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2. WHY DO WE TRADE? - Part I

2. WHY DO WE TRADE? - Part I. Six Valuable Lessons of Trade Theory. Free trade can raise aggregate economic efficiency and aggregate economic welfare. Some people will suffer losses with free trade.

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2. WHY DO WE TRADE? - Part I

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

  2. Six Valuable Lessons of Trade Theory • Free trade can raise aggregate economic efficiency and aggregate economic welfare. • Some people will suffer losses with free trade. • Free trade will benefit a country even if it is less efficient than all other countries in every industry. • A domestic firm may lose out in international competition even if it is the lowest cost producer in the world. • Trade protection may be beneficial for a country. • Although trade protection can be beneficial, the case for free trade remains strong.

  3. Index of Openness* * Ratio of exports + imports to GDP multiplied by 100 Some countries trade extensively, others very little. How can this be understood and explained? Source: The World Bank 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  4. Exports of goods and services in EU(% of GDP in 2012) *2011 value **2010 value Source: The World Bank 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  5. Major Concerns of Trade Theory? The classical theory of international trade is concerned with the following three questions: 1. What are the gains from trade? • In other words, if countries benefit from international trade, where do the gains come from, and how are they divided among the trading countries? 2. Why Do We Trade?

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

  7. Why Do We Trade? Autarky* price of a product in two countries: PS/PT PS/PT Finland China NSSA With trade prices start to equalize. NSSB P0 P0 NDSA NDSB QS Country B QS Country A 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage * Autarky = closed economy = no international trade allowed in a country

  8. Why Are the Prices Different? • Differences in technology or productivity • Difference in resource endowments • Difference in demand 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  9. Understanding the Gains from International Trade Nations (or firms in different nations) trade with each other because they benefit from it! We can divide the different trade theories in four categories... 2. Why Do We Trade?

  10. Different Trade Theories 1. Early Trade Theory: Mercantilists 2. Classical Trade Theory: Ricardian Model (section 2.1) 3. Modern Trade Theory: Heckscher-Ohlin Model (section 2.2) 4. Alternative Approaches to Trade Theory (section 2.3) 2. Why Do We Trade?

  11. 1. Early Trade Theory: Mercantilists • Until mid-eighteenth century, it was believed that the purpose of international trade was to keep exports greater than imports and pile up gold, and when/if deficits were created they believed that imports had to be restricted • Mercantilists assumed trade to be a zero-sum game since they assumed that fixed amounts of goods and of gold existed in the world and that trade merely determined their distribution among the various nations 2. Why Do We Trade?

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

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

  14. Economic Basis for Trade What are the factors that determine how countries will specialize in international trade? David Ricardo (Principles of Political Economy and Taxation (1817), developed the theory of comparative advantage... 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  15. Economic Basis for Trade continued Specialization and free trade will benefit all trading partners (= real wages will rise), even those who may be absolutely less efficient producers. According to this theory, 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  16. Absolute vs. Comparative Advantage Although comparative advantage is a simple concept, experience shows that it is a surprisingly hard concept for many people to understand (or accept). 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  17. Absolute vs. Comparative Advantagecontinued Indeed, Paul Samuelson — the Nobel laureate economist who did much to develop the model of international trade — has described comparative advantage as the best example he knows of an economic principle that is undeniably true yet not obvious to intelligent people. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  18. Definition: Absolute Advantage The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  19. Absolute Advantage - an Illustration Suppose country A and country B produce wheat, but that A's climate is more suited to wheat and its labor is more productive. Country A will therefore produce more wheat per acre than country B and use less labor in growing it and bringing it to the market. Country A thus enjoys an absolute advantage over country B in the production of wheat. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  20. Definition: Comparative Advantage The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other products than it could be in the other country. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  21. Comparative Advantage - an Illustration • Suppose that countries C and D both produce wheat and corn and that C enjoys an absolute advantage in the production of both - that is, C's climate is better than D's, and fewer of C's resources are needed to produce a given quantity of both wheat and corn • C and D each need to choose between planting land with wheat and corn 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  22. Comparative Advantage - an Illustrationcontinued • To produce more wheat, either country must transfer land from corn production and vice versa • Suppose that in country C, a bushel of wheat has an opportunity cost of two bushels of corn. At the same time, suppose that producing a bushel of wheat in country D requires to give up only one bushel of corn D enjoys a comparative advantage in producing wheat 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  23. Example 1: Gains from Mutual Absolute Advantage Assume a) two countries with fixed amount of land (100 acres) and land yields given in the table below b) only two products produced (wheat and cotton), c) preferences for food and clothing are such that both countries consume equalamounts of wheat and cotton. PPF:s before trade: 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  24. Example 1: Continued • When there is no trade, the allocation of resources will be such that both countries will produce 150 bushels of wheat and 150 bales of cotton. Australia New Zealand Wheat Wheat 600 W: 25 acres x 6 bu/acre C: 75 acres x 2 bales/acre W: 75 acres x 2 bu/acre C: 25 acres x 6 bales/acre 200 (150, 150) (150, 150) PPF 600 200 Cotton Cotton 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  25. Example 1:Continued • Expanded possibilities after trade: If countries realize that they should specialize (Australia in cotton and New Zealand in wheat) and trade, both countries could gain • Both are now specializing: 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  26. Example 1: Continued • In this situation 300 bushels of wheat is traded for 300 bales of cotton: New Zealand Australia Wheat Wheat 600 (300, 300) (300, 300) 200 600 200 Cotton Cotton 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  27. Example 1: Continued • Trade enables both countries to move beyond their previous resource and productivity constraints • both countries (after trade) can consume beyond their production possibilities (PPFs)! 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  28. Example 2: Gains from trade when one country has a double absolute advantage • Production Possibilities and Consumption in a Closed Economy(same assumptions as before): 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  29. Example 2: Continued • When countries realize that they can benefit from specialization and trade: Only partial specialization 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  30. Example 2:Continued If 100 bu of wheat from NZ is traded to 200 bales of cotton from Australia • Consumption after trade: Stage 3 • When countries specialize they will maximize their combined output and use resources more efficiently: both countries are better off than they were before the trade (closed economy consumptions were 300, 300 and 75,75) • both have moved beyond their own production possibilities 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  31. International Equilibrium with Increasing Costs • Next we will extend the classical model of trade to the more general case of increasing opportunity costs and introduce demand by means of social indifference curves Indifference Map and Consumer Equilibrium Increasing Opportunity Cost Clothing Clothing a) Product specific factors. b) Different industries use factors in different proportions. I’’’ I’’ PPF I’ Food Food 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  32. General Equilibrium in a Small Open Economy 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  33. Specialization Based on Comparative Advantage and the Resulting Gains from Trade America Britain Assume such a domestic price ratios that E (in US) and E* (in UK) are consumption and production in autarky (= no trade). Figure 1 (b) Figure 1 (a) 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  34. Specialization Based on Comparative Advantage and the Resulting Gains from Trade continued • Figure 1: In autarky, America produces and consumes at E, and Britain at E*. With trade, America shifts production from E to Q and consumes at S by exporting VQ units of food to Britain in exchange for VS units of British clothing. America is better off with trade because S lies on a higher indifference curve than E. Indeed, in our illustration, America consumes more food and more clothing at S than at E. Britain shifts production from E* to Q* and consumption from E* to S*. Britain’s welfare increases also. Trade triangles SVQ and Q*V*S* are identical. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  35. Different indifference curves! Same Production Technique in Both Countries, Trade Based on Different Taste Figure 2 In autarky US produces and consumes at A and UK at B. After free trade both will produce at Q but consume at A’ and B’, respectively. America Clothing Again both countries can consume beyond their production possibilities. Britain Food 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

