos

Autarkyrelative price

United States

DD

Note that specialization

is not complete in this

model.With increasing OC,

comparative product

prices are determined

by both supply anddemand factors.


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Increasing cost trading caseWheat Wheat

Autos Autos

United STates Canada

US

imports

Canada

exports

Canada imports

US exports

TOT lines (parallel)


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The impact of trade on jobs

Trade influences the mix of jobs

Importance of finding a job in an industry in which

country where you live has a comparative

advantage in

Trade has a lesser impact on the overall

number of jobs

chapter 02 foundations of modern trade theory

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