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M.A. FINAL ECONOMICS
PAPER II
INTERNATIONAL TRADE AND
FINANCE
WRITTEN BY
SEHBA HUSSAIN
EDITED BY
PROF.SHAKOOR KHAN
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M.A. FINAL ECONOMICS
PAPER II
INTERNATIONAL TRADE AND
FINANCE
BLOCK 1
THEORY OF INTERNATIONAL TRADE,
MEASUREMENT OF GAINS AND THEORY
OF INTERVENTION
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PAPER II
INTERNATIONAL TRADE AND FINANCE
BLOCK 1
THEORY OF INTERNATIONAL TRADE,
MEASUREMENT OF GAINS AND THEORY OF
INTERVENTION
CONTENTS
Page number
Unit 1 Theory of International trade 5
Unit 2 Measurement of gains from trade 25
Unit 3 Free trade and theories of intervention 41
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BLOCK 1 THEORY OF INTERNATIONAL TRADE,
MEASUREMENT OF GAINS AND THEORY OF
INTERVENTION
The aim of this block is to present certain theories and approaches related to theory of
international trade, measurement of gains and theory of intervention.
First unit deals with explaining the varieties of theories of international trade. Second
area of concern will be Ricardian model and theories of absolute advantage followed by
Heckscher Ohlin model. New trade theory and gravity model are explained in detailed
manner. Regulation of international trade and empirical testing of theory of absolute cost
were discussed in detail.
Unit 2 discusses concepts related to gains from trade. Measurement and distribution of
gains from trade and terms of trade will be explained in detail. Role of trade in
accelerating growth of nation is discussed in last section along with suitable examples.
The last unit that is unit 3 presents to you the basic and important concepts of free trade
and theories of intervention. Features of free trade are discussed in continuation with the
history of free trade. Economics of free trade and the basics of tariffs and trade barriers
will be other areas of discussion. Welfare implications of trade barriers; impact of tariffs
on prices and tariffs and their relevance in modern trade will be described in detailed
manner.
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UNIT 1
THEORY OF INTERNATIONAL TRADE
Objectives
After studying this unit you should be able to:
Define the theories of International trade
Understand the Ricardian model and concept of absolute and comparative advantage
Know the Heckscher and Ohlin model of trade
Explain new trade theory and gravity model of international trade
Describe regulations of international trade
Discuss the empirical testing of theory of absolute cost
Structure
1.1 Introduction
1.2 Varieties of theories of international trade
1.3 Ricardian model and theories of absolute advantage
1.4 Heckscher Ohlin model
1.5 New trade theory
1.6 Gravity model
1.7 Regulation of international trade
1.8 Empirical testing of theory of absolute cost
1.9 Summary
1.10 Further readings
1.1 INTRODUCTION
International trade is exchange of capital, goods, and services across international borders
or territories. It refers to exports of goods and services by a firm to a foreign-based buyer
(importer) in most countries; it represents a significant share of gross domestic product
(GDP). While international trade has been present throughout much of history (see Silk
Road, Amber Road), its economic, social, and political importance has been on the rise
in recent centuries.
Industrialization, advanced transportation, globalization, multinational corporations, and
outsourcing are all having a major impact on the international trade system. Increasing
international trade is crucial to the continuance of globalization. International trade is a
major source of economic revenue for any nation that is considered a world power.
Without international trade, nations would be limited to the goods and services produced
within their own borders.
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International trade is in principle not different from domestic trade as the motivation and
the behavior of parties involved in a trade do not change fundamentally regardless of
whether trade is across a border or not. The main difference is that international trade is
typically more costly than domestic trade. The reason is that a border typically imposes
additional costs such as tariffs, time costs due to border delays and costs associated with
country differences such as language, the legal system or culture.
Another difference between domestic and international trade is that factors of production
such as capital and labor are typically more mobile within a country than across
countries. Thus international trade is mostly restricted to trade in goods and services, and
only to a lesser extent to trade in capital, labor or other factors of production. Then trade
in goods and services can serve as a substitute for trade in factors of production. Instead
of importing a factor of production, a country can import goods that make intensive use
of the factor of production and are thus embodying the respective factor. An example is
the import of labor-intensive goods by the United States from China. Instead of importing
Chinese labor the United States is importing goods from China that were produced with
Chinese labor.
International trade is also a branch of economics, which, together with international
finance, forms the larger branch of international economics.
The first purpose of trade theory is to explain observed trade. That is, we would like to
be able to start with information about the characteristics of trading countries, and from
those characteristics deduce what they actually trade, and be right. Thats why we have a
variety of models that postulate different kinds of characteristics as the reasons for trade.
Secondly, it would be nice to know about the effects of trade on the domestic economy.
A third purpose is to evaluate different kinds of policy. Here it is good to remember that
most trade theory is based on neoclassical microeconomics, which assumes a world of
atomistic individual consumers and firms. The consumers pursue happiness
(maximizing utility) and the firms maximize profits, with the usual assumptions of
perfect information, perfect competition, and so on. In this world choice is good, and
restrictions on the choices of consumers or firms always reduce their abilities to
optimize. This is essentially why this theory tends to favor freer trade.
1.2 VARIETIES OF THEORIES OF INTERNATIONAL TRADE
Neoclassical theory has been successful because it is simple (though it may not always
look simple when youre learning it). For example most neoclassical trade theories
assume that the world only has two countries (which means that country As exports must
be country Bs imports). They also usually assume only two commodities in
international trade. If you try to generalize by adding more countries or commodities,
the math breaks down and you dont get clear results.
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One of the most important, and limiting, assumptions in neoclassical trade theory is that
firms produce under conditions of perfect competition. Any industry that is controlled by
a small number of firms is not perfectly competitive. There is a whole area of economics,
initially developed by Joan Robinson in the 1920's, that explores what happens under
imperfect competition. We wont get into it in this course, but if there are significant
economies of scale (which means that per-unit costs are smaller for bigger firms), then
you can get very different policy recommendations out of your model.
Does this mean that the simple neoclassical models are useless? No. Their most
important use is as a way to help you think through a set of issues. Neoclassical theory is
especially good at pointing out the links between different markets. But you should be
suspicious if you hear anyone saying that a theory shows that one policy or another is
the right one in the real world.
The most famous neoclassical model is also the simplest the model developed by the
English political economist David Ricardo in the early 1800s. Its simple because
Ricardo assumes that there is only one factor of production (i.e. type of input)
labor. This model makes the point that trade should, in principle; benefit both parties
even if one is more efficient. More sophisticated models were developed in the current
century as economists learned more maths. The best-known is the Heckscher-Ohlin
model, named after a couple of Swedish economists, which is often called Heckscher-
Ohlin-Samuelson (HOS) because of the important contributions made by the U.S.
economist Paul Samuelson. HOS includes two factors of production (e.g. labor and
land), and it shows that particular factors of production may be hurt by trade, though it
still agrees with Ricardo that there are overall gains from trade.
There are many other varieties of trade theory, making different assumptions and getting
different results. One kind that has gotten a lot of attention in recent years assumes
increasing returns to scale, which means that large producers are more efficient than
smaller producers. Ricardo, as noted above, assumed constant scale returns.
Neoclassical theories like HOS assume decreasing returns and get generally similar
results. If you allow increasing returns then bigger is better, and one nation may end up
dominating an industry, but it's hard to say which nation will do so. In this case, the
ability to intimidate and bluff may be important. So increasing returns undermines the
ability of theory to explain or predict observed trade. Perhaps more seriously, scale
economies may stack the deck against late-developers.
1.3 RICARDIAN MODEL AND THEORIES OF ABSOLUTE
ADVANTAGE
The Ricardian model focuses on comparative advantage and is perhaps the most
important concept in international trade theory. In a Ricardian model, countries specialize
in producing what they produce best. Unlike other models, the Ricardian framework
predicts that countries will fully specialize instead of producing a broad array of goods.
http://en.wikipedia.org/wiki/Comparative_advantage
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Also, the Ricardian model does not directly consider factor endowments, such as the
relative amounts of labor and capital within a country. The main merit of Ricardin model
is that it assumes technology differences between countries. Technology gap is easily
included in the Ricardian and Ricardo-Sraffa model (See the next subsection).
