INTERNATIONAL TRADE INTERNATIONAL TRADE THEORYTHEORYECN 430 / ECN 308ECN 430 / ECN 308

Aminur Rahman

Associate Professor of Economics

Independent University, Bangladesh

Absolute Advantage & Comparative Absolute Advantage & Comparative Advantage Advantage

USA: Absolute Advantage in the Production of food UK: Absolute Advantage in the Production of Clothing

Absolute Advantage Absolute Advantage

USA UK

Food 2 1

Clothing 4 6

Comparative Advantage Comparative Advantage

USA UK

Food 4 1

Clothing 8 6

International TradeInternational Trade

Comparative Advantage USA: Wheat Brazil: Coffee

Gains From TradeGains From Trade

INTRODUCTION TO NEOCLASSICAL INTRODUCTION TO NEOCLASSICAL TRADE THEORY (CHAPTER 3)TRADE THEORY (CHAPTER 3)

CH-3 MC P:44

As indicated in panel (a), in autarky the partner country produces and consumes at point e. With trade it now faces the international price ratio (Ps/Py)2, which is flatter than its internal relative prices in autarky. Consequently, production of the relatively more expensive good Y expands and production of good X contracts, until further adjustment is no longer profitable at point e’. Consumers now find good X relatively less expensive and adjust their consumption expenditures by moving from point e to point e’. The opening of trade allows the country to consume outside the PPF on the higher indifference curve W2, thus demonstrating the gains from trade (the difference between W1 and W2). Note that, with trade, both countries face the same set of relative product prices, (Px/Py)2.

OBSERVATION

1. T/T Autarkic prices of two countries2. T/T Sw= Dw in both commodity markets3. Better off Higher indifference curve4. No complete specialization5. Free trade equalizes opportunity

OFFER CURVES Determination of International Equilibrium Offers of a country at Alternative terms of tradeRelative Price of Food = Imports of clothing

Exports of foodsA: Gains from tradeB: Derivation of Demand Curve: AC: Derivation of Demand Curve: BD: International equilibrium Equilibrium terms of trade

TOT₂ USA offer is smaller than Britain’s offer (Ux) (USA not willing Fx) excess demand for food

PF ↑: Excess Sc Pc ↓ Relative Price of Food ↑ => K

INTERNATIONAL EQUILIBRIUM

THE HECKSHER-OHLIN MODEL (FACTOR ENDOWMENTS THEORY)

Two Premises:1. Commodities differ in their factor

endowments2. Countries differ in their factor endowments

Hecksher-Ohlin: A country has a comparative advantage in those commodities that

use its abundant factors intensively.

Major ingredients: Factors intensity and factor abundance

BASIC ASSUMPTIONS

1. Two countries, Two commodities with homogenous factors of production ( Labor and capital)

2. Technology: Same3. Constant Returns to Scale4. Strong Factor Intensity: Labor of Capital Intensives5. Incomplete specialization6. Perfect competition: Law of One Price7. Factor mobility: Perfectly mobile within countries,

immobile between countries8. Similarity of tastes: Similar but not Identical ( Same

Social Indifference Curve)9. Free Trade10. Transportation Costs: Zero

FACTOR INTENSITYFIXED COEFFICIENT OF PRODUCTIONLabor Ratio and Capital RatioCloth needs 6 labor and 2 capital and Steel nees 8 labor and 4

capitalCloth is labor intensive relative to steel as cloth needs more unit

of labor than the production of steel.Labor- Capital Ratio is higher in Cloth Production (6/2 > 8/4).Steel is Capital Intensive as Capital-Labor ratio is (4/8 > 2/6)

Optimal techniques

S

E

E’3

6

S

3 6

W/R²

2 W/R 3/4

Capital

L/K = 0.5_______________1. Physical and economic abundance

FACTOR PRICE EQUILIBRIUM THEOREM

Free trade equalizes factor rewards ( real rental) between countries and thus serves as a substitute for external factor mobility

Stopler Samuelson Theorem: An increase in the relative price of a commodity raises in terms of both commodities the real rewards of factor used intensively in production of the commodity and reduces, in terms of both commodities, the real reward of the other factor

Relative price of cloth ↑ W/P↑ in terms of cloth and steel and lowers (W/P) real rental rate of capital => C/S

THE RYBCZYNSKI THEOREMWhen the coefficients of production are given and factor supplies arefully employed, an expansion in the endowments of one factor of productionraises the output of the commodity that uses the expanded factor

intensivelyand reduces the output of the other commodity.

