Transcript International Trade

International Trade
What is International Trade?
• International trade is the buying and selling of
goods and services across international
boundaries
• Countries sell goods and services produced
domestically to buyers abroad-- exports
• Countries buy goods and services from other
countries for domestic use--imports
Why have international trade?
• Countries trade with each other because they get
‘gains from trade’
• An economy (or a firm) needs to decide what to produce
and what to trade given the scarce resources or more
specifically, its factor (resource) endowment (the
quantities and quality of factors of production as well as
levels of technology) (e.g. Land, natural resources, high
skilled labor, technology, etc.)
• Each country has different factor endowments
• concepts of absolute advantage and comparative
advantage
• worksheet
Modeling the Theory of Absolute
Advantage
ASSUMPTIONS
1) Two countries and two goods
2) Constant opportunity costs PPF is ……………………………………
3) Negligible transport costs
• A country has an absolute advantage in a good if with the same
quantity of resources, it can produce more of the good than
another country. (Or one country can produce a good using
fewer resources than another.)
• Theory of absolute advantage states that if countries specialize
in and export the good in which they have an absolute
advantage, the result is increased consumption in each country
(can CONSUME beyond the ppf). All countries will be better off
• (go to slide 21 OR review absolute advantage)
A PPC with constant costs
• When the PPC is a straight line, opportunity costs are constant
(do not change) as the economy moves from one point on the
PPC to another. It occurs when the factors of production are
equally suited to the production of both goods (e.g. basketball
and volleyballs which are very similar, needing similar
specialized factors of production)
Modeling the Theory of Absolute Advantage
• Consider a very simple world economy comprised of two
countries: Coffenia and Robotia, which produce coffee and
robots
• The following table show the quantities of coffee and robots
that one worker in one day can produce in Coffenia and
Robotia, if they produce only coffee or only robots
• When Coffenia only produces coffee, it can produce 8 units as
shown in point A (similarly, for the other points)
• Comparing the PPCs, it is evident that Coffenia has an absolute
advantage in coffee, since its PPC extends further out on the
coffee axis (vice versa in the case of Robotia who has a absolute
advantage in robots production)
Production and Consumption in case of
No Trade
• Coffenia and Robotia can produce anywhere
along their PPC, depending on how they allocate
their scarce resources
• If they decide not to trade with each other, each
one produces robots and coffee themselves.
• Suppose that Coffenia and Robotia spend half of
their resources producing coffee and the other
half on robots
• The results of this can be shown as follows
• As you can see, total production of the two goods in both
countries are 5.5 units of coffee and 5 units robots
• Use this autarky (no trade) result as the anchor to illustrate how
trade can improve the overall production and consumption of
the two goods
Production and Consumption with Trade
• Suppose that both countries agree to trade
and they each specialize and export the good
in which they have an absolute advantage
• Coffenia therefore specializes entirely in
production of coffee moving to point A on its
PPC and Robotia specializes entirely in the
production of robots, moving to point D on its
PPC
• Adding up the total production in both countries,
production has increased by 2.5 units of coffee and 1
robots
• There is a clear gain in the global and overall production
of the two goods (i.e. a more efficient allocation of global
resources).
(continue)
• Now suppose that Coffenia and Robotia agree
to trade with each other a the price ratio of
1:1 where they would trade 1 unit of coffee
for 1 robot
• In such case, they would agree to trade 3 units
of coffee for 3 robots (Coffenia exports 3 units
of coffee which Robotia imports and Robotia
exports 3 robots which Coffenia imports)
• This is summarized as follow
• As you can see, with trade, Coffenia consumes 5 units of coffee (8 – 3
they export) and 3 units of robots (which they import) while Robotia
consumes 3 units of coffee (which they import) and 3 robots (6 – 3
they export)
• Now, with respect to the PPC, this is represented with points G and H
• As you can see, where as both countries are producing on their PPC,
due to trade, they can consume at a point outside their PPC! They are
able to consume beyond what they could have produced themselves.