The Ricardian model makes the following assumptions:
1. Labor is the only primary input to production (labor is considered to be the ultimate source of value).
2. Constant Marginal Product of Labor (MPL) (Labor productivity is constant, constant returns to scale, and simple technology.)
3. Limited amount of labor in the economy 4. Labor is perfectly mobile among sectors but not internationally. 5. Perfect competition (price-takers).
The Ricardian model measures in the short-run, therefore technology differs
internationally. This supports the fact that countries follow their comparative advantage
and allows for specialization.
In economics, the law of comparative advantage refers to the ability of a party (an
individual, a firm, or a country) to produce a particular good or service at a lower
opportunity cost than another party. It is the ability to produce a product most efficiently
given all the other products that could be produced. It can be contrasted with absolute
advantage which refers to the ability of a party to produce a particular good at a lower
absolute cost than another.
Comparative advantage explains how trade can create value for both parties even when
one can produce all goods with fewer resources than the other. The net benefits of such
an outcome are called gains from trade. It is the main concept of the pure theory of
international trade.
1.3.1 Origins of the theory
Comparative advantage was first described by Robert Torrens in 1815 in an essay on the
Corn Laws. He concluded it was to England's advantage to trade with Portugal in return
for grain, even though it might be possible to produce that grain more cheaply in England
than Portugal.
However the term is usually attributed to David Ricardo who explained it in his 1817
book On the Principles of Political Economy and Taxation in an example involving
England and Portugal. In Portugal it is possible to produce both wine and cloth with less
labor than it would take to produce the same quantities in England. However the relative
costs of producing those two goods are different in the two countries. In England it is
very hard to produce wine, and only moderately difficult to produce cloth. In Portugal
both are easy to produce.
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Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still
for Portugal to produce excess wine, and trade that for English cloth. Conversely England
benefits from this trade because its cost for producing cloth has not changed but it can
now get wine at a lower price, closer to the cost of cloth. The conclusion drawn is that
each country can gain by specializing in the good where it has comparative advantage,
and trading that good for the other.
Examples
The following hypothetical examples explain the reasoning behind the theory. In
Example 2 all assumptions are italicized for easy reference, and some are explained at the
end of the example.
Example 1
Two men live alone on an isolated island. To survive they must undertake a few basic
economic activities like water carrying, fishing, cooking and shelter construction and
maintenance. The first man is young, strong, and educated. He is also, faster, better, more
productive at everything. He has an absolute advantage in all activities. The second man
is old, weak, and uneducated. He has an absolute disadvantage in all economic activities.
In some activities the difference between the two is great; in others it is small.
Despite the fact that the younger man has absolute advantage in all activities, it is not in
the interest of either of them to work in isolation since they both can benefit from
specialization and exchange. If the two men divide the work according to comparative
advantage then the young man will specialize in tasks at which he is most productive,
while the older man will concentrate on tasks where his productivity is only a little less
than that of the young man. Such an arrangement will increase total production for a
given amount of labor supplied by both men and it will benefit both of them.
Example 2
Suppose there are two countries of equal size, Northland and Southland, that both
produce and consume two goods, Food and Clothes. The productive capacities and
efficiencies of the countries are such that if both countries devoted all their resources to
Food production, output would be as follows:
Northland: 100 tonnes
Southland: 400 tonnes
If all the resources of the countries were allocated to the production of Clothes, output
would be:
Northland: 100 tonnes
Southland: 200 tonnes
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Assuming each has constant opportunity costs of production between the two products
and both economies have full employment at all times. All factors of production are
mobile within the countries between clothing and food industries, but are immobile
between the countries. The price mechanism must be working to provide perfect
competition.
Southland has an absolute advantage over Northland in the production of Food and
Clothing. There seems to be no mutual benefit in trade between the economies, as
Southland is more efficient at producing both products. The opportunity costs shows
otherwise. Northland's opportunity cost of producing one tonne of Food is one tonne of
Clothes and vice versa. Southland's opportunity cost of one tonne of Food is 0.5 tonne of
Clothes. The opportunity cost of one tonne of Clothes is 2 tonnes of Food. Southland has
a comparative advantage in food production, because of its lower opportunity cost of
production with respect to Northland. Northland has a comparative advantage over
Southland in the production of clothes, the opportunity cost of which is higher in
Southland with respect to Food than in Northland.
To show these different opportunity costs lead to mutual benefit if the countries
specialize production and trade, consider the countries produce and consume only
domestically. The volumes are:
Production and consumption
before trade
Food Clothes
Northland 50 50
Southland 200 100
TOTAL 250 150
This example includes no formulation of the preferences of consumers in the two
economies which would allow the determination of the international exchange rate of
Clothes and Food.
Given the production capabilities of each country, in order for trade to be worthwhile
Northland requires a price of at least one tonne of Food in exchange for one tonne of
Clothes; and Southland requires at least one tonne of Clothes for two tonnes of Food. The
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exchange price will be somewhere between the two. The remainder of the example works
with an international trading price of one tonne of Food for 2/3 tonne of Clothes.
If both specialize in the goods in which they have comparative advantage, their outputs
will be:
Production after trade
Food Clothes
Northland 0 100
Southland 300 50
TOTAL 300 150
World production of food increased. Clothing production remained the same. Using the
exchange rate of one tonne of Food for 2/3 tonne of Clothes, Northland and Southland are
able to trade to yield the following level of consumption:
Consumption after trade
Food Clothes
Northland 75 50
Southland 225 100
World total 300 150
Northland traded 50 tonnes of Clothing for 75 tonnes of Food. Both benefited, and now
consume at points outside their production possibility frontiers.
http://en.wikipedia.org/wiki/Production_possibility_frontier
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Assumptions in Example 2
Two countries, two goods - the theory is no different for larger numbers of
countries and goods, but the principles are clearer and the argument easier to
follow in this simpler case.
Equal size economies - again, this is a simplification to produce a clearer
example.
Full employment - if one or other of the economies has less than full
employment of factors of production, then this excess capacity must usually be
used up before the comparative advantage reasoning can be applied.
Constant opportunity costs - a more realistic treatment of opportunity costs the
reasoning is broadly the same, but specialization of production can only be taken
to the point at which the opportunity costs in the two countries become equal.
This does not invalidate the principles of comparative advantage, but it does limit
the magnitude of the benefit.
Perfect mobility of factors of production within countries - this is necessary to
allow production to be switched without cost. In real economies this cost will be
incurred: capital will be tied up in plant (sewing machines are not sowing
machines) and labour will need to be retrained and relocated. This is why it is
sometimes argued that 'nascent industries' should be protected from fully
liberalised international trade during the period in which a high cost of entry into
the market (capital equipment, training) is being paid for.
Immobility of factors of production between countries - why are there
different rates of productivity? The modern version of comparative advantage
(developed in the early twentieth century by the Swedish economists Eli
Heckscher and Bertil Ohlin) attributes these differences to differences in nations'
factor endowments. A nation will have comparative advantage in producing the
good that uses intensively the factor it produces abundantly. For example:
suppose the US has a relative abundance of capital and India has a relative
abundance of labor. Suppose further that cars are capital intensive to produce,
while cloth is labor intensive. Then the US will have a comparative advantage in
making cars, and India will have a comparative advantage in making cloth. If
there is international factor mobility this can change nations' relative factor
abundance. The principle of comparative advantage still applies, but who has the
advantage in what can change.
Negligible Transport Cost - Cost is not a cause of concern when countries
decided to trade. It is ignored and not factored in.
Assume that half the resources are used to produce each good in each
country. This takes place before specialization.
Perfect competition - this is a standard assumption that allows perfectly efficient
allocation of productive resources in an idealized free market.
