international economics · slope, or marginal rate of transformation, shows the opportunity costof...
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International Economics
Woraphon Yamaka
Chapter 2:Foundations of Modern Trade Theory
Modified form International Economics 9th Edition byRobert J. Carbaugh
Overview
The previous chapter discussed the importance of international trade.
This chapter answers the following questions: (1)What constitutes the basis for trade—that is, why do
nations export and import certain products?
(2) At what terms of trade are products exchanged in the world market?
(3)What are the gains from international trade in terms of production and consumption?
This chapter addresses these questions, first by summarizing the historical development of modern trade theory and next by presenting the contemporary
Carbaugh, Chap. 2
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Historical development of trade theoryMercantilism (During the period 1500–1800)
Regulation to ensure a positive trade balance If a country could achieve a favorable trade balance (a surplus of
exports over imports), it would realize net payments received from the rest of the world in the form of gold and silver.
Such revenues would contribute to increased spending and a rise in domestic output and employment.
Tariffs, quotas, and other commercial policies were proposed by the mercantilists to minimize imports in order to protect a nation’s trade position Critics: 1) It is possible only for short term, this theory will not exist in the
long term. 2) It assumes a static world economy. To the mercantilists, the
world’s wealth was fixed, which is not true. One gain 100% another would loss the same number that is 100%
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Foundations of trade theory
Example: Critics 1
Suppose England achieve a trade surplus that results in an inflow of gold and silver. Because these precious metals constitute part of England’s money supply, their inflow increases the amount of money in circulation.
This increase leads to a rise in England’s price level relative to that of its trading partners. English residents would therefore be encouraged to purchase foreign goods
England’s import increase but exports would decline. As a result, the country’s trade surplus would eventually be eliminated.
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Money supply Domestic Price residents buy foreign goods
import trade surplus
Example: Critics 2
Adam Smith’s The Wealth of Nations (1723–1790) mentioned that the world’s wealth is not a fixed quantity.
International trade permits nations to take advantage of specialization and the division of labor, which increase the general level of productivity within a country and thus increase world output (wealth).
(Absolute Advantage and Comparative advantage) Smith suggested that the world ‘s wealth is dynamic
view Both trading partners could simultaneously enjoy
higher levels of production and consumption with trade. ( Both can gain form trade)
Carbaugh, Chap. 2
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Carbaugh, Chap. 2
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Source: EHES WORKING PAPERS IN ECONOMIC HISTORY|NO. 93
What happens here?
Historical development of trade theory
Absolute advantage (Adam Smith)Countries benefit from exporting what they make
cheaper than anyone elseBut: nations without absolute advantage do not
gain from tradeComparative advantage (David Ricardo)
Nations can gain from specialization, even if they lack an absolute advantage
Carbaugh, Chap. 2
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Foundations of trade theory
Example8
Comparative advantage
Absolute advantageOutput per labor hour
Nation Wine Cloth
United States 5 bottles 20 yards US absolute advantage clothUnited Kingdom 15 bottles 10 yards UK absolute advantage Wine
Comparative advantageOutput per labor hour
Nation Wine Cloth MRT Wine MRT cloth
United States 40 bottles 40 yards 40/40 yards 40/40 bottlesUnited Kingdom 20 bottles 10 yards 10/20 yards 20/10 bottles
US absolute advantage on Cloth and Wine But: MRT Wine (US) > MRT Wine(UK)
Thus UK comparative advantage on Wine
Ricardo’s Comparative Advantage in money prices
Carbaugh, Chap. 2
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Comparative advantage
Cloth (yards) Wine (bottles)Nation Labor Wage Quant. Price Quant. Price
US 1 hr $20/hr 40 $0.50 40 $0.50UK 1 hr £5/hr 10 £0.50 20 £0.25UK 1 hr $8 10 $0.80 20 $0.40
*** (Suppose that $1.6 = £1 thus £5 $8 )
US is better in producing Cloth
UK is better in producing Wine
Production possibilities schedule (Extension of Ricardo theory) Ricardo’s law of comparative advantage suggested
that specialization and trade can lead to gains for both nations. His theory, however, depended on the restrictive assumption of the labor theory of value, in which labor was assumed to be the only factor input. However, in practice, labor is only one of several factor inputs. This is not true in the reality
This schedule shows various alternative combinations of two goods that a nation can produce when all of its factor inputs (land, labor, capital, entrepreneurship) are used in their most efficient manner.
The production possibilities schedule thus illustrates the maximum output possibilities of a nation. (Note that we are no longer assuming labor to be the only factor input, as Ricardo did)
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Comparative advantage
PPF
Mountain Bikes
Bee
rAs the economy shifts resources from beer to mountain bikes: PPF becomes
steeper opp. cost of
mountain bikes increases
As you can see the slope lines are not constant along the PPF
Marginal Rate of Transformation12
Comparative advantage
Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another)There are two reasons for constant costs. First, the factors of production are perfect substitutes for each other. Second, all units of a given factor are of the same quality.
Production possibilities schedules: constant opportunity costs
13
Comparative advantage
Which country is the opportunity cost of Autos lower?