Cloth

Capital

J

VH G

Labour

M

Steel

∆ Ls↑Cloth production ↑Steel ↓ => capital released to match with expanded cloth production

Once constraints become binding JEH is the PPF

STOPLER- SAMUELSON THEOREM

Q ‘

GMCloth

Steel

Production at Qx with tariff

RICARDO: Free Trade Benefits all S-s- Protection hurts everyone ↓Disagreed “Cheap Labor” (Foreign) for protection

Labor CapitalTechnology: Cloth 4 1

Steel 2 2

Magnification effect: W/P ↑ Rental ↓Relative price of cloth ↑→ ∏↑ => ↓ for steel (Q-Q’)Reorganziation of the structure of Production technology MPLK change Excess demand for labor _ less capital

FACTOR PRICE EQUALIZATION THEOREM

As labor becomes cheaper compared to capital W/R↓→ labor intensive commodities become cheaper relative to the capital intensive commodity

When W↓→ steel → S1 and Cloth C1

Cloth → Cheaper relative to steel as C1 lies on lower isocost less than S1

MS

S1

c1c

Cloth

Steel

N

Unit Cost ( Save 100) of each product

F

M

R

P

BE

A

OD N S

W

W/R

America

PC/PS

Autarky priceUSA: OSBRITAIN: ODON= Common Commodity Price Ratio

ALTERNATIVE TRADE THEORIES AND EMPIRICAL TESTING MAC Dougall- Balassa- Steru 1937 → Wage in the USA twice as high as UK

OUTPUT PER WORKER MORE THAN TWICE → US MONEY COST LOWER COST ADVANTAGE FOR US OVER UK.

TWICE => NO COST ADVANTAGE Less than twice: UK AOUT

TESTING OF HYPOTHESIS: EXPORT RATIO: US ex to UK ex PRODUCTIVITY RATIO: output per US worker to UK worker WHEN PRODUCTIVITY RATIO WAS HIGHER THAN 2, then US had a larger

share of EXPORT market and when lower UK had this.

THE LEONTIEF PRADOX

IMPORT COMPETING PRODUCTION REQUIRED 30% MORE CAPITAL PER WORKER THAN US EXPORT PRODUCTION

- JUST OPPOSITE OF HECKSCHER-OHLIN THEOREMEXPLANATION OF PARADOX1. FACTOR INTENSITY REVERSALS SEPARATE US FROM REST

OF THE WORLD- INVALIDATE H-O THEOREM2. BY PROTECTING US INDUSTRIES THAT ARE RELATIVELY

INTENSIVE IN UNSKILLED LABOR- US TARIFF AND NON-TARIFF BARRIER TO INTERNATIONAL TRADE EXCLUDE LABOR INTENSIVE IMPORTS

3. SCARCITY OF NATURAL RESOURCES IN USA -> IMPORT CAPITAL INTENSIVE PRODUCT

4. US EXPORT INDUSTRY USES SKILLED LABOR5. CONSUMPTION BIAS towards capital intensive good- But on the contrary it is toward labor intensive goods

SPECIFIC FACTOR MODEL

→ COMPARATIVE ADVANTAGE → Relative abundance of ‘specific factor’

SPECIFIC FACTOR USE ↑→ P↑→ Better off and other factor worse off

→ Specific factor ↑ ( Small economy) OUTPUT↑ OUTPUT OF OTHER COMMODITY ↓

→ Mobile factor ↑ output of both commodity ↑ Mobile factor worse off → specific factor better off

B

A

NI

J*

J

OH* H

Corn

Steel

LINDER’S THESISCOUNTRY EXPORTS THOSE MANUFACTURED GOODS FOR WHICH THERE IS BROAD

LOCAL MARKET→ NO BIG SUPPORTTechnological GAP THEORY is BASED ON THE SEQUENCE OF INNOVATION AND

IMITATION. USA → ADVANTAGE IN R&D→ Export Technologically Advanced Product

A

2

B

T

S

R

U

1 3

Auto

PlantN V

DECREASING OPPORTUNITY COSTS- ALL GAINS : EU CASE

E= Before trade production point for US vs UK at UVAfter tradeUSA = V and Consumes A, UK → U and B

Both gain even though no differenceGF T/T

GROWTH AND TRADE

CAPITAL ACCUMULATION:

CAPITAL DEEPENING(CAPITAL STOCK ↑ POPULATION↑ HIGHER Y↑ AND STANDARD OF LIVING→ ENDOGENOUSI – S CAPITAL STOCK

TECHNICAL PROGRESSCLASSIFICATION --? NEUTRAL (NT)

LABOR SAVING (LS)HICKSIAN DEFINITION CAPITAL SAVING (CS)

LS:

ba

A

aC

Ba

LO

K b

b

a

MA

b

a

K

LOOB TO OA

•Labor is saved per unit of capital employed• At W – R ratio shown by the slope of bb at B K-L ratio > at OA then OB

U¹

U

EE¹

V V¹STEEL

CLOTH

UE

E¹

V V¹

Labor growth worse off

STEEL

CLOTH

BALANCED GROWTH NEUTRAL PRODUCTION EFFECT. WELFARE CONSTANT

E¹

E

U

U¹

V V¹O

Capital Growth

BETTER OFF

STEEL

CLOTH

Labor Supply Labor Intensive good ↑Less capital to work with Negative

Effects on Small Country

E

E¹

CLOTH

STEEL

E

E¹

CLOTH

WORSE OFFSTEEL

E

E¹

CLOTH

STEELBETTER OFF

THE THEORY OF TARIFFTYPES: IMPORT DUTY, EXPORT DUTY, AD VALOREM, SPECIFIC, COMPOUND

1. Consumption effect: GC2. Production effect: KH

( Protective effect)3. Trade effect: JF4. Revenue effect: JHGF5. Redistribution effect

Consumer surplus ↓( Area 1,2,3 and 4)Area 1 -> ProducerArea 2 and 4: dead weight loss

GENERAL EQUILIBRIUM ANALYSISEFFECT ON DOMESTIC PRICEEFFECT ON PRODUCTIONEFFECT ON VALUE OF PRODUCTION AND WELFAREEFFECT ON CONSUMPTION

DISTRIBUTION OF INCOME : TARIFF REVENUE VOLUME OF

TRADE

EFFECT ON LARGE COUNTRY

TERMS OF TRADE EFFECTEFFECTS OF TARIFF ON DOMESTIC PRICESMETZLER’S PARADOXTARIFF AND WELFARETARIFF WORLD OUTPUT↓SUBOPTIMAL ALLOCATION OF COMMODITIES

AMONG CONSUMERS

• TARIFF IMPROVES LARGE COUNTRY TERMS OF TRADE• SMALL COUNTRY TARIFF VOLUME OF TRADE ↓ ( POINT D)• MONOPOLY- MONOPOLY POWER• USA DESIRED VOLUME OF TRADE CONTRACTS ( OEo OD)• SUPPLY↓ BY S1So

• DEMAND FOR CLOTH ↓ C1Co• STEEL MARKET – MONOPOLIST• CLOTH MARKET- MONOPSONIST• RESTRICTS SUPPLY TO RAISE PRICE• RESTRICTS DEMAND TO BUY IT AT

LOWER PRICE• RELATIVE PRICE OF STEEL ↑• TOT ↑

TARIFF AND WORLD WELFARE

TARIFF INTERFERES WITH THE MAXIMIZATION OF WELFARE

(a)TARIFF REDUCES THE WORLD OUTPUT OF COMMODITIES BY REVERSING THE PROCESS OF INTERNATIONAL DIVISION OF LABOR, WHICH IS DICTATED BT THE “ LAW OF COMPARATIVE ADVANTAGE” MRTA ≠ MRTB

(b) THE TARIFF FORCES A SUBOPTIMAL ALLOCATION OF COMMODITIES AMONG THE CONSUMERS

Commodity price equation FREE TRADE MRSA ≠ MRSB

TARIFF MRSA ≠ MRSB AS PRICE DIVERGENCE OCCURS

TARIFF AND DOMESTIC PRICE

LARGE COUNTRY: TARIFF MAKES IMPORTED COMMODITY RELATIVELY CHEAPER IN THE REST OF THE WORLD

PARADOX? METZLERTARIFF CAUSES “the price of the imported

commodities to fall more than the tariff”WHY? (a) the foreign demand for imports is