Example 3
The economist Paul Samuelson provided another well known example in his Economics.
Suppose that in a particular city the best lawyer happens also to be the best secretary, that
http://en.wikipedia.org/wiki/Paul_Samuelsonhttp://en.wikipedia.org/wiki/Economics_(textbook)
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is he would be the most productive lawyer and he would also be the best secretary in
town. However, if this lawyer focused on the task of being an attorney and, instead of
pursuing both occupations at once, employed a secretary, both the output of the lawyer
and the secretary would increase.
1.3.2 Effects on the economy
Conditions that maximize comparative advantage do not automatically resolve trade
deficits. In fact, in many real world examples where comparative advantage is attainable
may in fact require a trade deficit. For example, the amount of goods produced can be
maximized, yet it may involve a net transfer of wealth from one country to the other,
often because economic agents have widely different rates of saving.
As the markets change over time, the ratio of goods produced by one country versus
another variously changes while maintaining the benefits of comparative advantage. This
can cause national currencies to accumulate into bank deposits in foreign countries where
a separate currency is used.
Macroeconomic monetary policy is often adapted to address the depletion of a nation's
currency from domestic hands by the issuance of more money, leading to a wide range of
historical successes and failures.
1.3.3 Criticism
Development economics
The theory of comparative advantage, and the corollary that nations should specialize, is
criticized on pragmatic grounds within the import substitution industrialization theory of
development economics, on empirical grounds by the SingerPrebisch thesis which states
that terms of trade between primary producers and manufactured goods deteriorate over
time, and on theoretical grounds of infant industry and Keynesian economics. In older
economic terms, comparative advantage has been opposed by mercantilism and economic
nationalism. These argue instead that while a country may initially be comparatively
disadvantaged in a given industry (such as Japanese cars in the 1950s), countries should
shelter and invest in industries until they become globally competitive. Further, they
argue that comparative advantage, as stated, is a static theory it does not account for the
possibility of advantage changing through investment or economic development, and thus
does not provide guidance for long-term economic development.
Free mobility of capital in a globalized world
Ricardo explicitly bases his argument on an assumed immobility of capital:
" ... if capital freely flowed towards those countries where it could be most
profitably employed, there could be no difference in the rate of profit, and no
other difference in the real or labour price of commodities, than the additional
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quantity of labour required to convey them to the various markets where they
were to be sold."
He explains why from his point of view (anno 1817) this is a reasonable assumption:
"Experience, however, shows, that the fancied or real insecurity of capital, when not
under the immediate control of its owner, together with the natural disinclination which
every man has to quit the country of his birth and connexions, and entrust himself with all
his habits fixed, to a strange government and new laws, checks the emigration of capital."
Some scholars, notably Herman Daly, an American ecological economist and professor at
the School of Public Policy of University of Maryland, have voiced concern over the
applicability of Ricardo's theory of comparative advantage in light of a perceived increase
in the mobility of capital: "International trade (governed by comparative advantage)
becomes, with the introduction of free capital mobility, interregional trade (governed by
Absolute advantage)."
Adam Smith developed the principle of absolute advantage. The economist Paul Craig
Roberts notes that the comparative advantage principles developed by David Ricardo do
not hold where the factors of production are internationally mobile. Limitations to the
theory may exist if there is single kind of utility. The very fact that people want food and
shelter already indicates that multiple utilities are present in human desire. The moment
the model expands from one good to multiple goods, the absolute may turn to a
comparative advantage. However, global labor arbitrage, where one country exploits the
cheap labor of another, would be a case of absolute advantage that is not mutually
beneficial.
Economist Ha-Joon Chang criticized that the comparative advantage principle may have
helped developed countries maintain relative advancedness of technology and industry
over developing countries. In his book Kicking Away the Ladder, Chang argued that all
major developed countries, including the United States and United Kingdom, used
interventionist, protectionist economic policies in order to get rich and then tried to forbid
other countries from doing the same. For example, according to the comparative
advantage principle, developing countries with a comparative advantage in agriculture
should continue to specialize in agriculture and import high-technology widgits from
developed countries with a comparative advantage in high technology. In the long run,
developing countries would lag behind developed countries, and polarization of wealth
would set in. Chang asserts that premature free trade has been one of the fundamental
obstacles to poverty alleviation in many developing world. Recently, Asian countries
such as South Korea, Japan and China have utilized protectionist economic policies in
their economic development.
1.3.4 Modern development of the Ricardian model
The Ricardian trade model was studied by Graham, Jones, McKenzie and others. All the
theories excluded intermediate goods, or traded input goods such as materials and capital
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goods. McKenzie(1954), Jones(1961) and Samuelson(2001)emphasized that considerable
gains from trade would be lost once intermediate goods were excluded from trade. In a
famous comment McKenzie (1954, p.179) pointed that "A moment's consideration will
convince one that Lancashire would be unlikely to produce cotton cloth if the cotton had
to be grown in England."
Recently, the theory was extended to the case that includes traded intermediates. Thus the
"labor only" assumption (#1 above) was removed from the theory. Thus the new
Ricardian theory, or the Ricardo-Sraffa model, as it is sometimes named, theoretically
includes capital goods such as machines and materials, which are traded across countries.
In the time of global trade, this assumption is much more realistic than the Heckscher-
Ohlin model, which assumes that capital is fixed inside the country and does not move
internationally.
1.4 HECKSCHER-OHLIN MODEL
In the early 1900s an international trade theory called factor proportions theory emerged
by two Swedish economists, Eli Heckscher and Bertil Ohlin. This theory is also called the
Heckscher-Ohlin theory. The Heckscher-Ohlin theory stresses that countries should
produce and export goods that require resources (factors) that are abundant and import
goods that require resources in short supply. This theory differs from the theories of
comparative advantage and absolute advantage since these theory focuses on the
productivity of the production process for a particular good. On the contrary, the
Heckscher-Ohlin theory states that a country should specialise production and export
using the factors that are most abundant, and thus the cheapest. Not to produce, as earlier
theories stated, the goods it produces most efficiently.
The Heckscher-Ohlin model was produced as an alternative to the Ricardian model of
basic comparative advantage. Despite its greater complexity it did not prove much more
accurate in its predictions. However from a theoretical point of view it did provide an
elegant solution by incorporating the neoclassical price mechanism into international
trade theory.
The theory argues that the pattern of international trade is determined by differences in
factor endowments. It predicts that countries will export those goods that make intensive
use of locally abundant factors and will import goods that make intensive use of factors
that are locally scarce. Empirical problems with the H-O model, known as the Leontief
paradox, were exposed in empirical tests by Wassily Leontief who found that the United
States tended to export labor intensive goods despite having capital abundance.
The H-O model makes the following core assumptions:
1. Labor and capital flow freely between sectors 2. The production of shoes is labor intensive and computers is capital intensive 3. The amount of labor and capital in two countries differ (difference in
endowments)
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4. free trade 5. technology is the same across countries (long-term) 6. Tastes are the same.
The problem with the H-O theory is that it excludes the trade of capital goods (including
materials and fuels). In the H-O theory, labor and capital are fixed entities endowed to
each country. In a modern economy, capital goods are traded internationally. Gains from
trade of intermediate goods are considerable, as it was emphasized by Samuelson (2001).
1.4.1 Reality and Applicability of the Heckscher-Ohlin Model
The Heckscher-Ohlin theory is preferred to the Ricardo theory by many economists,
because it makes fewer simplifying assumptions. In 1953, Wassily Leontief published a
study, where he tested the validity of the Heckscher-Ohlin theory. The study showed that
the U.S was more abundant in capital compared to other countries; therefore the U.S
would export capital- intensive goods and import labour-intensive goods. Leontief found
out that the U.S's export was less capital intensive than import.
After the appearance of Leontief's paradox, many researchers tried to save the Heckscher-
Ohlin theory, either by new methods of measurement, or either by new interpretations.