Both countries are now better off with trade
To Sum: Theory of Absolute Advantage
• The above analysis illustrated that both countries
become better off because specialization
according to absolute advantage leads to a
‘global’ reallocation of resources where
production takes place by the most efficient (low
cost) producers
• -> page 3 of H/O
Theory of Comparative Advantage
• The theory of absolute advantage explains part of gains from
specialization and trade
• David Ricardo (19th centuryeconomist ) introduced the idea of
comparative advantage to show that countries can gain from
specialization and trade even if one country has the absolute
advantage in both goods. It is only necessary that countries have
different opportunity costs (relative costs) for their goods, so that the
production of one good is relatively cheaper in one country than in
another, even if it is not absolutely cheaper
• And that the EXCHANGE RATE is …………..
• To sum, comparative advantage refers to the situation where one
country has a lower opportunity cost (relative cost) in the production
of a good than another country
• Go over WS question (page 4)
Illustrating the Theory of Comparative
Advantage
• Consider a very simple world economy comprised of two
countries: Cottonia and Microchippia, producing cotton and
microchips
• The following table show the quantities of cotton and
microchips that one worker in one day (i.e. per unit of inputs)
can produce if only one or the other good is produced
• As we can see, unlike the previous case, Microchippia
has an absolute advantage in the production of both
cotton and, because with the same resources (one
workermicrochips in one day), it can produce more of
both goods than Cottonia
• The PPC of this case is illustrated as follows
• As you can see, unlike the previous case where the PPCs
crossed, Microchippia’s PPC lies entirely above the PPC of
Cottonia
• The question now is should the countries still trade? If so
how and which goods should each country produce?
• In order to determine whether trade is still beneficial and
which goods the two countries should produce, we need
to consider the opportunity cost of producing each good
at the expense of other good for both countries
• Recap: opportunity cost is the next best alterative
forgone and sacrificed in order to obtain something. In
this case, it is the production of the good that is not
produced due to the production of the other good
– The opportunity cost of producing cotton is the quantity of
microchips that must be sacrificed to produce an extra unit of
cotton (∆ microchips / ∆ cotton as you move from one point of
PPC to another)
– The opportunity cost of producing microchips is the quantity
of cotton that must be sacrificed to produce an extra unit of
microchip (∆ cotton / ∆ microchips as you move from one
point of PPC to another)
• As the PPC has a constant slope, the opportunity
costs are constant between the two goods
throughout the PPC
– There is no increasing cost and the resources are
equally substitutable for the two goods
• Thus, to calculate the opportunity cost of cotton,
we divide the maximum number of microchips
that can be produced (x intercept) by the
maximum number of cotton that can be
produced (y intercept) for each country
• This gives the following results
Calculating the Opportunity Costs and
Comparative Advantage
(continued)
• Microchippia has a lower opportunity cost in producing
microchips but Cottonia has a lower opportunity cost in
producing cotton
• In this scenario, Cottonia has a comparative (or relative)
advantage in cotton production, while Microchippia has
acomparative advantage in microchips
• And based on the idea of comparative advantage by Ricardo,
Cottonia should specialize in cotton production and export
cotton and import microchips, while Microchippia should
specialize in microchip production and export microchips and
import cotton
• But the question is how do we know this comparative
advantage would lead to gains from trade for both countries?
Moreover, should both countries specialize fully (100%)in
producing one good as in the case when each country had an
absolute advantage in one of the good?
Suppose NO specialisation & trade
• If the countries do not trade and each country
uses half of their resources to produce each of
the goods. Cottonia produces 10 cotton and 5
microchips; Microchippia makes 12.5 cotton and
25 microchips.
• In this case, there is a total/global production of
22.5 cotton and 30 microchips
Specialization trade
• Microchippia ,who has the absolute advantage in both cotton
and microchips, does not fully specialize in the production of
microchips. Rather, they still produce some cotton
• For example……. if Microchippia spends 8/10 of their resources
on microchips (total of 8/10 x 50 = 40 units of microchips) and
2/10 of their resources on cotton (total of 2/10 x 25 = 5 units of
cotton)
• Cottonia continues to specialize fully in the production of
cotton (20 units)
• The two countries then trade 10 units of both goods at the
exchange rate of 1:1 (consider why this exchange rate is
beneficial to BOTH countries)
• In this case, Microchippia eventually consumes 15 units of
cotton and 30 units of microchips and Cottonia consumes 10
units of cotton and 10 units of microchips. Both consume
outside their respective PPCs  there are clear gains of trade
Summarising…..