inelastic (b) the tariff levying country’s MPI is

very low the protection provided to the import competing industries is negative

EFFECTIVE RATE OF PROTECTION

ERP = V¹-V V

V¹ Value added at domestic pricesV Value added at world prices

Stopler- Samuelson theoremAM ↑↓ relative price of a commodity ↑ or ↓ of

factor used intensively in its production

ARGUMENT FOR PROTECTIONOPTIMAL TARIFF

TWO CONFLICTING EFFECTS ON WELFARE:i)IMPROVE TERMS OF TRADEii)VOLUME OF TRADE FALLS WELFARE ↓

Max Welfare Marginal T/T benefits = Marginal Volume of trade cost

•Monopoly – Monopsony PowerBrazil : Coffee Japan: Auto

•Average and Marginal T/TVolume of trade Max Welfare

MTT = Opp. Cost Domestic of exportable

ECONOMIC ARGUMENT FOR TARIFF

• TARIFF FOR REVENUE PROTECTION• CHEAP FOREIGN LABOR• TARIFF TO MAINTAIN EMPLOYMENT• INDUSTRIAL POLICY

NON-ECONOMIC ARGUMENTPolitical, cultural, and sociological goals

FOUR SPECIFIC OBJECTIVES1. A CERTAIN LEVEL OF PRODUCTION ( MILITARY)2. A CERTAIN LEVEL OF CONSUMPTION ( RESTRICTION

OF LUXURY GOODS)3. “SELF- SUFFICIENCY”4. “EMPLOYMENT OF A FACTOR OF PRODUCTION

(LABOR)

CPT:9 INSTRUMENTS OF COMERCIAL POLICYEXPORT TAXESEFFECTS OF EXPORT TAXES(GRAPHICAL PRESENTATION)

90 300 700 1150

s D₁

A

B C4 53

21

s¹D

60

3520

F H M G

T (DOMESTIC PRICE)

WORLD PRICE

PRICE

RICE

•AT WORLD PRICE 60 = DOMESTIC PRODUCTION 115090 CONSUMED (F)1060 EXPORT (FG)EXPORT TAX 25↓ P → 35DOMESTIC PRODUCTION ↓ 700 (C)DOMESTIC CONSUMPTION ↑ 300(B) EXPORT FALLS – 400 (BC)PRODUCTION SURPLUS ↓ 1 – 5AREA 4 TAX REVENUE1+2 = CONSUMER SURPLUS3= OVER CONSUMPTION5= UNDER PRODUCTION

II EXPORT SUBSIDY: NEGATIVE EXPORT TAXQUANTITATIVE RESTRICTIONSRESTRICTION OF PHYSICAL VOLUME OF EITHER

EXPORT OR IMPORT OPEN QUOTA OR IMPORT LICENSESSpecific amount from any where abnormal profit

PDOM ↑

IMPORTERS AT COMPETITIVE PRICES?K Free TradeSupply of Export

Import tax or quota equivalence

Q

GF

HE

S¹

JSO

40 50

D

1560130012001000

D¹ IMPORT DEMAND

Price

Quantity/ import

QUOTA PD ↑ (13) (F) Lower PF (H)A 30% IMPORT TAX --JK

III DIFFERENCE BETWEEN QUOTAS AND IMPORT TAXRevenue Effect, Certainty

QUOTA- LICENCE FEE CERTAIN UNCERTAINTIES

IMPORT TAX: REVENUE

EXPORT QUOTA : F. PRICE ↑ PD ↓

VOLUNTARY EXPORT RESTRICTIONS

Voluntary cut of export otherwise import tax by IMPORTER

INTERNATIONAL CARTELS

G

E

F

G₁ Q

G

S¹D

P₂

P₁

P

DUMPING: PERSISTENT- PREDATORY- SPORADIC- GATT

∏ MAX => CARTEL

CUSTOM UNION

Approaches of International Trade Liberalization• International Approach• Regional Approach

-Preferential Trading Club-Free Trade Area-Customs Union- Common Market- Economic Union

Reduce Tariff but keep original tariff with rest of the world

Abolish tariff but keep original tariff with rest of the world

Abolish Tariff but Common Tariff with rest of the world

COMMON MARKET

CUSTOM UNION + FREE MOVEMENTS OF ALL FACTOR OF PRODUCTIONS

ECONOMIC UNIONCOMMON MARKET + UNIFICATION OF DEMANDMANAGEMENT POLICY + MONETARY UNION SINGLE CURRENCY

TRADE CREATION

IMPROVES THE INTERNATIONAL MOVEMENT OF RESOURCES BY SHIFTING THE NATIONAL FOCUS OF PRODUCTION FROM HIGH COST TO LOW COST PRODUCER WELFARE ↑

TRADE DIVERSION

DIVERSION OF TRADE FROM CHEAP PRODUCER TO HIGH PRICE PRODUCER WELFARE ↓ INCREASING COST