Leamer emphasized that Leontief did not interpret HO theory properly and claimed that
with a right interpretation paradox did not occur. Brecher and Choudri found that, if
Leamer was right, the American workers consumption per head should be lower than the
workers world average consumption.
Many other trials followed but most of them failed. Many of famous textbook writers,
including Krugman and Obstfeld and Bowen, Hollander and Viane, are negative about
the validity of H-O model.. After examining the long history of empirical research,
Bowen, Hollander and Viane concluded: "Recent tests of the factor abundance theory [H-
O theory and its developed form into many-commodity and many-factor case] that
directly examine the H-O-V equations also indicate the rejection of the theory."
Heckscher-Ohlin theory is not well adapted to the analyze South-North trade problems.
The assumptions of HO are less realistic with respect to N-S than N-N (or S-S) trade.
Income differences between North and South is the one that third world cares most. The
factor price equalization [a consequence of HO theory] has not shown much sign of
realization. HO model assumes identical production functions between countries. This is
highly unrealistic. Technological gap between developed and developing countries is the
main concern of the poor countries.
1.4.2 Specific factors model and Factor-Price Equalization
The fourth major theorem that arises out of the Heckscher-Ohlin model is called the
factor-price equalization theorem. Simply stated the theorem says that when the prices of
the output goods are equalized between countries as they move to free trade, then the
prices of the factors (capital and labor) will also be equalized between countries.
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This implies that free trade will equalize the wages of workers and the rents earned on
capital throughout the world.
The theorem derives from the assumptions of the model, the most critical of which is the
assumption that the two countries share the same production technology and that markets
are perfectly competitive.
In a perfectly competitive market the return to a factor of production depends upon the
value of its marginal productivity. The marginal productivity of a factor, like labor, in
turn depends upon the amount of labor being used as well as the amount of capital. As the
amount of labor rises in an industry, labor's marginal productivity falls. As the amount of
capital rises, labor's marginal productivity rises. Finally the value of productivity depends
upon the output price commanded by the good in the market.
In autarky, the two countries face different prices for the output goods. The difference in
prices alone is sufficient to cause a deviation in wages and rents between countries,
because it affects the marginal productivity. However, in addition, in a variable
proportions model the difference in wages and rents also affects the capital-labor ratios in
each industry, which in turn affects the marginal products. All of this means that for
various reasons the wage and rental rates will differ between countries in autarky.
Once free trade is allowed in outputs, output prices will become equal in the two
countries. Since the two countries share the same marginal productivity relationships it
follows that only one set of wage and rental rates can satisfy these relationships for a
given set of output prices. Thus free trade will equalize goods prices and wage and rental
rates.
Since the two countries face the same wage and rental rates they will also produce each
good using the same capital-labor ratio. However, because the countries continue to have
different quantities of factor endowments, they will produce different quantities of the
two goods.
Global Competitiveness Index (2006-2007): competitiveness is an important determinant
for the well-being of states in an international trade environment.
In this model, labor mobility between industries is possible while capital is immobile
between industries in the short-run. Thus, this model can be interpreted as a 'short run'
version of the Heckscher-Ohlin model. The specific factors name refers to the given that
in the short-run, specific factors of production such as physical capital are not easily
transferable between industries. The theory suggests that if there is an increase in the
price of a good, the owners of the factor of production specific to that good will profit in
real terms.
Additionally, owners of opposing specific factors of production (i.e. labor and capital) are
likely to have opposing agendas when lobbying for controls over immigration of labor.
Conversely, both owners of capital and labor profit in real terms from an increase in the
http://en.wikipedia.org/wiki/Global_Competitiveness_Indexhttp://en.wikipedia.org/wiki/Competitiveness
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capital endowment. This model is ideal for particular industries. This model is ideal for
understanding income distribution but awkward for discussing the pattern of trade.
1.4.3 StolperSamuelson theorem and factor price
The StolperSamuelson theorem is a basic theorem in trade theory. It describes a relation
between the relative prices of output goods and relative factor rewards, specifically, real
wages and real returns to capital.
The theorem states that under some economic assumptions (constant returns, perfect
competition) a rise in the relative price of a good will lead to a rise in the return to that
factor which is used most intensively in the production of the good, and conversely, to a
fall in the return to the other factor.
It was derived in 1941 from within the framework of the HeckscherOhlin model by Paul
Samuelson and Wolfgang Stolper, but has subsequently been derived in less restricted
models. As a term, it is applied to all cases where the effect is seen. Ronald W. Jones and
Jos Scheinkman (1977) show that under very general conditions the factor returns
change with output prices as predicted by the theorem. If considering the change in real
returns under increased international trade a robust finding of the theorem is that returns
to the scarce factor will go down, ceteris paribus. A further robust corollary of the
theorem is that a compensation to the scarce-factor exists which will overcome this effect
and make increased trade Pareto optimal.
The original HeckscherOhlin model was a two factor model with a labour market
specified by a single number. Therefore, the early versions of the theorem could make no
predictions about the effect on the unskilled labour force in a high income country under
trade liberalization. However, more sophisticated models with multiple classes of worker
productivity have been shown to produce the StolperSamuelson effect within each class
of labour: Unskilled workers producing traded goods in a high-skill country will be worse
off as international trade increases, because, relative to the world market in the good they
produce, an unskilled first world production-line worker is a less abundant factor of
production than capital.
The StolperSamuelson theorem is closely linked to the factor price equalization
theorem, which states that, regardless of international factor mobility, factor prices will
tend to equalize across countries that do not differ in technology.
Derivation
Considering a two-good economy that produces only wheat and cloth, with labour and
land being the only factors of production, wheat a land-intensive industry and cloth a
labour-intensive one, and assuming that the price of each product equals its marginal
cost, the theorem can be derived.
The price of cloth should be:
http://en.wikipedia.org/wiki/Tradehttp://en.wikipedia.org/wiki/Real_wagehttp://en.wikipedia.org/wiki/Real_wagehttp://en.wikipedia.org/wiki/Economichttp://en.wikipedia.org/wiki/Heckscher%E2%80%93Ohlin_modelhttp://en.wikipedia.org/wiki/Paul_Samuelsonhttp://en.wikipedia.org/wiki/Paul_Samuelsonhttp://en.wikipedia.org/wiki/Wolfgang_Stolperhttp://en.wikipedia.org/wiki/Ronald_W._Joneshttp://en.wikipedia.org/wiki/Jos%C3%A9_Scheinkmanhttp://en.wikipedia.org/wiki/International_tradehttp://en.wikipedia.org/wiki/Ceteris_paribushttp://en.wikipedia.org/wiki/Compensationhttp://en.wikipedia.org/wiki/Pareto_optimalhttp://en.wikipedia.org/wiki/Heckscher%E2%80%93Ohlin_modelhttp://en.wikipedia.org/wiki/First_worldhttp://en.wikipedia.org/wiki/Factor_price_equalization_theoremhttp://en.wikipedia.org/wiki/Factor_price_equalization_theorem
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(1)
with P(C) standing for the price of cloth, r standing for rent paid to landowners, w for
wage levels and a and b respectively standing for the amount of land and labour used.
Similarly, the price of wheat would be:
(2)
with P(W) standing for the price of wheat, r and w for rent and wages, and c and d for the
respective amount of land and labour used.
If, then, cloth experiences a rise in its price, at least one of its factors must also become
more expensive, for equation 1 to hold true, since the relative amounts of labour and land
are not affected by changing prices. It can be assumed that it would be labour, the
intensively used factor in the production of cloth that would rise.
When wages rise, rent must fall, in order for equation 2 to hold true. But a fall in rent also
affects equation 1. For it to still hold true, then, the rise in wages must be more than
proportional to the rise in cloth prices.
A rise in the price of a product, then, will more than proportionally raise the return to the
most intensively used factor, and a fall on the return to the less intensively used factor.
