Transcript CH_14

CHAPTER 14
INTERNATIONAL TRADE
AND
PRODUCTION
Objectives of the Chapter:
• Understand the role of comparative advantage in determining the pattern of
trade
• Understand how the terms of trade help to explain the distribution of the
gains from trade.
• Appreciate the importance of market structures in determining the pattern of
trade
• Discuss the significance of foreign direct investment as an alternative to
trade.
What is Globalization
Globalization basis is increased cross-border interaction
• in the form of increased flows of trade in goods and services
• flows of international capital.
These international flows affect all of us as
consumers, and most of us as 'producers'.
 The prices of the goods we are able to
purchase as consumers and the variety
available are determined, directly or
indirectly, by international trade.
 In many sectors of the economy the
market conditions faced by firms are
determined by competition in world
markets. These world market conditions
also affect firms' employment levels, and
hence wages and incomes throughout an
economy.

It is not only individuals in high-income
countries who are affected by the flows of
trade and investment.
 Also opportunities for economic
development for low-income countries.
 The combined exports of many of the
economies of East Asia have increased
ten-fold in real terms over the last 25
years.
 Other low-income countries have been
less successful in responding to the
opportunities created by trade, and some
have even come to see trade as more of a
threat than an opportunity.

WORLD TRADE
'Globalization' hit the headlines after many
years in which world trade increased
substantially faster than world income.
see Figure 14.1.
 The period from the nineteenth century to
the start of the First World War also saw a
growth in trade to income ratios.
 The inter-war period saw a decrease in
world trade, followed by a steady recovery
from 1950 onwards.

Factors lead to these changes
One factor is transport and communication
technologies: see Figure 14.2.
 New information and communication
technologies have also had an impact on
trade volumes.
 The combination of better
telecommunications, air freight and faster
ocean transport has led to substantial time
savings in international transactions,
which have facilitated trade growth.

Import Tariffs
see Figure 14.3 which shoes the behavior
of import tariffs.
 The vertical axis is a measure of import
tariffs (that is, the percentage tax rates on
imports) for a sample of 35 countries.
 Nineteenth-century tariff rates were low,
and Britain had completely free trade. The
average was rising somewhat, however, as
the USA and some European countries
sought to industrialize behind tariff
barriers.

 The
inter-war period saw a dramatic
lurch into protectionism by all the
major countries. average US tariff
rates raised to over 60 per cent, and
by 1933 the exports of the main
industrial nations had fallen to 25 per
cent of their 1929 levels.
General Agreement on Tariffs and
Trade (GATT)
After the Second World War responsibility
for liberalizing world trade was taken up
by GATT, the General Agreement on Tariffs
and Trade.
 This was set up by the International
Monetary Fund (IMF) and the International
Bank for Reconstruction and Development
(IBRD, more commonly known as the
World Bank).

 GATT
initiated negotiations to
liberalize trade, and deep tariff cuts
were made in the late 1940s and
early 1950s.
 These cuts were followed up by
Rounds of trade negotiations.
Rounds of Trade Negotiations
 Kennedy
Round of trade negotiations
in the 1960s,
 Tokyo Round of the 1970s,
 Uruguay Round of the 1980s and
1990s,
 and the recent Doha Round.
The success of these negotiations has
been impressive and they have brought
about a steady decline in tariff rates.
 In developed countries the import tariffs
on manufactures now average less than 4
per cent, although agricultural protection
remains high: in 1999 agricultural import
tariffs averaged 17 per cent in the EU and
11 per cent in the USA.

 The
GATT became the World Trade
Organization (WTO) in 1995 and
extended its role in several ways.
 One was to start promoting the
liberalization of trade in services
(under the General Agreement on
Trade in Services or GATS)
 and the removal of barriers to
inwards investment (under the Trade
Related Investment Measures or
TRIMs agreement).
Free Trade Areas (customs unions)
European Union (EU).
 North American Free Trade Agreement or
NAFTA (comprising Canada, the USA and
Mexico)
 Mercosur (comprising Argentina, Brazil,
Uruguay and Paraguay).
 NAFTA, Mercosur and other countries in
the Americas are also currently holding
discussions with a view to forming a Free
Trade Area of the Americas.

