International Economics

1. International Economics Classical and Neoclassical Trade Theory

2. Foundations of trade theory Historical development of trade theory • Mercantilism • Regulation to ensure a positive trade balance • Critics: possible only for short term; assumes static world economy • Absolute advantage (Adam Smith) • Countries benefit from exporting what they make cheaper than anyone else • But: nations without absolute advantage do not gain from trade • Comparative advantage (David Ricardo) • Nations can gain from specialization, even if they lack an absolute advantage

3. Comparative advantage Absolute & Comparative Advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour Nation WineCloth United States 5 bottles 20 yards United Kingdom 15 bottles 10 yards Comparative advantage: the US has an absolute advantage in both goods Output per labor hour Nation WineCloth United States 40 bottles 40 yards United Kingdom 20 bottles 10 yards

4. Comparative advantage Ricardo’s Comparative Advantage in money prices Cloth (yards) Wine (bottles) Nation LaborWage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.50 20 £0.25 UK 1 hr $8 10 $0.80 20 $0.40 (at $1.6 = £1)

5. Comparative advantage Production possibilities schedule • Generalizes theory to include all factors, not just labor • Shows combinations of products that can be made if all factors are used efficiently • Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another)

6. Comparative advantage Marginal Rate of Transformation

7. Comparative advantage Production possibilities schedules: constant opportunity costs

8. Comparative advantage Trading under constant opportunity costs

9. Comparative advantage Production gains from specialization: constant opportunity costs Before After Net Gain Specialization Specialization (Loss) AutosWheat AutosWheatAutosWheat US 40 40 120 0 80 -40 Canada 40 80 0 160 -40 80 World 80 120 120 160 40 40

10. Comparative advantage Consumption gains from trade: constant opportunity costs Before After Net Gain Trade Trade (Loss) AutosWheat AutosWheatAutosWheat US 40 40 60 60 20 20 Canada 40 80 60 100 20 20 World 80 120 120 160 40 40

11. Increasing opportunity costs Production possibilities schedule under increasing costs

12. Bringing demand into the model Indifference curves and int'l. trade

13. Increasing opportunity costs Trading under increasing costs: US

14. Increasing opportunity costs Trading under increasing costs: Canada

15. 1. FT cons’n point • trade pattern-”Trade triangle” 2. FT prod’n point 3. NB: Home consumes more food than it produces (i.e. imports food) 4. NB: Home produces more cloth than it consumes (i.e. exports cloth)

16. Increasing opportunity costs Production gains from specialization: increasing opportunity costs Before After Net Gain Specialization Specialization (Loss) AutosWheat AutosWheatAutosWheat US 5 18 12 14 7 -4 Canada 17 6 13 13 -4 7 World 22 24 25 26 3 3

17. Increasing opportunity costs Consumption gains from trade: increasing opportunity costs Before After Net Gain Trade Trade (Loss) AutosWheat AutosWheatAutosWheat US 5 18 5 21 0 3 Canada 17 6 20 6 3 0 World 22 24 25 27 3 3

18. Bringing demand into the model Basis for trade, gains from trade

19. Why relative price differentials? Factor endowment theory (Heckscher-Ohlin) • Comparative advantage is explained entirely by different national supply conditions, especially resource endowments • Nations export products that use inputs which are relatively abundant (cheap) at home, and import products which need inputs which are relatively scarce (expensive) at home

20. Why relative price differentials? Factor endowment theory: assumptions • Nations all have the same tastes and preferences (same indifference curves) • They use factor inputs which are of uniform quality • They all use the same technology

21. Factor endowment model Comparative advantage according to factor endowment theory Autarky equilibrium

22. Factor endowment model Comparative advantage according to factor endowment theory Post-trade equilibrium

23. Factor endowment model Factor endowment theory: implications • Factor price equalization • The shift within each nation towards use of cheaper factors, and away from expensive ones, leads to more equal factor prices (if factors are mobile) • Distribution of income • Trade changes domestic distribution of income as demand for different factors changes • Tests of factor endowment theory • Emphasize the importance of varieties of different factors (such as human capital) and accounting for changes in resource endowment; other explanations are also important

24. Factor Price Equalisation Theorem • In Hecksher-Ohlin's world, by trade, each countries' factor price (W/r) will be eventually the same. (Remember that in the H-O world, commodities can freely move while factors cannot. However, as a result of free trade of commodities, factor prices will be the same as well as commodity prices). • The relation between factor price (W/r) and factor intensity (K/L) • Assumptions we sustain: • As wage is relatively higher (W/r ), producers use more K-intensive technology (k = K/L ) • X is more labour intensive (kX = KX /LX < kY = KY /LY) • Both countries have the same production technologies.

25. Relazione tra prezzo relativo dei fattori e prezzo relativo dei beni-paese H If H country's total endowment ratio is kh, the wage-rental ratio in H will range (W/r)U < (W/r) < (W/r)L

26. La relazione tra prezzo dei fattori (W/r) e prezzo dei beni (PX / PY) • As (W/r) increases, PX / PY increases, because X is more labour intensive. • Before trade, (PX / PY )F is greater than (PX / PY)H as H is labour abundant. • Therefore, from the corresponding factor prices, (W/r)F > (W/r)H before trade.

27. Relazione tra prezzo relativo dei fattori e prezzo relativo dei beni-paese F

28. Teorema del pareggiamento del prezzo dei fattori • By trade, the two countries' commodity prices will converge (1) to the one world price (PX / PY).W • Eventually, (PX / PY).F = (PX / PY).W = (PX / PY).H after trade. • When (PX / PY). = (PX / PY).W, the only corresponding factor price (1) is (W/r)W • With (W/r)W , both H and F use kX and kY for the two sectors' production.

29. Teorema del pareggiamento del prezzo dei fattori

30. Teorema del pareggiamento del prezzo dei fattori • We sustain the assumption that X is (always) more labour intensive. However, sometimes it is possible that two industries change the order of factor intensities. Suppose kY > kX when (W/r) is low, but kY < kX when (W/r) is high. • Then the graph we saw before changes:

31. Il caso della inversione dell’intensità fattoriale

32. Il caso della inversione dell’intensità fattoriale • The relation between (W/r) and (PX / PY) is not linear any more. When (W/r) is low, (1) as (W/r) increases, PX / PY increases because X is more labour intensive. Once (W/r) is higher (1) than (W/r)*, Y is more labour intensive. Therefore, as (W/r) increases, Py increases faster than Px, i.e. (PX / PY ) decreases. • In this case, even if there is one commodity price (PX / PY )w in the world by trade, two factor prices (1) (W/r)' and (W/r)" can exist. We cannot guarantee that H and F have the same (W/r).