Transcript Lecture 17 Slides

EF310: International Trade
and Business
Lecture 17
Theories of International Trade
Last week…
• We looked at two theories of international trade
(i.e. of how countries benefit from trade, and of what
determines the patterns of international trade):
– The theory of Absolute Advantage (Adam Smith)
– The theory of Comparative Advantage (David Ricardo)
– Both emphasise differences between countries and the role of
specialisation
– Crucially important to understand the difference between these
two theories… why was AA not sufficiently satisfactory in
explaining trade?
– As we saw, Comparative Advantage is based on the concept of
opportunity cost
Comparative Advantage
The process of increasing total “world” output
through specialisation can continue until either:
1. England is fully specialised in cloth production,
or
2. Portugal is fully specialised in wine production,
or
3. Both countries are fully specialised
Comparative Advantage
Comparative advantage demonstrates, in theory at least, how countries
can benefit from trade, even if they do not hold an absolute advantage
in the production of any type of good
However, the theory cannot tell us exactly what the pattern of production
(and trade) will be…
… this depends on demand…
Say everyone wants to consume wine and nobody wants cloth… then
there is no incentive for either country to produce cloth, both will
produce only wine and thus there is no incentive to trade either
(remember trade is motivated by differences between countries)
If on the other hand, the world demand for wine is greater than Portugal’s
ability to produce wine, using all its available resources, then England
(with a comparative disadvantage) will, nevertheless, also produce
some wine to satisfy the excess demand
Comparative Advantage
• What about prices?
• We might speculate that both industries in England
(being less efficient producers) would be driven out of
business by the competition from the more efficient
Portuguese producers…
• As we’ve seen, this would not be efficient from a world
output point of view (as we have demonstrated that total
output would increase under specialisation)…
• So how, in reality, will (less efficient) English firms
compete??
Comparative Advantage
• Without trade would expect a uniform wage rate in all
sectors (with competitive labour markets)… remember we
are assuming homogenous labour and that labour can move
between sectors (within an economy)…
• Price of a good = wage * no. of units of labour required
• (under perfect competition, price = cost of production)
• (we’re still assuming a single factor of production: labour)
• When countries trade, relative wages will adjust to reflect
the productivity of labour (assuming perfect competition and
wage flexibility)…
• How?...
Comparative Advantage
• Say, in our numerical example, wage rates are equal in England and
Portugal…
• Higher productivity in Portugal means unit labour costs are lower (average
costs lower => lower prices)
• Demand for goods produced in Portugal increases
• Demand for labour increases, pushing up the wage rate
• This process continues until England becomes competitive in at least one
type of production…
• Result: higher wages in Portugal, reflecting higher productivity of
Portuguese workers… relatively lower wages in England allow English
goods to be competitive
• In general then, we can say that international differences in wages make it
possible for countries to compete with each other… (the magnitude of
wage differentials will be determined by world demand)
Comparative Advantage
• Theory shows gains from trade…
• There are net gains from trade from the “world’s”
point of view… a net gain to “society”…
• But how are these gains distributed??
• Depends on the terms of trade (relative
international prices)…
• Empirical evidence…
Comparative Advantage
Empirical evidence…
• Famous study by English economist G.D.A. MacDougall:
– Looked at data for US and UK trade patterns in 1937
– Examined relative productivity in each country for 25 different
industries
– Hypothesis that market share would depend on relative labour
productivity and relative prices
– US wages were about twice as high as British at the time, therefore
US labour had to be twice as productive in order to be competitive
(equal unit labour costs)…
– MacDougall found that in 20 of the 25 industries, American market
share was higher where US labour was at least twice as productive
as UK labour
– Findings supported the view that CA can be explained by labour
productivities
Comparative Advantage
Empirical evidence…
• H. Glejser (University of Brussels):
– Compared relative prices for the 6 original EEC members
in 1958, with trade flows in 1966 (after considerable tariff
reductions and therefore greater free trade…)
– Found that low relative prices tended to be correlated
with large market shares
– Evidence supports the view that CA determines trade
(independently of whether the simple Ricardian model
adequately describes reality)
Comparative Advantage
Assumptions of the Ricardian model:
• Two goods, two countries
• One factor of production: labour
• Labour is homogenous (and perfectly mobile between
sectors within the economy)
• Goods are homogenous
• Ignoring transport costs
• Holding labour internationally immobile… etc.
• These are simplifying assumptions (generally required for
the purposes of constructing a useful model)…
• Assumptions (even if somewhat unrealistic) should not be a
problem, provided the model explains reality (in this case
trade patterns – according to preceding evidence, it does)
Extending Comparative Advantage model
Heckscher-Ohlin theory
• Eli Heckscher, Bertil Ohlin
• Two Swedish economists, developed the theory in the early 20th C.
• H-O: a variant of CA
• Focus is on factor endowments
(i.e. a country’s endowment or stock of productive ingredients; land,
labour, capital, natural resources, skills… etc.)
“indirectly, factors in abundant supply are exported, and factors in
scanty supply are imported”
- B. Ohlin
Heckscher-Ohlin Theory
• ‘factor proportions’ model of international trade
• Focuses on countries’ endowments of inputs
• Adds resource endowments to the neoclassical
formulation of trade theory
• Predicts that trade will occur according to a
country’s initial endowments of resources…
– e.g. countries with abundant labour supply will
specialise in the production of labour-intensive goods
Heckscher-Ohlin Theory
• Why factor endowments?
– Seem to be one of the most important explanations of CA
(i.e. what determines an economy’s CA)
– Also, link to distribution of income (within economies)
– Factor endowments (at least partly) determined by
economic phenomena… e.g. capital stock dependent on
past economic behaviour (present state of the economy,
savings, investment etc., determines future capital stock…)
… thus we can establish a relationship between trade and
economic development and growth
– Can also make factor endowments approach general
enough to take account of many factors behind trade:
– Climate, technical secrets, patents, geographic location,…
can all be regarded as factors of production
Heckscher-Ohlin Theory
• H-O predicts trade (CA) according to factor
endowments…
• E.g. trade between the ‘developed world’ and less
developed countries… tends to follow CA or factorendowment principles:
– US: has abundant capital (technology etc.)
– India: has abundant labour supply
– Thus India specialises in labour-intensive goods and
services, whereas US specialises in capital-intensive
production…
Neoclassical trade theory
•
•
•
•
Based on the idea of comparative advantage
Assumption of perfect competition
Differences between countries
Specialise according to what each does
relatively best (where opportunity costs are
lowest)
• Trade increases the consumption possibilities of
consumers in all countries