1.5 NEW TRADE THEORY
New Trade theory tries to explain several facts about trade, which the two main models
above have difficulty with. These include the fact that most trade is between countries
with similar factor endowment and productivity levels, and the large amount of
multinational production (i.e. foreign direct investment) which exists. In one example of
this framework, the economy exhibits monopolistic competition and increasing returns to
scale. There are three basic theories that global marketer has to comprehend: 1.
Comparative Advantage Theory 2. Trade or product trade cycle theory 3. Business
orientation theory
1.6 GRAVITY MODEL
The Gravity model of trade presents a more empirical analysis of trading patterns rather
than the more theoretical models discussed above. The gravity model, in its basic form,
predicts trade based on the distance between countries and the interaction of the
countries' economic sizes. The model mimics the Newtonian law of gravity which also
considers distance and physical size between two objects. The model has been proven to
be empirically strong through econometric analysis. Other factors such as income level,
diplomatic relationships between countries, and trade policies are also included in
expanded versions of the model.
http://en.wikipedia.org/wiki/Monopolistic_competitionhttp://en.wikipedia.org/wiki/Law_of_gravityhttp://en.wikipedia.org/wiki/Econometric
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1.7 REGULATION OF INTERNATIONAL TRADE
Traditionally trade was regulated through bilateral treaties between two nations. For
centuries under the belief in mercantilism most nations had high tariffs and many
restrictions on international trade. In the 19th century, especially in the United Kingdom,
a belief in free trade became paramount. This belief became the dominant thinking
among western nations since then. In the years since the Second World War,
controversial multilateral treaties like the General Agreement on Tariffs and Trade
(GATT) and World Trade Organization have attempted to promote free trade while
creating a globally regulated trade structure. These trade agreements have often resulted
in discontent and protest with claims of unfair trade that is not beneficial to developing
countries.
Free trade is usually most strongly supported by the most economically powerful nations,
though they often engage in selective protectionism for those industries which are
strategically important such as the protective tariffs applied to agriculture by the United
States and Europe. The Netherlands and the United Kingdom were both strong advocates
of free trade when they were economically dominant, today the United States, the United
Kingdom, Australia and Japan are its greatest proponents. However, many other countries
(such as India, China and Russia) are increasingly becoming advocates of free trade as
they become more economically powerful themselves. As tariff levels fall there is also an
increasing willingness to negotiate non tariff measures, including foreign direct
investment, procurement and trade facilitation. The latter looks at the transaction cost
associated with meeting trade and customs procedures.
Traditionally agricultural interests are usually in favour of free trade while manufacturing
sectors often support protectionism. This has changed somewhat in recent years,
however. In fact, agricultural lobbies, particularly in the United States, Europe and Japan,
are chiefly responsible for particular rules in the major international trade treaties which
allow for more protectionist measures in agriculture than for most other goods and
services.
During recessions there is often strong domestic pressure to increase tariffs to protect
domestic industries. This occurred around the world during the Great Depression. Many
economists have attempted to portray tariffs as the underlining reason behind the collapse
in world trade that many believe seriously deepened the depression.
The regulation of international trade is done through the World Trade Organization at the
global level, and through several other regional arrangements such as MERCOSUR in
South America, the North American Free Trade Agreement (NAFTA) between the
United States, Canada and Mexico, and the European Union between 27 independent
states. The 2005 Buenos Aires talks on the planned establishment of the Free Trade Area
of the Americas (FTAA) failed largely because of opposition from the populations of
Latin American nations. Similar agreements such as the Multilateral Agreement on
Investment (MAI) have also failed in recent years.
http://en.wikipedia.org/wiki/List_of_bilateral_free_trade_agreementshttp://en.wikipedia.org/wiki/Mercantilismhttp://en.wikipedia.org/wiki/Tariffhttp://en.wikipedia.org/wiki/United_Kingdomhttp://en.wikipedia.org/wiki/Free_tradehttp://en.wikipedia.org/wiki/Second_World_Warhttp://en.wikipedia.org/wiki/Multilateralhttp://en.wikipedia.org/wiki/General_Agreement_on_Tariffs_and_Tradehttp://en.wikipedia.org/wiki/World_Trade_Organizationhttp://en.wikipedia.org/wiki/Free_tradehttp://en.wikipedia.org/wiki/Developing_countrieshttp://en.wikipedia.org/wiki/Developing_countrieshttp://en.wikipedia.org/wiki/Protectionismhttp://en.wikipedia.org/wiki/United_Stateshttp://en.wikipedia.org/wiki/United_Stateshttp://en.wikipedia.org/wiki/Europehttp://en.wikipedia.org/wiki/Netherlandshttp://en.wikipedia.org/wiki/Australiahttp://en.wikipedia.org/wiki/Japanhttp://en.wikipedia.org/wiki/Trade_facilitationhttp://en.wikipedia.org/wiki/Transaction_costhttp://en.wikipedia.org/wiki/Customshttp://en.wikipedia.org/wiki/Recessionhttp://en.wikipedia.org/wiki/Great_Depressionhttp://en.wikipedia.org/wiki/MERCOSURhttp://en.wikipedia.org/wiki/North_American_Free_Trade_Agreementhttp://en.wikipedia.org/wiki/European_Unionhttp://en.wikipedia.org/wiki/Free_Trade_Area_of_the_Americashttp://en.wikipedia.org/wiki/Free_Trade_Area_of_the_Americashttp://en.wikipedia.org/wiki/Multilateral_Agreement_on_Investmenthttp://en.wikipedia.org/wiki/Multilateral_Agreement_on_Investment
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1.7.1 Risk in international trade
Companies doing business across international borders face many of the same risks as
would normally be evident in strictly domestic transactions. For example,
Buyer insolvency (purchaser cannot pay);
Non-acceptance (buyer rejects goods as different from the agreed upon
specifications);
Credit risk (allowing the buyer to take possession of goods prior to payment);
Regulatory risk (e.g., a change in rules that prevents the transaction);
Intervention (governmental action to prevent a transaction being completed);
Political risk (change in leadership interfering with transactions or prices); and
War and Acts of God.
In addition, international trade also faces the risk of unfavorable exchange rate
movements (and, the potential benefit of favorable movements).
1.8 EMPIRICAL TESTING OF THEORY OF ABSOLUTE COST
During the seventeenth and eighteenth centuries the dominant economic philosophy was
mercantilism, which advocated severe restrictions on import and aggressive efforts to
increase export. The resulting export surplus was supposed to enrich the nation through
the inflow of precious metals. Adam Smith (1776), who is regarded as the father of
modern economics, countered mercantilist ideas by developing the concept of absolute
advantage. He argued that it was impossible for all nations to become rich
simultaneously by following mercantilist prescriptions because the export of one nation is
another nations import. However, all nations would gain simultaneously if they practiced
free trade and specialized in accordance with their absolute advantage. Table I,
illustrating Smiths concept of absolute advantage, shows quantities of wheat and cloth
produced by one hours work in two countries, the United States and the United
Kingdom.
TABLE 1
Absolute
advantage
Wheat (bushel/hr) 6 1
Clothes (yards/hr) 4 5
US UK
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Division of labor and specialization occupy a central place in Smiths writing. Table I
indicates what the international division of labor should be, as the United States has an
absolute advantage in wheat and the U.K. has an absolute advantage in cloth. Smiths
absolute advantage is determined by a simple comparison of labor productivities across
countries.
Smiths theory of absolute advantage predicts that the United States will produce only
wheat (W) and the U.K. will produce only cloth (C). Both nations would gain if they
have unrestricted trade in wheat and cloth. If they trade 6W for 6C, then the gain of the
United States is 1/2 hours work, which is required to produce the extra 2C that it is
getting through trade with the U.K. Because the U.K. stops wheat production, the 6W it
gets from the United States will save six hours of labor time with which 30C can be
produced. After exchanging 6C out of 30C, the U.K. is left with 24C, which is equivalent
to almost five hours labor time.
