Transcript Trade

Chapter 4: Trade:
Factor Availability and
Factor Proportions Are Key
McGraw-Hill/Irwin
Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Possibilities under Increasing
Costs
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Production possibilities with
increasing costs
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Why is the PPC bowed out? – law of
increasing opportunity cost
The slope of the PPC increases as we move
to the right
Why? Wheat and cloth use factors in
different proportions (even with CRS
industries)
Readjustment causes effects similar to the
law of diminishing returns
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Why choose to produce at S0?
If at S1, producing an extra unit of cloth costs only
1W/C, therefore produce more cloth
 If at S3, producing an extra unit of cloth costs
3W/C, therefore produce less cloth
 If a S0, the opportunity cost of cloth is the same as
the price – no reason to adjust production
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Individual’s Utility Levels to Consumption of
Two Goods
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Review of consumer theory
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Indifference curves – meaning, shape
Budget line Y=PwQw+PcQc and
Qw=Y/Pw – (Pc/Pw)Qc
The optimal point is where the budget
constraint is tangent to the indifference curve
At that point the slope of the indifference curve
is equal to Pc/Pw
We apply the same theory using community
indifference curves and the PPC
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Figure 4.3 – Indifference Curves and
Production Possibilities without
Trade
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Production and consumption with
trade
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The free-trade equilibrium is at a price ratio of
1W/C – this is the slope of the price line
Production is at S1
Consumption is at C1 – the tangent point of the
price line and the highest community
indifference curve
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US
Exports: 40 billion units of wheat (80-60)
 Imports: 40 billion units of cloth (60-20)
 Trade triangle: S1TC1
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ROW
Exports: 40 billion units of cloth (100-60)
 Imports: 40 billion units of wheat (55-15)
 Trade triangle: C1TS1
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Derive D and S curves for cloth in US
At 1W/C US consumes 60 units of cloth (point C1)
 At 2W/C US consumes (and produces) 40 units of
cloth (market equilibrium) (point So)
 At 1W/C US produces 20 units of cloth (point S1)
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Derive demand and supply curves for cloth in
ROW
At 1W/C ROW consumes 60 units of cloth (point
C1)
 At 2W/C ROW consumes (and produces) 80 units
of cloth (market equilibrium) (point So)
 At 1W/C ROW produces 100 units of cloth (point
S1)
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Gains from trade with variable
costs
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Trade allows a country to consume at a point above
its PPC
Trade allows each country to achieve a higher
community indifference curve
Distribution of benefits???
Which country gains more?
The higher its export prices (compared to equilibrium
before trade) the more a country gains
 The lower its import prices (compared to pre-trade) the
more a country gains
 Terms of trade – the price of exports relative to the
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Gains from trade with variable
cost
ROW
will have better terms of trade if the price of cloth (its
export product) is higher
 the international price line will be steeper leading to a
higher community indifference curve
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US
will have better terms of trade if the price of wheat
(its export product) is higher
 The international price line will be flatter leading to a
higher community indifference curve
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Gains from trade with variable
cost
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Increased production of the export product (wheat
in US; cloth in ROW)
Reduced production of the import competing
product (cloth in US;wheat in ROW)
Resource re-allocation from import-competing to
export product
Countries do not specialize completely in
producing their export product
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Gains from trade with variable
cost
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More efficient world production
From 50+30=80 units of wheat (S0 in US and ROW)
 To 80+15=95 units of wheat (S1 in US and ROW)
 Cloth production unchanged at 120 units
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Increased consumption of the imported product
(cloth in US, wheat in ROW)
Increase in real income (income effect)
Consumption of exported product can decrease or
increase depending on the strength of income and
substitution effects
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Trade patterns and the Heckscher-Ohlin
Theory of Trade
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The patterns of trade are determined by
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production differences – different shapes of PPC
demand differences – differences in community
indifference curves
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The Heckscher-Ohlin theory:
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A country will export products that use relatively
intensively those production factors found relatively
abundantly in the country
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Wheat is land-intensive
Land is relatively cheaper in US (land is abundant in US)
The US has a comparative advantage and exports wheat
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Trade patterns and the HeckscherOhlin Theory of Trade
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A country will import products that use
relatively intensively those production factors
that are relatively scarce in the country.
 Cloth
is labour-intensive
 Labour is more expensive in the US (scarce)
 The US imports cloth
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Heckscher-Ohlin Theory of Trade
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A country will export products that use relatively
intensively those production factors found relatively
abundantly in the country, and import products that use
relatively intensively those production factors that are
relatively scarce in the country.
H-O comparative advantage is actually a triple
comparison:
 across countries
 across products
 across factors of production
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Summary
The Neo-Classical Model
 The Heckscher-Ohlin Theory
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