COMPARATIVE ADVANTAGE AND THE
GAINS FROM TRADE
 The
basic framework for analyzing
the determinants of trade flows and
the effects of trade on the economy
is the idea of comparative advantage
by going back to David Ricardo,
writing in 1817.
COMPARATIVE ADVANTAGE
Suppose that there is only two countries
(Home and Foreign) and two goods (call
bicycles and coats).
 Each country can produce both goods.
 consumers in each country want to
consume both goods. If there is no trade,
the consumers must be supplied by local
production.
 What happens when there is trade? Each
country will specialize in producing and
exporting the good which it has relatively
more productive.

Production Possibility Frontier
 It
describes how much of the two
goods each country can produce. See
Figure 14.4
 The vertical axis is the number of
coats produced and the horizontal
axis is the number of bicycles
produced.
The bold line H-J on Figure 14.4(a). This is
Home's PPF, and the points on the line
indicate the output levels that Home can
achieve. Thus if Home produces no
bicycles it can produce 200 coats;
 if it produces no coats it can produce 100
bicycles. A number of combinations are
possible, so the output mixture 100 coats
and 50 bicycles also lies on the ppf line.

Suppose that Home has 100 workers and
that each worker can produce either two
coats or one bicycle.
 The Home ppf is constructed by observing
that if all the workers are employed in the
coat industry, Home can produce 200
coats;
 if all the workers are employed in the
bicycle industry, Home can produce 100
bicycles.
 Employing some workers in each industry
means that a number of different
combinations of bicycles and coats are
possible, and these combinations are
given by the ppf.

The Foreign ppf is given by the line F-G on
Figure 14.4(b).
 It is constructed in a similar way but using
different numbers. Let us assume that
Foreign has 200 workers, each of whom
can produce either 0.5 coats or 0.5
bicycles.
 If all workers are employed in the coat
industry, the output is 100 coats and zero
bicycles, and so on.
 If there is no trade between Home and
Foreign, the level of production in each
country is determined by consumer
demand at, say, point AH in Home and AF
in Foreign.

opportunity cost
 Although
we usually measure the
cost of something in terms of money,
a more fundamental measure is what
has to be given up in order to attain
the thing. This is referred to as the
opportunity cost.
 In the last example, the opportunity
cost of one extra bicycle in the Home
economy is two coats.
Allow for trade
suppose that the relative prices on the
world market (in which our two countries
are the only traders) are such that 1
bicycle costs 1.5 coats.
 We can think of this in terms of the price
of a bicycle being $300 and the price of a
coat being $200, although it is not
necessary to specify these prices exactly.
It is only the ratio that matters - that is,
1.5:1.

How does this ratio affect production and
consumption in each economy?
 In Home, the production of each bicycle
has an opportunity cost of 2 coats, but
importing a bicycle costs 1.5 coats.
 Home therefore closes its bicycle industry
and specializes in the production of coats
at point QH on Figure 14.4(a).
 It can purchase bicycles on the world
market, and the combinations of bicycles
and coats it can attain by producing coats
at QH and trading are shown by the
dashed line.

 If
all Home's coat production were
exported it could afford to import
133 units of bicycles (200 coats at a
price of $200 can fund the purchase
of 133 bicycles at a price of $300).
 But consumers want to consume
both goods, so Home's consumption
will not go this far but will stop at a
point such as CH.
In Foreign we have the converse situation.
Each bicycle produced has an opportunity
cost of 1 coat and exporting a bicycle
finances the purchase of 1.5 coats. The
bicycle industry expands, and the Foreign
economy ends up at point QF on Figure
14.4(b), that is, specializing in bicycles
(100 bicycles).
 If Foreign exported all of its bicycle
production (100 units) it could afford to
import 150 coats (100 x $300/$200), but
the domestic demand for bicycles will
mean that some are consumed at Home.
So consumption will end up at a point
such as CF.

Conclusions from example


First, trade is determined by a comparison of the
opportunity costs of producing each good in each
country. Bicycles are exported by the economy
with the lower opportunity cost of producing
bicycles (Foreign) and imported by the economy
with the higher opportunity cost of producing
bicycles (Home).
Because it is cheaper (in terms of opportunity
cost) to produce bicycles relative to coats in
Foreign than it is in Home, we say that Foreign
has a COMPARATIVE ADVANTAGE in bicycles. In
the same way, Home has a comparative
advantage in coats. It is comparative advantage
that determines the pattern of trade.
 Every
country has a comparative
advantage in something.
 A country may be unproductive in
every activity, but compared with
other countries it will be relatively
less unproductive in some activities
than others - and these are the
activities in which it has a
comparative advantage.
COMPARATIVE ADVANTAGE
A country has a comparative advantage in
the production of good X if the opportunity
cost of producing a unit of X, in terms of
other goods foregone, is lower in that
country than it is abroad.
 ABSOLUTE ADVANTAGE
 A country has an absolute advantage in
the production of good X if it costs less in
terms of resources to produce a unit of X
in that country than it does abroad.