  36. Trade Based on Different Taste continued • Figure 2: Trade based on different tastes. America and Britain share the same production frontier MN. In autarky, America produces and consumes at A, and Britain at B. With free trade, both countries produce at Q, but America consumes at A’ and Britain at B’. Trade triangles A’VQ and QSB’ are identical. 2. Why Do We Trade? - 2.1 The Law of Comparative Advantage

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

  38. What are the ultimate determinants of comparative advantage? • Ricardo did not bother to answer this question • He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology), but he did not explain the basis for these differences. Implicit reason in his example was climate... 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  39. What are the ultimate determinants of comparative advantage?continued • It remained to Heckscher and Ohlin to offer an explanation for comparative advantage • And this theory has become, since 1930s, the orthodox explanation of the ultimate cause of international trade Eli Heckscher (1879 - 1952) Bertil Ohlin (1899-1979) 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  40. What are the ultimate determinants of comparativeadvantage?continued • Their basic idea is: 1. Commodities differ in their factor requirements 2. Countries differ in their factor endowments 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  41. What are the ultimate determinants of comparativeadvantage?continued A country has comparative advantage in those commodities that use its abundant factors intensively. • This is why labor-abundant countries, such as India and China export footwear, rugs, textiles, and other labor intensive commodities; and land-abundant countries, such as Argentina, Australia, and Canada, export meat, wheat, wool, and other land-intensive commodities 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  42. The Basic Assumptions of the Heckscher-Ohlin Model: 1. Number of countries, factors, and commodities are all two (often referred to as the 2 x 2 x 2 model) 2. Technology is the same in both countries 3. Constant returns to scale 4. Strong factor intensity 5. Incomplete specialization 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  43. The Basic Assumptions of the Heckscher-Ohlin Model continued: 6. Perfect competition 7. Factors are perfectly mobile within each country but perfectly immobile between countries 8. Tastes are largely similar between countries 9. Free trade 10. Transportation costs are zero 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  44. Heckscher-Ohlin Theorem with a Single Technique • The structure of trade, in general, can be traced back to differences in factor endowments, technology, and tastes • Since Heckscher-Ohlin theory assumes that technology and tastes are similar between countries, it attributes the comparative advantage to differences in factor endowments 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  45. Heckscher-Ohlin Theorem with a Single Technique continued In summary, the capital-abundant country exports the capital-intensive commodity, and the labor-abundant country exports the labor-intensive commodity. 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  46. Example 1: Factor Endowments and Production-Possibilities • One country • Required inputs per unit of output 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  47. Example 1: Continued Cloth M • 600 Capital Constraint J 225 • E Labor constraint • 150 JEH is the PPF G H • • 0 Steel 150 200 450 Figure 3 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  48. Example 1: Continued • Figure 3: Derivation of the production-possibilities frontier. If the economy had an unlimited supply of capital (labor), it would be able to produce along the labor constraint JG (capital constraint MH). When the supplies of both factors are limited, both constraints become binding and the production frontier coincides with the heavy kinked line JEH. Because steel is capital intensive relative to cloth, the capital constraint is steeper than the labor frontier. 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  49. Heckscher-Ohlin Theorem with a Single Technique Figure 4 Cloth Since same tastes in both countries, only one set of communal indifference curves. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but consumes in C*. Steel Figure 4 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

  50. Heckscher-Ohlin Theorem with a Single Technique • Figure 4: Production frontiers JQH and J*Q*H* reflect the fact that America is endowed with more capital than Britain, while Britain is endowed with more labor than America. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but shifts consumption to C*. Trade triangles CQV and Q*C*V* are identical. America exports steel, and Britain cloth. 2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

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