Transcript International Trade

International Trade
Mgmt. 418
Assoc. Prof. Dr. Şule Lokmanoğlu Aker
Chapter 3
The Classical World of David
Ricardo and Comparative
Advantage
The Principles of Political Economy and
Taxation (1817)
Assumptions of the Basic
Ricardian Model
1.
2.
3.
4.
Each country has a fixed endowment of resources, and all units of each
particular resource is identical.
The factors of production are completely mobile between alternative
uses within a country. It implies that the prices of factors of production
also are the same among these alternative uses.
The factors of production are completely immobile externally, ie, they do
not move between countries.
Labor theory of value is employed in the model.



5.
No other inputs are used in the production process,
Any other input is measured in terms of labor embodied in the production
process,
The other input/labor ratio is the same in all industries, ie, the good
embodying two hours of labor is twice as expensive as a good using only one
hour.
The level of technology is fixed for both countries.
Assumptions cont...
6. Costs of production are constant, ie, the supply
curve for any good is horizontal.
7. There is full employment.
8. The economy is characterized by perfect
competition.
9. There is no government intervention.
10. Transportation costs are zero.
11. Two-country, two-commodity model is too
simplistic.
Ricardian Comparative
Advantage
Wine
Cloth
Price ratios
in Autarky
Portugal
80 hrs/bbl
90 hrs/yd
England
129 hrs/bbl
100 hrs/yd
1 W:8/9 C
(or 1C:9/8W)
1 W:6/5 C
(or 1C:5/6W)
The labor requirements per unit of production reflect the technology
in each country and imply relative value of each commodity. Above
Portugal has an absolute advantage in production of both
commodities. However, Portugal is relatively more efficient in
production of wine than cloth.
Autarky ratios
Autarky (pretrade) price ratios show the price ratios when
the country has no international trade.
In England, 1barrel of wine should exchange for 6/5 yards
of cloth (since the same labor time is embodied in each
quantity), while in Portugal, 1 barrel would exchange
for only 8/9 yard of cloth.
Thus Portugal gains if it produces wine and exchanges 1
barrel for 6/5 yards.
And England gains if it produces cloth and exchanges 1
yard for 9/8 barrels of wine (instead of 5/6 barrel at
home)
Gains from trade
Autarky price ratios:
England →
1 barrel of wine exchanges
for 1.2 (6/5) yards of cloth
Portugal →
1 barrel of wine exchanges
for 0.89 (8/9) yards of cloth
So England gains if she buys wine at any
price less than 1.2 C, and Portugal gains
when she buys more than 0.89 C for 1W.
Terms of Trade
Terms of trade is the international price ratios of
commodities in international trade.
After trade, there will be a common price for wine
and cloth in England and Portugal. Because
the demand for cloth in England will rise also to
exchange it for wine from Portugal.
Thus, the prices of both wine and cloth will
change. There will be a new equilibrium
depending on the demand in two countries.
This new price will not be only determined by the
labor content.
The equilibrium terms of
trade
This equilibrium will bring about a balanced
trade, where exports = imports in total
value, for each country.
If one of the countries have a trade surplus,
the price-specie-flow mechanism starts,
and the surplus is eliminated, because
prices and wages increase in the surplus
country, and imports increase, bringing
trade to equilibrium.
Export concentration of
selected countries
Country
X categories
Argentina (1994)
Colombia (1994)
Cuba (1989)
Iceland (1994)
Japan (1994)
food and live animals
basic manufactures
food and live animals
food and live animals
machines, transport equipment,
basic manufactures
food and live animals,
crude materials (exc. Oil)
minerals, fuels, etc,
chemicals and related products
New Zealand (1994)
Saudi Arabia (1992)
%of total X
35.3
18.1
80.1
76.6
71.9
10.8
42.2
19.0
92.5
4.5
Comparative advantage and
total gains from trade – Table 3
Ricardian production characteristics
Cloth
Wine
Price ratios
in autarky
Country A
Country B
1 hr/yd
2 hrs/yd
3 hrs/bbl
4 hrs/bbl
1W:3C
1W:2C
In the above example, Country B benefits when it can
exchange 1W with 3C. And Country A bebefits, when it
switches one worker from wine production to cloth
production.
Equilibrium terms of trade
It lies between the two countries’
comparative strength and elasticity of
demand of each country for the other’s
product.
It is referred to as reciprocal demand, a
concept developed by John Stuart Mill in
1848.
Location of factors of
production
If the return on a factor of production is larger
than the other one, the other moves to that
location until productivity and returns are
equalized.
This explains the movement of labor
between countries and between the
regions in the same country.
Resource constraints
Suppose Country A has 9,000 hrs of labor
available, and Country B has 16,000 hrs of
labor available.
As in Table 3, Country A can produce 9,000 yards
of cloth and no wine, or 3,000 barrels of wine
and no cloth, or any combination in between
absorbing 9,000 hrs of labor.
Country B can produce 8,000 yds of cloth and no
wine, 4,000 bbl of wine and no cloth, or any
combination in between absorbing 16,000 hrs
of labor.
Complete specialization
In the previous example, neither of the countries
changed their production of wine and cloth.
In complete specialization, all resources are
devoted to the production of one good, with no
production of the other good. If Country A
produces only cloth and Country B produces
only wine, they exchange 2,000 bbl of W with
5,000 yds of cloth. Country A has 10,000 hrs
(4,000x1 + 2,000x3), Country B has 18,000 hrs
(5,000x2 + 2,000x4). So both countries are
better-off.
Maximum gains from trade
Economic incentives cause production to move to
the endpoint of the frontier, where the
maximum gains from trade is realized.
The cost of producing one wine is two yards of
cloth, but the return of producing 1 barrel of
wine is 2.5 yards of cloth.
So production of both goods in two countries
expand to the endpoint at the PPF with
specialization.
Comparative advantage and the
developing countries
In 1880’s, cost differences were taken as given and part of the
environment (governed by natural endowment of a country’s
resources). Eg, quantity of usable land, the quality of soil, the
presence of natural resources, the climate, cultural characteristics
influencing things such as entrepreneurship, labor skills, and
organizational capacity.
So there is a basis for trade between developing countries, and
between industrialized (which are more effficient in the production
of all commodities) and developing countries.
Developing countries should participate in trade and use their
resources, which otherwise would remain idle. They would buy
many consumption, and other goods from the developed countries.
Ricardo
He argued that benefits from trade resulted
not from the employment of underused
resources, but from the more efficient use
of domestic resources which come about
through specialization and producing
according to comparative advantage.
John Stuart Mill
He pointed out the dynamic effects of trade, such as
acquiring foreign capital and technology, the impact of
trade on allocation of resources, and the accumulation
of savings.
Also contacts with foreign countries and cultures could
help break the binding chains of tradition, alter wants,
and stimulate enterpreneurship, inventions, and
innovations.
There could be some negative consequences of trade,
such as, producing goods that have few links with the
rest of the economy, producing export goods at the
expense of goods required for the domestic needs, and
dual economy.
Developing countries
They complain that they trade at a
disadvantage with powerful industrialized
countries.
The terms of trade is determined by
developed countries and for the benefit of
them.
As a result trade makes poor countries
poorer, and rich countries richer as the
international statistics show.