Table 14.1 pursues this line of reasoning
and summarizes the model. The first block
of the table gives the labour inputs
required to produce a bicycle and a coat in
each country.
 If the wages are as shown in the second
block, the unit costs of production of each
good in each country are as described in
the third block. If we compare these costs
with world prices (which, with free trade,
are also the internal prices in each
country)

Why trade will occur and what the
pattern of trade will be?



The important conclusion from comparative
advantage is that each country gains from trade.
Trade increases the size of each economy's
consumption set, in the sense that each economy
can now afford to consume more than it could in
the absence of trade.
There are two reasons for this welfare gain.
– First, trade allows countries to specialize according to
comparative advantage, thus bringing about an efficient
world allocation of production.
– Second, countries are no longer constrained to consume
what they produce; they can exchange goods through
world trade and hence consume along the dashed lines
in Figure 14.4.
Terms of trade
A
country's terms of trade are the
ratio of its export prices to its import
prices.
 TT= export price/ import price * 100
 This shows that it is the terms of
trade that determine the distribution
of the gains from trade between
countries, and that changes in the
terms of trade cause one country to
gain and the other to lose.
 The
concepts of comparative
advantage and the gains from trade
are regarded as the most important
results in the whole of economics.
SOURCES OF COMPARATIVE
ADVANTAGE

1.
2.
•
The two main sources of comparative
advantage are cross-country differences
in
Technology
Endowments: the stocks of labour, capital
and other resources in a country.
These differences arise because of
different intensities of research and
development (R&D) activity, and different
speeds of absorption of new technologies
in different countries.
endowments




Endowments: Each economy contains within it
quantities of natural resources, land of different
types, labour of different skill levels and physical
capital of different sorts (machines, roads,
houses and so on).
We can refer to each of these human and
physical resources as a separate factor of
production. And we can refer to the collective
stock of factors of production as the
endowment of the economy.
Endowments may change over time - as saving
leads to the accumulation of more capital, or
education raises the skill level of the labour force.
But at each point in time the endowment
determines the productive potential of the
economy, the relative productivity of the
economy in each good, and hence the
The relationship between an economy's
endowment and its comparative
advantage is the subject matter of the
Heckscher-ohlin theory of trade. (Eli
Heckscher and Bertil Ohlin were Swedish
economists writing in the first half of the
twentieth century.) The theory is based on
two observations:
 The first observation is that economies
differ in the relative quantities of their
different factors of production. India is
relatively abundantly endowed with
unskilled labour, the USA with skilled
labour, and Germany with physical capital
(machinery and so on).

The second observation is that the
production of different goods requires the
usage of factors of production in different
proportions: aircraft production is quite
skilled labour intensive; the assembly of
electronics is rather unskilled labour
intensive.
 Putting these observations together, the
theory predicts that countries will have a
comparative advantage in goods that are
relatively intensive users of the factor of
production with which they are relatively
well endowed. Thus, the USA has a
comparative advantage in aircraft
production, for example.

Heckscher-ohlin theory has more to offer
than the observation that countries have a
comparative advantage (and hence will
export) the goods intensive in factors with
which they are relatively well endowed.
 It also provides a structure within which
we can investigate the effects of trade on
the prices of different factors of production
- that is, on the wages of skilled and
unskilled labour, land rents, and the return
on capital.


Suppose that Foreign is well endowed with
unskilled labour and Home is relatively poorly
endowed with unskilled labour. One would then
expect the wages of unskilled labour to be
relatively low in Foreign (there is a lot of it) and
high in Home (where it is relatively scarce). Now
allow for trade. Foreign will export goods
intensive in unskilled labour, and this will have
the effect of raising the demand for unskilled
labour, and hence will raise the wage. Home will
import goods intensive in unskilled labour, so
reducing the demand for Home's unskilled labour
and reducing the wage. This argument suggests
two things. First, that we can identify the gainers
and losers within each economy from trade. And
second, that trade will tend to bring about the
convergence of factor prices across countries.
 The
identification of gainers, and
possible losers, is straightforward.
Relatively abundant factors in a
country will gain from trade, and
relatively scarce factors may lose.
For example, consider the
enlargement in 1994 of the North
American Free TradE Agreement
(NAFTA) to include Mexico.