Nations can produce more quantities of goods in which they have absolute advantage
with the labor time they save through international trade. Though Smith successfully
established the case for free trade, he did not develop the concept of comparative
advantage. Because absolute advantage is determined by a simple comparison of labor
productivities, it is possible for a nation to have absolute advantage in nothing. In Table I,
if the labor productivity in cloth production in the United States happened to be 8 instead
of 4, then the United States would have absolute advantage in both goods and the U.K.
would have absolute advantage in neither.
Adam Smith, however, was much more concerned with the role of foreign trade in
economic development and his model was essentially a dynamic one with variable factor
supplies, as pointed out by Hla Myint (1977).
David Ricardo (1817) was concerned with the static resource allocation problem when he
defined the concept of comparative advantage, which is determined not by absolute
values of labor productivity but by labor productivity ratios. Ricardo would have
interpreted the numbers in Table I by pointing out that, whereas U.S. labor in wheat
production is 1.5 (= 6/4) times as productive as it is in cloth production, the U.K.s labor
productivity in wheat is only one fifth of its labor productivity in cloth. Therefore, the
United States has comparative advantage in wheat and by inverting these ratios one can
show that the U.K. has comparative advantage in cloth.
This pattern of comparative advantage will not be affected if the United Sates has
absolute advantage in both wheat and cloth, which will be the case if we raise U.S. labor
productivity in cloth from 4 to 8. This is because 3/4 will still be greater than 1/5. The
rationale of labor productivity ratios comes from Ricardos labor theory of value.
Ricardo treated labor as the only source of value, as all other factors of production (such
as capital) are also produced by labor. Thus the price of a good (P) is simply equal to the
wage rate (w) times the labor (L) used in production, divided by output (Q), as profit is
zero in competitive markets: P = (w L)/Q. Because the average productivity of labor is a
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= Q / L, P = w / a. If the labor market is competitive, the wage rate paid in all industries
will be the same. Therefore, the ratio between the price of wheat (Pw) and the price of
cloth (Pc) will be equal to the ratio between average productivity of labor in cloth (ac)
and average productivity of labor in wheat (aw): [Pw / Pc] = [ac / aw]. This creates a
direct link between comparative advantage and relative commodity prices in a
competitive economy. If the United States has comparative advantage in wheat
production, wheat will be relatively cheaper in the United States than in the U.K., which
provides the basis for trade.
Ricardos theory of comparative advantage creates hope for technologically backward
countries by implying that they can be a part of world trading system even though their
labor productivity in every good may be lower than that in the developed countries. In the
Ricardian model, trade is a win-win situation, as workers in all trading countries are able
to consume more of all goods. Ricardo was blissfully unaware of the complications that
would be created if his model included another factor such as capital, and if the producers
had responded to changes in factor price ratio in favor of the cheaper factor. It was
Wolfgang Stolper and Paul A. Samuelson (1941) who later discussed the effect of
international trade on income distribution.
The comparative advantage model has many unrealistic assumptions, which ignore the
fact that the real world consists of many countries producing many goods using many
factors of production. Each market is assumed to be perfectly competitive, when in
reality there are many industries in which firms have market power. Labor productivity is
assumed to be fixed and full employment is guaranteed. The model assumes that
technology differences are the only differences that exist between the countries. Finally,
in a dynamic context, comparative advantage changes, as trade in goods and capital alter
the trading countries factor endowments.
Hajime Oniki and Hirofumi Uzawa (1965) have shown in a formal model how trade and
economic growth continuously change patterns of trade and specialization. In spite of its
shortcomings, some of which have been removed by subsequent research (see Chipman
19651966), Ricardos model carries a message that cannot be ignored. Ricardos most
important contribution lies in the fact that he was the first economist to link specialization
with opportunity cost, which is the basis of modern trade theory. As for empirical testing
of Ricardos theories, G. D. A. MacDougall (19511952) demonstrated that trade
between the United States and the U.K. in 1937 followed Ricardos prediction. As a
matter of fact, Ricardian theory performs better in empirical testing than most other
theories.
Activity 1
1. What do you understand by theories of trade? Discuss Ricardo Model in detail along with suitable examples.
2. What are the assumptions in Heckscher Ohlin model of trade? 3. Discuss the difference between new trade theory and the gravity model. 4. Write a brief note on empirical testing of theory of absolute cost.
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1.9 SUMMARY
The unit started with the discussion of trade theories and variety of these theories. In the
next section Ricardian model of absolute advantage was dealt. In a Ricardian model,
countries specialize in producing what they produce best. Unlike other models, the
Ricardian framework predicts that countries will fully specialize instead of producing a
broad array of goods. The next concern was Heckscher and Ohlin model. The theory
argues that the pattern of international trade is determined by differences in factor
endowments. It predicts that countries will export those goods that make intensive use of
locally abundant factors and will import goods that make intensive use of factors that are
locally scarce. New trade theory was discussed followed by the gravity model.
Regulations of International trade were explained in detail and finally empirical testing of
theory of absolute cost was revealed.
1.10 FURTHER READINGS
Guillory, Gil (March 25, 2005). "comparative advantage versus absolute advantage". Mises Economics Blog. Ludwig von Mises Institute.
Harrington, James W. "International Trade Theory". Geography 349 Absolute advantage. University of Washington
Carbaugh, Robert J. (2005). "International Economics". Foundations of trade theory 10th edition. Thomson/South-Western.
Joshi, Rakesh Mohan, (2009) International Business, Oxford University Press, New Delhi and New York
Frances Stewart, Recent Theories of International Trade: Some Implications for the South, Henryk Kierzkowski(Ed.) 1989 Monopolistic Competition and
International Trade, Oxford University Press
http://en.wikipedia.org/wiki/Factor_endowmentshttp://en.wikipedia.org/wiki/Factor_endowmentshttp://en.wikipedia.org/wiki/Good_(economics)http://blog.mises.org/archives/003386.asphttp://blog.mises.org/archives/003386.asphttp://faculty.washington.edu/jwh/349lec03.htmhttp://econ-server.umd.edu/~araujo/courses/econ340/slides/Chapter2.pdf
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UNIT 2
MEASUREMENT OF GAINS FROM TRADE
Objectives
After studying this unit you should be able to:
Understand the approach of gains from trade
Know the methods of measurement and distribution of gains from trade
Appreciate the approaches terms of trade
Describe the role of trade in the growth of the economies
Structure
2.1 Introduction
2.2 Measurement and distribution of gains from trade
2.3 Terms of trade
2.4 Trade as an engine of economic growth
2.5 Summary
2.6 Further readings
2.1 INTRODUCTION
Gains trade in economics refers to net benefits to agents from voluntary trading with each
other. It is commonly described as resulting from:
specialization in production from division of labor, economies of scale, and
relative availability of factor resources and in types of output by farms,
businesses, location, and economies
a resulting increase in total output possibilities
trade through markets from sale of one type of output for other, more highly
valued goods.
Market incentives, such as reflected in prices of outputs and inputs, are theorized to
attract factors of production, including labor, into activities according to comparative
advantage, that is, for which they each have a low opportunity cost. The factor owners
then use their increased income from such specialization to buy more-valued goods of
which they would otherwise be high-cost producers, hence their gains from trade. The
concept may be applied to an entire economy for the alternatives of autarky (no trade) or
trade. A measure of total gains from trade is the sum of consumer surplus and producer
profits or, more roughly, the increased output from specialization in production with
resulting trade. Gains from trade may also refer to net benefits to a country from lowering
barriers to trade such as tariffs on imports.
