Transcript Issue 1 - Patrick M. Crowley

ECON3315 – International
Economic Issues
Instructor: Patrick M. Crowley
Issue 1: Free trade and comparative advantage
Overview
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Some basics
Trade and the gravity model
Absolute vs comparative advantage
Theory of comparative advantage
Ricardian model of trade
Heckscher-Ohlin model of trade
Increasing returns model of trade
Leontief paradox
Patterns of trade
Some basics
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Macroeconomics vs microeconomics
Ceteris paribus
GDP = ?
GNP = ?
National income accounting identity:
Value of Production = Income = Expenditure
Using expenditure:
GDP = Y = C + I + G + (X – M)
Real variable ($) = Nominal variable($)/Prices
Real variable (%) = Nominal variable(%) - ∏
Some basics
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Unemployment rate = #U/(#E+#U)
Govt budget balance = T – G
if >0 - budget surplus
if <0 - budget deficit
Trade balance = X – M
if >0 - trade surplus
if <0 - trade deficit
FDI = Foreign direct investment
Balance of payments:
Current a/c +Financial a/c = 0
Exchange rates
Demand and supply
US trade
US trade relatively small…
2007
…but large $ amounts
US trading patterns
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Q: So why does the US trade with larger
European countries?
A: Because their GDP is bigger – larger countries
produce more g&s and have more to sell in the
export market
So gravity model suggests that distance and size of
economy determine how much trade is done
between countries
Size of EU economy and trade with the US
What determines amount of trade?
1.
2.
3.
4.
5.
6.
Size
Distance
Size of economy
Cultural affinity (language, historical
association)
Multinational corporations – about 1/3rd of
world trade is between different divisions of
same company.
Borders ( - different currencies, languages)
Gravity model
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In its basic form, the gravity model assumes that only
size and distance are important for trade in the following
way:
Tij = A * (Yi * Yj)/Dij
where
Tij is the value of trade between country i and
country j
A is a constant
Yi the GDP of country i
Yj is the GDP of country j
Dij is the distance between country i and country
j
Gravity model results
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Estimates of the effect of distance from the
gravity model predict that a 1% increase in
the distance between countries is associated with
a decrease in the volume of trade of
0.7% to 1%.
Trade agreements between countries are
intended to reduce the formalities and tariffs
needed to cross borders, and therefore to
increase trade. Gravity model shows that they do
this.
Adding NAFTA countries
…but even free trade doesn’t take away
border effect
Examples of trade flows for BC
Transportation speed and technology
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Gravity model suggests distance is important, but surely
speed and technology associated with transportation
have led to a “smaller” world?
Wheels, sails, compasses, railroads, telegraph, steam
power, automobiles, telephones, airplanes, computers,
fax machines, internet, fiber optics,… are technologies
that have increased trade.
But history has shown that political factors, such as
wars, can change trade patterns much more than
innovations in transportation and communication.
2 waves of globalization
How have patterns of trade changed
between these 2 periods?
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Today, most of the volume of trade is in manufactured
products such as automobiles, computers, clothing and
machinery.
• Services such as shipping, insurance, legal fees and
spending by tourists account for 20% of the volume of
trade.
• Mineral products (e.g., petroleum, coal, copper) and
agricultural products are a relatively small part of
trade.
World trade composition
World trade composition - 2008
…other differences
UK exported mostly manufactured goods and imported raw
materials in early 1900s. US mostly imported and exported raw
materials and agricultural products.
Now, both countries import and export mostly manufactured
products…
…and same pattern clear for developing
countries
…but most jobs are non-Tradable ( - they are
connected to the Services part of the economy)
Source: J. Bradford Jensen and Lori G. Kletzer, “Tradable Services: Understanding the Scope and
Impact of Services Outsourcing,” Peterson Institute of Economics Working Paper 5-09, May 2005
Mercantilism & absolute advantage
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Mercantilism – idea that trade is a zero-sum game
– more you export, the better off you are as you
have gold coming in to pay for the exports.
Hume’s price-specie mechanism showed that this
wasn’t the case…the accumulation of gold would
lead to inflation which would correct trade
imbalance.
Adam Smith advocated instead absolute advantage
– idea that with free trade country that can supply
cheapest g&s would prevail.
Objections: i) Fear was that developing countries
would suffer, as they usually were at an earlier
stage of production; and ii) that loss of welfare to
those who lost could offset gains from trade.
Absolute vs comparative advantage
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Absolute advantage (Adam Smith) – advantage
based solely on cost considerations
Comparative advantage (David Ricardo) – takes into
account both scarcity of resources and cost
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A country has a comparative advantage in
producing a good if the opportunity cost of producing
that good is lower in the country than it is in other
countries
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Example:
• Japan can produce 300m electronic goods, compared to
100m tons of rice that it could otherwise produce.
• Indonesia can produce 300m electronic goods, compared to
150m tons of rice that it could otherwise produce.
Comparative advantage example
Start with both countries not trading ( - called “autarky”), and then
assume that they trade. Can both countries be made better off?
A: YES!!!
Why? Because Japan
has a comparative
advantage in
electronics, so should
specialize in
electronics, while
Indonesia has a comp
adv in rice so should
specialize in rice
production
Potential Million
Million
max gains electronics tons rice
Japan
+300m
-100m
Indonesia
-300m
+150m
0
+50m
Total
Comparative advantage example
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The production possibility frontier (PPF) of an economy shows
the maximum amount of a goods that can be produced for a fixed
amount of resources.