It is to be expected that the owners of capital and skilled
labour in the USA would have been in favour of the treaty,
as capital and skilled labour are the factors that the USA is
abundantly endowed with, relative to Mexico.
At the same time, it is to be expected that unskilled labour
in the USA would have been opposed to the treaty, as their
position of relative scarcity would have been removed once
there was free trade with Mexico.
This was true in the run up to signing the treaty, just as it is
now the case that some US labour unions are among the
most vocal opponents of globalization. Furthermore, recent
decades have seen a large increase in wage inequality in
the USA, with the wages of high-skill workers rising much
more rapidly than those of unskilled workers. Some of this
is probably attributable to trade, although the consensus
among people who have researched this issue is that the
development of new technologies has been much more
important than trade (for example, the replacement of
unskilled workers by automated production processes).
TRADE POLICY
no trade or free trade



historically, free trade has been rather rare.
Governments have employed a variety of trade
policy measures both to restrict trade volumes
and, by taxing trade, to raise government
revenue. The main instruments of these
interventions have been import tariffs and
quotas.
A TARIFF is a tax imposed on imported goods, in
addition to the usual domestic taxes.
A QUOTA is a quantity limit on import volumes,
typically administered by making importers
obtain a licence and ensuring that a fixed supply
of licences is available.
THE EFFECTS OF TRADE
POLICY
 How
does trade policy affect the
economy?
 suppose a single good that is both
imported and produced domestically,
 and consider the implications of
putting a tariff on the good.
 look at supply and demand for the
single good.



A tariff will cut the volume of imports to the economy.
Economy's trade must be in balance in the long run. If a
tariff cuts imports it must, in the long run, also cut exports.
The mechanism through which this is brought about is a
change in relative prices, which we can think of as a change
in the exchange rate. A lower volume of imports will
improve the balance of trade, which will lead the exchange
rate to be higher than it would have been otherwise, which
in turn will reduce exports.
This negative effect of import policy on exports is
sometimes overlooked, with dire consequences. Many less
developed countries have followed policies involving tight
import controls, causing their currencies to be 'over valued'
and frustrating attempts to develop export industries.
A
partial equilibrium analysis of a
tariff is given in Figure 14.5. The
horizontal axis measures the
production and consumption of the
good under study; the vertical axis
measures the price of the good. The
home economy's supply (S) and
demand (D) curves are illustrated. If
there is no trade the price would
have to be Pa, that is, the price at
which home supply equals home
demand.
 Suppose
now that the price of the
good on the world markets is Pw
(expressed in domestic currency
units). If there is free trade this is
also the price inside the home
economy. At this lower price,
consumption is Cf and production is
Qf. The difference between domestic
consumption and production, (Cf Qf), is met by imports.
 Now
consider the effects of a tariff at
a per unit rate of t. This is added to
the world price, giving a price (in the
horne economy) of P w + t, and a
consumption and production of Ct
and Qt respectively. As would be
expected, imports fall.


Note first that the government collects the tariff
revenue; the value of this is the volume of
imports (Ct - Qt) times the tariff rate, t, so it is
given by the area B. Consumers lose, as the price
they pay for the good has increased by t per unit;
the cost is the price increase multiplied by the
consumption level Ct, giving the area E + A + B,
plus the cost associated with the tariff-induced
reduction in consumption (area C), giving a total
cost to consumers of area E + A + B + C. Home
producers receive a higher price. Their gain is the
area E, measuring the higher price on the
quantity they produce (E + A), minus the
increased marginal cost of supply, A.
The tariff has therefore reduced welfare in the
economy as a whole.
Optimal tariffs
 we
argued that protection reduced
welfare. Are there circumstances in
which this result can be overturned?
The answer is affirmative in two
quite distinct sets of circumstances.
These circumstances go under the
labels' the optimal tariff argument'
and' second best tariffs'.

In our analysis of tariffs we assumed that the
world price of the product under study was
constant, and unchanged by the tariff policy.
However, this may not be the case, as the effect
of a tariff is to reduce demand for the product,
and this may be expected to have an effect on
the world price. In general, a fall in demand will
tend to reduce the world price, and this is a
terms of trade improvement from the point of the
view of the importing country. It will bring a gain
in welfare which could offset the losses identified
so far, and it may even bring a net gain to the
economy. The optimal tariff is the tariff rate that
maximizes this net gain.