The Benefits of Trade by Elmer G. Wiens

1. The Benefits of TradebyElmer G. Wiens

2. Benefits of Increasing World Trade? • Many people are skeptical about the benefits of trade. • The Vancouver Sun’s Stephen Hume predicts that a billion people will fall back into extreme poverty because of soaring food prices under the existing arrangements for trade among countries. • Countries like Japan, who import a large proportion of food stuffs, are trying to increase food production to become more self-reliant. • Why has the world moved deliberately to freer trade through international arrangements like NAFTA and the W.T.O., despite doubts about more free trade?

3. Canadian Goods & Services: exports, imports, balance of trade & GDPBillions of Dollars • The production of goods and services for exports accounts for 1 / 3 of domestic production of goods and services • Canada’s balance of trade equals exports less imports.

4. Determinants of Canada’s Pattern of Trade • What are the benefits of free trade? • What are the arguments against free trade? • Why does Canada export specific goods and services? • Why does Canada import specific goods and services? • Why are our favourite trading partners the USA, Japan, the U.K., the E.E.C. countries, and China?

5. Economic Benefits of Specialization and Exchange A. Comparative Advantage – David RicardoB. Economies of Scale – Adam Smith • A. Comparative Advantage: countries have differing opportunity costs of producing specific goods. • Example: • Canada and the USA • Crude Petroleum and Automotive Products • Canada can produce a barrel of oil at a lower cost relative to manufacturing a car, compared to the USA. • Canada has a comparative advantage in crude oil production. • USA has a comparative advantage in manufacturing cars.

6. A. Comparative Advantage – David Ricardo • The next slide depicts the analysis of comparative advantage of the 19th century economist, David Ricardo. • Suppose Canada can produce 200 extra barrels of oil if it produces one less car and moves the freed-up resources into oil production. • Canada’s opportunity cost of producing a car is 200 barrels of oil. Its opportunity cost of producing one barrel of oil is 1 / 200 of a car • Similarly, suppose the USA’s opportunity cost of producing a car is 150 barrels of oil. Its opportunity cost of producing one barrel of oil is 1 / 150 of a car. • Canada has a comparative advantage in oil over the USA: • -- 1 / 200 versus 1 / 150 • Canada has a comparative disadvantage in cars: • -- 200 versus 150

7. A. Comparative Advantage – David RicardoCanada: Crude PetroleumUSA: Automotive Products

8. Crude Petroleum Production

9. Canadian Crude Petroleum: exports, imports, balance of tradeBillions of Dollars • Canada’s increasing exports and balance of trade in crude petroleum indicate its continuing comparative advantage in crude oil production. • Canada exports 2.3 million barrels of petroleum to the USA each day, the USA’s top source.

10. Car Manufacturing

11. Canadian Automotive Products:exports, imports, balance of trade Billions of Dollars • Canadian exports of automotive products have fallen, while its imports have increased. • Its balance of trade in automotive products has decreased to the point where we now have a deficit.

12. Comparative Advantage – David Ricardo Canada: Crude PetroleumUSA: Automotive Products • It would appear that Ricardo’s theory of comparative advantage, based on opportunity costs, has some legs. • Canadian production of crude petroleum has increased relative to the production of automotive products. • How long will this trend continue?

13. B. Economies of Scale – Adam Smith • The 18th century economist, Adam Smith, explained the notion of economies of scale in the Wealth of Nations. • A firm can obtain cost advantages of expanding output if by increasing its fixed costs it shifts its short-run average total cost curve down and to the right along its long-run average cost curve. • To achieve these economies of scale, automotive manufactures close inefficient plants in Canada and upgrade to more efficient plants in the USA. • In the diagram of the next slide, I approximate the LRAC by a quadratic function. • A firm can chose its SRAC by choosing its fixed costs – plant and equipment.

14. Economic Benefits of Specialization and ExchangeB. Economies of Scale – Adam Smith • B. Economies of Scale: cost advantage of expansion of output by a firm that shifts its short-run average total cost curve (SRAC) down and to the right along its long-run average cost curve (LRAC).

15. B. Economies of Scale: Sources • Specialized machinery and production lines with greater investment in capital equipment and automation. • Skilled, specialized, and trained labour force working with machinery. • Research and development making the technological improvements possible. • Managerial innovations • Lower per unit marketing costs as advertising is spread over greater output • Access to lower cost financing, e.g. borrowing at lower interest rates. • Let’s look at the effects of economies of scale on opportunity costs!

16. B: Comparative Advantage: Economies of Scale ExploitedCanada: Crude PetroleumUSA: Automotive Products • In this scenario, on the one hand when the USA’s automotive industry exploits economies of scale, American comparative advantage in cars increases. • On the other hand, Canada’s comparative advantage in oil increases as Canada’s automotive industry becomes less efficient.

17. USA Automotive Industry:Limits to Specialization • The diagram on the next slide depicts the following situation: • Assume three major firms behave competitively in the USA’s automotive industry. • Short-run equilibrium obtains for each firm where Price = Marginal Cost, with Marginal Cost increasing. • The demand function is mildly quadratic. So, at the equilibrium price output level, industry marginal revenue is positive and the elasticity of demand is greater than one in absolute value. • Long-run equilibrium obtains when further expansion of plant and equipment moves the SRAC curves upward and to the right, as the opportunity cost of producing cars increases. • Long-run and short-run diseconomies limit the extent of specialization.

18. Limits to Specialization: Short RunDiminishing marginal returns to variable inputsFirms produce where marginal cost = price with mc increasing U.S.A. Automobile Industry Competitive Version

19. Unexploited Economies of Scale: Opportunity Costs Unexploited Economies of Scale: Monetary Costs • As a review, let’s convert the opportunity cost tables to monetary costs. • If the cost of producing a Canadian car is $10,000, then the cost of producing one barrel of oil is $10,000 / 200 = $50. If the cost of producing an American car is $9,000, then the cost of one barrel of oil is $9,000 / 150 = $60. • Buying oil in Canada and selling it in the US could obtain a profit. Buying cars in the US and selling them in Canada could obtain a profit.

20. Question: Part A. Complete the bottom table.Exploited Economies of ScaleOpportunity Costs Monetary costs

21. Question: Part B. • What are the assumptions underlying Ricardo’s theory of the benefits of trade due to comparative advantage? • Describe Ricardo’s model as set out in your textbook. -Write a two page essay to hand in at your next class.

22. Works consulted • Krugman, Paul. Pop Internationalism. Cambridge: MIT Press. • Wonnacott, P., R. Wonnacott, and A. Blomqvist, Economics. Toronto: McGraw-Hill. • Wikipedia: The Free Encyclopedia: Various Web Pages • Statistics Canada: Various Publications. • Next topic: 1. Efficiency gains to producers from exports. 2. Efficiency gains to consumers from imports.