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Agent_(economics)http://en.wikipedia.org/wiki/Tradehttp://en.wikipedia.org/wiki/Division_of_laborhttp://en.wikipedia.org/wiki/Economies_of_scalehttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Economyhttp://en.wikipedia.org/wiki/Production-possibility_frontierhttp://en.wikipedia.org/wiki/Marketshttp://en.wikipedia.org/wiki/Pricehttp://en.wikipedia.org/wiki/Factors_of_productionhttp://en.wikipedia.org/wiki/Comparative_advantagehttp://en.wikipedia.org/wiki/Comparative_advantagehttp://en.wikipedia.org/wiki/Production-possibility_frontierhttp://en.wikipedia.org/wiki/Goodshttp://en.wikipedia.org/wiki/Autarkyhttp://en.wikipedia.org/wiki/Consumer_surplushttp://en.wikipedia.org/wiki/Profit_(economics)http://en.wikipedia.org/wiki/Tariffs
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From publication of Adam Smith's The Wealth of Nations in 1776, it has been widely
argued, that, with competition and absent market distortions, such gains are positive in
moving toward free trade and away from autarky or prohibitively high import tariffs.
Rigorous early statements of the conditions under which this proposition holds are found
in Samuelson in 1939 and 1962. For the analytically tractable general case of Arrow-
Debreu goods, formal proofs came in 1972 for determining the condition of no losers in
moving from autarky toward free trade. It does not follow that no tariffs are the best an
economy could do. Rather, a large economy might be able to set taxes and subsidies to its
benefit at the expense of other economies. Later results of Kemp and others showed that
in an Arrow-Debreu world with a system of lump-sum compensatory mechanisms,
corresponding to a customs union for a given subset set of countries (described by free
trade among a group of economies and a common set of tariffs), there is a common set of
world' tariffs such that no country would be worse off than in the smaller customs union.
The suggestion is that if a customs union has advantages for an economy, there is a
worldwide customs union that is at least as good for each country in the world
2 . 2 M E A S U R E M E N T A N D D I S T R I B U T I O N O F
G A I N S F R O M T R A D E
There are potentially many gains in economic welfare to be achieved through free trade:
Greater choice of products for consumers
Increased competition for producers
Other countries can supply certain products more efficiently
Trade speeds up the pace of technological progress and innovation
Businesses are better placed to exploit economies of scale
Political benefits from expansion of global trade
The theory of comparative advantage can show these gains from trade: The diagrams
below take you through an example:
Establishing the comparative advantage:
http://en.wikipedia.org/wiki/Adam_Smithhttp://en.wikipedia.org/wiki/The_Wealth_of_Nationshttp://en.wikipedia.org/wiki/Distortions_(economics)http://en.wikipedia.org/wiki/Free_tradehttp://en.wikipedia.org/wiki/Tariffshttp://en.wikipedia.org/wiki/Arrow-Debreu_modelhttp://en.wikipedia.org/wiki/Arrow-Debreu_modelhttp://en.wikipedia.org/wiki/Lump_sum_taxhttp://en.wikipedia.org/wiki/Customs_union
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With half their economic resources allocated to each product, Germany can produce more
of both freezers and dishwashers than Italy. But Italy is closest to Germany in producing
freezers. The opportunity cost of each extra freezer for Italy is 1/4 dishwasher, whereas
for Germany the opportunity cost is 1/2 of a dishwasher. Italy should therefore specialise
in the production of freezers. Germany has a comparative advantage in freezers.
The effects of specialisation
Specialisation has led to an increase in output of both goods (pre specialisation output is
shown in brackets at the bottom of the table)
Gains from trade between the two countries
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For mutually beneficial trade to take place an acceptable term of trade between freezers
and dishwashers has to be established. Both countries stand to gain from a swap of 3
freezers for 1 dishwasher. The allocation of output after trade has taken place is shown in
the table above.
The main reason why the presence of economies of scale can generate trade gains is
because the reallocation of resources can raise world productive efficiency. Basic
Assumptions
Suppose there are two countries, the US and France, producing two goods, clothing and
steel, using one factor of production, labor. Assume the production technology is
identical in both countries and can be described with the following production functions.
Production of Clothing:
US France
where
QC = quantity of clothing produced in the U.S.
LC = amount of labor applied to clothing production in the U.S.
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aLC = unit-labor requirement in clothing production in the U.S. and France ( hours of labor
necessary to produce one rack of clothing)
and where all starred variables are defined in the same way but refer to the process in
France. Note that since production technology is assumed the same in both countries, we
use the same unit-labor requirement in the US and the French production function.
Production of Steel: The production of steel is assumed to exhibit economies of scale in
production.
US France
where
QS = quantity of steel produced in the U.S.
LS = amount of labor applied to steel production in the U.S.
aLS(QS) = unit-labor requirement in steel production in the U.S. ( hours of labor necessary
to produce one ton of steel). Note, it is assumed that the unit labor requirement is a
function of the level of steel output in the domestic industry. More specifically we will
assume that the unit-labor requirement falls as industry output rises.
Resource Constraint: The production decision is how to allocate labor between the two
industries. We assume that labor is homogeneous and freely mobile between industries.
The labor constraints are given below.
US France
where L is the labor endowment in the US and L* is the endowment in France. When the
resource constraint holds with equality it implies that the resource is fully employed.
Demand: We will assume that the US and France have identical demands for the two
products.
A Numerical Example
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We proceed much as Ricardo did in presenting the argument of the gains from
specialization in one's comparative advantage good. First we will construct autarky
equilibrium in this model assuming that the two countries are identical in every respect.
Then we will show how an improvement in world productive efficiency can arise if one
of the two countries produces all of the steel that is demanded in the world.
Figure 1
Suppose the exogenous variables in the two countries take the values in the following
table.
US
L = 100
France
L* = 100
Let the unit-labor requirement for steel be read off of the adjoining graph. The graph
shows that when 50 tons of steel are produced by the economy, the unit-labor
requirement is 1 hour of labor per ton of steel. However, when 120 tons of steel are
produced, the unit-labor requirement falls to hour of labor per ton of steel.
An Autarky Equilibrium
The US and France, assumed to be identical in all respects, will share identical autarky
equilibria. Suppose the equilibria are such that production of steel in each country is 50
tons. Since at 50 tons of output, the unit-labor requirement is 1, it means that the total
amount of labor used in steel production is 50 hours. That leaves 50 hours of labor to be
allocated to the production of clothing, which with a unit-labor requirement of 1 also,
means that total output of clothing is 50 racks. The autarky production and consumption
levels are summarized below.
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Autarky Production/Consumption
Clothing
(racks)
Steel (tons)
US 50 50
France 50 50
World Total 100 100
The problem with these initial autarky equilibria is that because demands and supplies are
identical in the two countries, the prices of the goods would also be identical. With
identical prices, there would be no incentive to trade if trade suddenly became free
between the two countries.
Gains from Specialization
Despite the lack of incentive to trade in the original autarky equilibria, we can show,
nevertheless, that trade could be advantageous for both countries. All that is necessary is
for one of the two countries to produce all of the good with economies of scale and let the
other country specialize in the other good.
For example, suppose we let France produce 120 tons of steel. This is greater than the
100 tons of world output of steel in the autarky equilibria. Since the unit-labor
requirement of steel is when 120 tons of steel are produced by one country, the total
labor can be found by plugging these numbers into the production function. That is, since
QS* = LS
*/aLS, QS* = 120 and aLS = , it must be that LS
* = 60. In autarky it took 100 hours
of labor for two countries to produce 100 tons of steel. Now it would take France 60
hours to produce 120 tons. That means more output with less labor.
If France allocates its remaining 40 hours of labor to clothing production and if the US
specializes in clothing production, then production levels in each country and world totals
after the reallocation of labor would be as shown in the following table.
Reallocated Production
Clothing
(racks)
Steel (tons)
US 100 0
France 40 120
World Total 140 120
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The important result here is that it is possible to find a reallocation of labor across
industries such that world output of both goods rises. Or in other words, there is an
increase in world productive efficiency.
If output of both goods rises then surely it must be possible to find a term of trade such
that both countries would gain from trade. For example, if France were to export 60 tons
of steel and import 30 racks of clothing then each country would consume 70 units of
clothing (20 more than in autarky) and 60 tons of steel (10 more than in autarky).