Note: constant opportunity costs is the cost of the product that the country given up
Trading under constant opportunity costs
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Comparative advantage
With constant opportunity costs, a nation will specialize in the product of its comparative advantage. The principle of comparative advantage implies that with specialization and free trade, a nation enjoys production gains and consumption gain
Suppose that the terms of trade agreed on is a 1:1 ratio, whereby 1 auto is exchanged for 1 bushel of wheat. Based on these conditions, let line ttrepresent the international terms of trade for both countries. This line is referred to as the trading possibilities line
Production gains from specialization under constant opportunity costs (Example)
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Comparative advantage
Autos Wheat Autos Wheat Autos Wheat
US A 40 40 B120 0 80 -40Canada A’ 40 80 B’ 0 160 -40 80World 80 120 120 160 40 40
Before After Net GainSpecialization Specialization (Loss)
Suppose the world has two courtiers (US and Canada)US is good in producing Autos, but Canada is good at wheat. This example show that when US and Canada specialize inthe product of its comparative advantage.The world’s wealth increase
Consumption gains from trade: constant opportunity costs (Example)
Carbaugh, Chap. 2
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Comparative advantage
Autos Wheat Autos Wheat Autos Wheat
US A 40 40 C 60 60 20 20Canada A’ 40 80 C’ 60 100 20 20World 80 120 120 160 40 40
Before After Net GainTrade Trade (Loss)
Assume that the United States and Canada achieve a terms-of-trade ratio that permits both trading partners to consume at some point outside their respective production possibilities schedules (Figure in slide 13)
Form BC
Carbaugh, Chap. 2
17 Why we choose the new trade at point c ?
Dynamic Gains From Trade18
• The previous analysis of the gains from international trade stressed specialization and reallocation of existing resources—the so-called static gains from specialization.
• However, these gains can be dwarfed by the effect of trade on the country’s growth rate and thus on the volume of additional resources made available to, or utilized by, the trading country. These are known as the dynamic gains from international trade as opposed to the static effects of reallocating a fixed quantity of resources.
Trade can also generate dynamic gains by stimulating economicgrowth. There are many success stories of growth through trade. However, the effect of trade on growth is not the same for all countries. In general, the gains tend to be less for a large country such as the United States than for a small country such as Belgium.
Dynamic Gains From Trade
Carbaugh, Chap. 2
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International trade more efficient use of an economy’s resources, higher output and income more saving more investment higher rate of economic growth
International trade allows small and moderately sized countries to establish and operate many plants of efficient size expand their production and employ more specialized labor and equipment
International trade open trade forces inefficient firms to exit the industry high competion allows more productive firms to grow raise the averageindustry efficiency
Example
Changing comparative advantage under constant opportunity cost (due to productivity)
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Comparative advantage
If productivity in the Japanese computer industry grows faster than it does in the U.S. computer industry, the opportunity cost of each computer produced in the United States increases relative to the opportunity cost of the Japanese. For the United States, comparative advantage shifts from computers to autos.
Suppose that the MRT of automobiles into computers initially equals 1.0 for the US and 2.0 for Japan. The United States thus has a comparative advantage in the production of computers and a comparative disadvantage in auto production. Then both nations experience productivity increases in computers but no productivity change in automobiles.
Shift due to computer productivity change
How US’s computer industry cope with this problem?
Carbaugh, Chap. 2
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• To cope with changing comparative advantages, computer producers are under constant pressure to reinvent themselves
• Intel, Motorola, and Texas Instruments abandoned the dynamic-random-access-memory (DRAM) business and invested more heavily in manufacturing microprocessors and logic products
• A fact of economic life is that no producer can remain the world’s low-cost producer forever. As comparative advantages change, producers need to hone their skills to compete in more profitable areas.
Production possibilities schedule under increasing opportunity cost
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Increasing opportunity costs
Under increasing costs, the slope of the concave production possibilities schedule varies as a nation locates at different points on the schedule. Because the MRT equals the production possibilities schedule’s slope, it will also be different for each point on the schedule.
Carbaugh, Chap. 2
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High skill
High skill
Low skill
High skill
Low skill
low skill
High skill
low skill
Wheat Autos
Trading under increasing costs: US
Carbaugh, Chap. 2
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Increasing opportunity costs
E1A=3W
Trading under increasing costs: Canada
Carbaugh, Chap. 2
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Increasing opportunity costs
1W=0.33A
1W=1A
1W=3A
Production gains from specialization: increasing opportunity costs (Example)
Carbaugh, Chap. 2
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Autos Wheat Autos Wheat Autos Wheat
US A 5 18 B 12 14 7 -4Canada A’ 17 6 B’ 13 13 -4 7World 22 24 25 27 3 3
Before After Net GainSpecialization Specialization (Loss)
Increasing opportunity costs
The process of specialization continues in both nations until the relative cost of autos is identical in both nations and U.S. exports of autos are precisely equal to Canada’s imports of autos. Likewise U.S. import of wheats are precisely equal to Canada’s export of wheats.
Carbaugh, Chap. 2
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High skill
High skill
Low skill
High skill
Low skill
low skill
High skill
low skill
Wheat Autos
Consumption gains from trade: increasing opportunity costs (Example)
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Autos Wheat Autos Wheat Autos Wheat
US A 5 18 C 5 21 0 3Canada A’ 17 6 C’ 20 6 3 0World 22 24 25 27 3 3
Before After Net GainTrade Trade (Loss)
Increasing opportunity costs
Form BCUS : Assume that the United States prefers to consume the same number of autosas it did in the absence of trade. It will export 7 autos for 7 bushels of wheat from point B, achieving a post-trade consumption point at C.
Canada holds constant its consumption of wheat, it will export 7 bushels of wheat for 7 autos form point B’ and achieve a post-trade at C’.