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If QE represents the quantity of electronics produced and QR
represents the quantity of rice produced, then the production
possibility frontier of the domestic economy has the equation:
aLEQE + aLRQR = L
- where aLE and aLR measure the productivity of labor. So in this
example:
Opportunity cost = slope = -(aLE/aLR) [assuming R is on the
vertical axis of the PPF]
Let’s now put example numbers in plot the PPF:
Comparative advantage example
For Japan, opp
cost = 1/3 and
for Indonesia,
opp cost = ½
Unit labor requirements
As long as the
opp cost is
different trade
can benefit both
parties
Electronics
Rice
Japan
aLE = 2
aLR = 6
Indonesia
a*LE = 4
a*LR = 8
Graphing this with rice on the vertical axis and electronics on
the horizonatal axis, lhs is Indonesia and rhs is Japan.
Comparative advantage example
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Presumably
before trade the
price in each
country should
equal the opp
cost (aa)
Why? Otherwise
wages would be
different in each
sector
So when trade
occurs, the price
changes in both
countries ( to cc
which is the same
in both graphs)
Consumption
point moves
beyond the PPC
1 = autarky production & consumption
2 = free trade production point (i.e. with
specialization)
3 = free trade consumption point
Comparative advantage example
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Note that free trade production and consumption points
are at different places. – and that trade allows the
country to move outside its PPC
Given the numbers, how much labor is there in each
country?
Idea here is that wages reflect productivity, so that
comparative advantage happens because of productivity
differences, not because of wage differences
But is this the case in reality?
Productivity and wages compared with the US
Ricardo’s comparative advantage theory criticisms
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Does this result hold in a world with many goods?
What happens to the losers from trade?
What about labour standards?
Surely this could lead to worker exploitation?
Wouldn’t this constitute a “race to the bottom” in terms of
things like environmental standards? Human rights?
What about capital? Doesn’t this play a role?
What about technology? Don’t different goods use
different processes that require different amounts of
labor and capital? – this criticism led to the HeckscherOhlin model which was drawn up by 2 Swedish
economists
Other trade theories – H-O model
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2 factors of production –L & K
Trade depends on factor intensity
In autarky, if there’s a lot of L compared to K in one
country, then w will be low compared to other country
Assume 2 products – each requiring a a different degree of
labor intensity compared to capital (Rice would be L
intensive , whereas electronics will be K intensive).
Continuing our example…assume K = 400 in both J and I,
but that labor endowments differ so that LJ = 600 and LI =
1200.
We measure production processes by their K/L ratio. The necessary
amounts of K and L to produce each good are given by:
Other trade models: H-O
Looking at the K/L
ratio, electronics is
clearly K intensive, and
rice is clearly labour
intensive.
But I has more labor,
then without trade if we
look at the w/r ratio,
then:
(w/r)I < (w/r)J
So that rice must be
expensive in J and
electronics are
expensive in I
Factor requirements
Electronics Rice
K
12
10
L
4
20
K/L 3
0.5
Other trade models: H-O
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Now let them trade! What happens??
Obviously I specializes in rice and J specializes in
electronics. So price of electronics comes down in I and
price of rice comes down in J. But increased demand for
rice raises wI and lowers wJ, and likewise will raise rJ and
lower rI. This is known as the “Stolper-Samuelson theory”.
When will this process stop? When they have the same
product prices…so that:
(pE/pR)J = (pE/pR)I
But this also means that:
(w/r)J = (w/r)I
This is known as “factor price equalization”
Other trade models: H-O - results
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Countries have a “comparative advantage”, not
because of productivity differences, but because of
differences in endowments of factors
A country should produce the good which is
intensive in the factor that the country is relatively
abundant in.
Idea can also be extended to natural resources leads to the insight that if you have lots of natural
resources you should produce those, and those
factors that are intensively used in their
exploitation will benefit. Also countries that are
not endowed with natural resources have to
develop labor skills or technological know-how to
have something to trade
Leontief paradox
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H-O leads to thought that as US is most K-abundant in
the world, we should be exporting K-intensive goods and
importing L-intensive goods.
The paradox is that all the data shows that this isn’t the
case
Leontief paradox
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But US is complicated, as has lots of labour too, but
even when tested on other developed countries, H-O
doesn’t seem to work.
But H-O does seem to work on trade flows between low
and high income countries.
See below for China
Other theories: Krugman
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Motivation here is to explain
fact that most trade that
occurs, occurs between
developed countries, and they
tend to trade the same goods
Uses notion of economies of
scale
2 factors, 2 heterogeneous
goods, internal economies of
scale
Example: red wine and white
wine – schedule for either is on
right
Litres
Hrs of
L
Units of
L/Litre
10
80
8
20
120
6
30
150
5
40
160
4
50
200
4
Other theories: Krugman
1 – autarky production and consumption
2 – after trade occurs, one country specializes in production of
white, other country in red
3 – after trade, consumers in both countries have increase in
consumption of both red and white wine
Other theories: Krugman
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In fact price for both red and white wine will fall
as output increases in both countries
Both countries produce same product, but
differentiated versions
Leads to notion of inter-industry and intraindustry trade
Patterns of trade
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About 25% of world trade is intra-industry
Level of intra-industry trade is industry
dependent
Intra-industry trade
Intra-industry trade