The final conclusion of this numerical example is that when there are economies of scale
in production then free trade, after an appropriate reallocation of labor, can improve
national welfare for both countries relative to autarky. The welfare improvement arises
because by concentrating production in the economies of scale industry in one country,
advantage can be taken of the productive efficiency improvements.
2.3 TERMS OF TRADE
In international economics and international trade, terms of trade or TOT is the relative
prices of a country's export to import. "Terms of trade" are sometimes used as a proxy for
the relative social welfare of a country, but this heuristic is technically questionable and
should be used with extreme caution. An improvement in a nation's terms of trade (the
increase of the ratio) is good for that country in the sense that it has to pay less for the
products it imports. That is, it has to give up fewer exports for the imports it receives.
2.3.1 The term
"Terms of trade" takes a plural form. However, it is a single number that represents the
ratio of the relative prices.
Significance
Changes in a country's terms of trade can have important effects on its balance of
payments and on its economic growth. Deterioration in the NBTT, for example, will
worsen a country's trade balance -- unless it is offset by an increase in export volume --
so that in order to restore balance it will need to export more and/or import less. Since
domestic investment in most developing countries depends heavily on imported capital
equipment, spare parts, etc., any substantial cut in imports will hit investment and thereby
restrict, or even reduce, economic growth. Conversely, a substantial improvement in a
country's NBTT, or in its ITT, would allow it to expand imports, including imports of
capital equipment, and thus lay a basis for continued, or accelerated, economic growth in
the future.
The terms of trade measures the rate of exchange of one good or service for another when
two countries trade with each other.
For international trade to be mutually beneficial for each country, the terms of trade must
lay within the opportunity cost ratios for both countries.
http://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/International_tradehttp://en.wikipedia.org/wiki/Social_welfarehttp://en.wikipedia.org/wiki/Importhttp://en.wikipedia.org/wiki/Export
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We calculate the terms of trade as an index number using the following formula:
Terms of Trade Index
ToT = 100 x Average export price index / Average import price index
If export prices are rising faster than import prices, the terms of trade index will rise.
This means that fewer exports have to be given up in exchange for a given volume of
imports.
If import prices rise faster than export prices, the terms of trade have deteriorated. A
greater volume of exports has to be sold to finance a given amount of imported goods and
services.
The terms of trade fluctuate in line with changes in export and import prices. Clearly the
exchange rate and the rate of inflation can both influence the direction of any change in
the terms of trade.
2.3.2 Oil prices and the terms of trade
Many developing countries are heavily dependent on exporting oil. And volatility in
international commodity markets creates serious problems with these countries terms of
trade. In the chart below, notice how closely the annual % change in the terms of trade
follows the movement in oil export prices.
When oil values collapsed in 1998, developing countries faced the enormous problem of
having to export much more oil to pay for a given volume of imports. The worsening in
the terms of trade will have adversely affected living standards in these countries. There
has been a sharp rebound in global oil prices this year, helping to boost the terms of trade
for oil exporters.
2.3.3 Terms of trade for developing nations
Developing countries can be caught in a trap where average price levels for their main
exports decline in the long run. This depressed the real value of their exports and worsens
the terms of trade. A greater volume of exports have to be given up to finance essential
imports of raw materials, components and fixed capital goods.
The problems intensified in 1998 with the collapse in the currencies of many Asian
developing countries. A big fall in the terms of trade signifies a reduction in real living
standards since imports of goods and services have become relatively more expensive.
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Figure 2
2.3.4 Terms of trade and competitiveness
Consider the effects of a large fall in the value of the exchange rate. The effect should be
a fall in export prices and a rise in the cost of imports. This worsens the terms of trade
index. But the lower exchange rate restores competitiveness for a country since demand
for exports should grow and import demand from domestic consumers should slow
down.
Much depends on how producers respond to the lower exchange rate. And for countries
without a diversified industrial base, the decline in earnings from each unit of exports has
a damaging effect on output, investment and employment.
2.3.5 Two country model CIE economics
In the simplified case of two countries and two commodities, terms of trade is defined as
the ratio of the price a country receives for its export commodity to the price it pays for
its import commodity. In this simple case the imports of one country are the exports of
the other country. For example, if a country exports 50 dollars worth of product in
exchange for 100 dollars worth of imported product, that country's terms of trade are
50/100 = 0.5. The terms of trade for the other country must be the reciprocal (100/50 =
2). When this number is falling, the country is said to have "deteriorating terms of trade".
If multiplied by 100, these calculations can be expressed as a percentage (50% and 200%
respectively). If a country's terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it
has experienced a 30% deterioration in its terms of trade. When doing longitudinal (time
series) calculations, it is common to set the base year to make interpretation of the results
easier.
In basic Microeconomics, the terms of trade are usually set in the interval between the
opportunity costs for the production of a given good of two countries.
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Terms of trade is the ratio of a country's export price index to its import price index,
multiplied by 100
2.3.6 Multi-commodity multi-country model
In the more realistic case of many products exchanged between many countries, terms of
trade can be calculated using a Laspeyres index. In this case, a nation's terms of trade is
the ratio of the Laspeyre price index of exports to the Laspeyre price index of imports.
The Laspeyre export index is the current value of the base period exports divided by the
base period value of the base period exports. Similarly, the Laspeyres import index is the
current value of the base period imports divided by the base period value of the base
period imports.
Where
price of exports in the current period
quantity of exports in the base period
price of exports in the base period
price of imports in the current period
quantity of imports in the base period
price of imports in the base period
Basically: Export Price Over Import price times 100 If the percentage is over 100% then
your economy is doing well (Capital Accumulation) If the percentage is under 100% then
your economy is not going well (More money going out then coming in)
2.3.7 Other terms-of-trade calculations
1. The net barter terms of trade is the ratio (expressed as a percentage) of relative export and import prices when volume is held constant.
2. The gross barter terms of trade is the ratio (expressed as a percent) of a quantity index of exports to a quantity index of inputs.
3. The income terms of trade is the ratio (expressed as a percent) of the value of exports to the price of imports.
4. The single factorial terms of trade is the net barter terms of trade adjusted for changes in the productivity of exports.
5. The double factorial terms of trade adjusts for both the productivity of exports and the productivity of imports.
2.3.8 Limitations
http://en.wikipedia.org/wiki/Laspeyres_index
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Terms of trade should not be used as synonymous with social welfare, or even Pareto
economic welfare. Terms of trade calculations do not tell us about the volume of the
countries' exports, only relative changes between countries. To understand how a
country's social utility changes, it is necessary to consider changes in the volume of trade,
changes in productivity and resource allocation, and changes in capital flows.
The price of exports from a country can be heavily influenced by the value of its
currency, which can in turn be heavily influenced by the interest rate in that country. If
the value of currency of a particular country is increased due to an increase in interest rate
one can expect the terms of trade to improve. However this may not necessarily mean an
improved standard of living for the country since an increase in the price of exports
perceived by other nations will result in a lower volume of exports. As a result, exporters
in the country may actually be struggling to sell their goods in the international market
even though they are enjoying a (supposedly) high price. An example of this is the high
export price suffered by New Zealand exporters since mid-2000 as a result of the
historical mandate given to the Reserve Bank of New Zealand to control inflation.
In the real world of over 200 nations trading hundreds of thousands of products, terms of
trade calculations can get very complex. Thus, the possibility of errors is significant.
2.4 TRADE AS AN ENGINE OF ECONOMIC GROWTH
The Classical and Neo Classical economists believed that participation in international
trade could be a strong positive force for economic development. There are some related
reasons that can be analyzed to support this argument. One approach to development is to
concentrate in producing export in industrial sector. Promoting exports could directly
lead to economic development either through encouraging production of goods for export
or allowing accumulation of foreign exchange which enables importation of capital
inputs indispensable for export. Moreover, such trade may result in facilitates more
diffusion of knowledge, enhance efficiency of input. Hence, pace the progress of
economic development. In any of these three cases, international trade can be described
as an engine of growth. (See Hogendorn, 1996, Cyper & Dietz, 1997).
There are various standard methods that have been test