• The theory or LAW of comparative advantage states that it
is possible for all countries to gain from specialization and
trade if countries SPECIALIZE according to their
COMPARATIVE ADVANTAGE. The global allocation of
resources improves a more efficient resource allocation
and increased global output, allowing countries to
consume outside their PPCs
(i.e. by specializing in the production of a good (or service), an economy can
use its resources more efficiently ( lower opportunity costs ). Thus it can
produce more of one good and trade some of it for other goods produced
more efficiently in other economies)
(But in order to achieve the increase in the output of ALL goods, we must consider different
extent/degree of specialization (not full specialization) of the production of the two goods,
particularly by the country which has an absolute advantage in producing both of the goods)
Evaluation: Assumptions of Theory of
Comparative Advantage
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There are two countries and two goods – relaxing this assumption is OK
Constant opportunity costs- problems if costs increase as production increases
There are no transportation/transaction costs – there are transportation costs which
will affect the real cost of the goods  it is not worthwhile to trade some goods
Which type of opportunity cost ratios would imply NO gains from trade
Factors of production are immobile and fixed – but in reality, labor and capital do
move between countries (eg within European Union)
Technology is fixed – but in reality, technology is always advancing
There is full employment of resources (as illustrated on PPC) – not true in reality
Imports and exports balance each other – but in reality there are imbalances in trade
(trade deficits and surpluses)
Other criticisms (not assumptions):
– Specialization according to Comparative Advantage may lead to too much
specialization which can make the country more vulnerable to economic
fluctuations e.g. world food prices effect economically less developed countries
(ELDCs) which specialize in agriculture.
– Specialization may also hinder economic development as the economic structure
does not evolve from agriculture  manufacturing  service
Gains from FREE trade:
1) Specialization according to COMPARATIVE
ADVANTAGE:  more efficient resource allocation.
Global production and consumption will increase
+ 2) Economies of scale: exporting firms produce
more output and invest in methods which will
achieve economies of scaleto lower costs and
prices for consumers
• + 3) Increased competition (the car industry in Japan
is oligopolistic, but closer to monopolistic competition
globally) lower prices, increased choice for consumers etc
• 4) Acquiring needed resources: countries may need natural
resources or capital goods that are not available domestically
e.g. oil for Japan
‘gains from trade’ (continued)
• 5) Flow of new ideas and technology: new ideas,
technologies, skills, etc. can be transferred from
one country to another
•  Trade as an engine for economic growth:
specialization, economies of scale, increased
competition, acquisition of needed resources,
technological advances, etc. will all contribute
toward increases in domestic output
•  Advantages of FREE TRADE
World Trade Organization
• World Trade Organization – is an international government
organization (like the UN) which provides an institutional and
legal framework for the trading system that exists between
nations worldwide
• It is an advocate for liberalizing trade (free trade)
• It suggests and monitors trade rules, provides a forum for trade
negotiations, and settles trade disputes between MEMBER
countries
World Trade Organization
• https://www.wto.org/index.htm
Modelling the advantages of FREE TRADE
with a world (or international price)
• Cottonia’s domestic market for cotton is shown below using
the usual demand and supply curves
• The question of whether or not Cottonia should trade cotton
with the world depends on whether or not they have a
comparative advantage in producing cotton. This can be
analyzed through looking at whether the domestic price of
cotton is lower or higher than the world price of cotton
(continued)
• Suppose Cottonia’s cotton market is small
compared to the global market, so that its
buying and selling activities do not have the
ability to affect the world price
• This means that the world supply of cotton
facing Cottonia is …………………, appearing as
………………………..Cottonia can sell or buy any
quantities of cotton at the world price
• This is shown as follows…
•
Welfare gains from trade
(Handout Page 7 and Last Page Q1)
• Show the world supply
curve, assuming
Cottonia has a
comparative
DISADVANTAGE
• Show imports with free
trade
• Show changes in
consumer surplus,
producer surplus and
community surplus