trade
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Lecture-2tradeweek2.pptx2 Should Nigeria Strive for Self-Sufficiency in Food?
International Trade
John McLaren
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2.1 A Presidential Agenda 2.2 The Comparative Advantage Argument Formalized: Introducing the Ricardian Model 2.3 Autarky in the Ricardian Model 2.4 Free Trade in the Ricardian Model 2.5 So What Actually Happened? 2.6 Additional Insights from Ricardo’s Model
Most countries are net food importers.
Particularly true of lower-income countries.
i.e., “dependent on world market for food”
Many commentators view this as a problem per se:
Leads to call for self-sufficiency in food.
E.g., Nigeria
Approximately 80% “self-sufficiency ratio” in cereals.
Pres. Obasanjo (1999-2007) outspoken booster of the idea.
Ways in which Nigeria has pushed toward food self-sufficiency.
Loans to farmers.
Subsidized inputs.
Underwriting agricultural research -- new crop hybrids.
Tightly restricting, even banning, cereals imports.
E.g., rice and wheat import ban, 1986-95.
Arguments for import ban?
Possible national security/international bargaining power argument in some cases.
E.g. Risk of siege, boycott, blockade.
Perhaps applicable to medieval city states; Cuba; Former Soviet Union; 19th century Hawaii.
Probably not relevant to Nigeria.
Arguments against.
Biggest one: Comparative advantage.
Import ban could harm Nigerian food security by depressing real income.
Idea: Prevents benefits of specializing in what farmers can produce most efficiently.
We will first examine comparative advantage
models in detail.
According to these type of models, countries are
different, and any difference between two
countries – in technology, climate, culture,
factor proportions, consumer preferences, for
example – can lead to opportunities for mutual
gain from trade.
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In order to formalize the comparative advantage
argument, we will use the classic formulation by 19th
century British economist David Ricardo.
According to the Ricardian model, technological differences across countries is the reason for trade.
Before analyzing it in more detail, let’s see some brief
history of how this theory is developed.
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2. Brief History
The Mercantilists
Mercantilism: was the dominant attitude toward international trade in the 17th and 18th centuries.
Gold and silver served as money.
Symbolized a nation’s wealth.
Nations encouraged exports and restricted imports as a method to improve inflow of gold and silver
Mercantilists assumed trade was a zero-sum game (like a poker).
Meaning: It could not be mutually beneficial to all parties.
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Absolute Advantage
Definition: A country has an absolute advantage in a commodity if its workers are more productive in producing that commodity than workers in the other country.
Adam Smith (1776) ‘The Wealth of Nations’
By assuming that each country could produce some commodities using less labor than its trading partners, he showed that all parties could benefit
Trade improved the allocation of labor, ensuring that each good would be produced in the country where the good’s production required the least labor.
Result would be a larger total quantity of goods produced in the world.
Trade would be a positive-sum game.
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Comparative Advantage
Definition: A country has a comparative advantage in a commodity if its opportunity cost in producing that commodity is lower than the other country’s.
Opportunity Cost (of commodity-1): The amount of commodity-2 that must be given up in order to obtain one additional unit of commodity-1.
David Ricardo (1817) ‘Principles of Political Economy and Taxation’
Illustrated that trade's potential benefits to the world were more than even Adam Smith imagined
Paul Samuelson: ‘Comparative advantage is the best example of an economic principle that is undeniably true yet not obvious to intelligent people’
So, if you understand it by the end of this chapter – you have come a long way in your study of international trade!
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Understanding the comparative advantage argument: the Ricardian model.
Two countries: ‘Nigeria’ and ‘America’ (North + South).
Two goods: Rice and cocoa.
130 million people in Nigeria and 390 million people in America (everyone is a farmer).
1 farmer in one season in Nigeria can produce 1 unit of rice or 3 units of cocoa.
1 farmer in one season in American can produce 2/3 units of rice or of cocoa.
Not a realistic picture of either economy.
We’re ignoring Nigeria’s oil, for example.
But the point we’re making would emerge in a much more complicated, realistic model as well.
Opportunity cost.
Opportunity cost of producing rice in Nigeria is 3 units of cocoa.
Opportunity cost of producing rice in America is 1 unit of cocoa.
Opportunity cost of producing cocoa in Nigeria is 1/3 units of rice.
Opportunity cost of producing cocoa in America is 1 unit of rice.
Important (though obvious) observation:
In each country, the opportunity cost of one good is the reciprocal of the opportunity cost of the other good.
Comparative advantage defined.
The country with the lowest opportunity cost of producing a good has a comparative advantage in that good.
Therefore, Nigeria has a comparative advantage in .....
....cocoa.
and a comparative disadvantage in ....
....rice.
Crucially important (if obvious) observation:
A country must have a comparative advantage in something.
A country can’t have a comparative advantage in both goods.
Due to the reciprocal property of opportunity costs.
Contrast with absolute advantage.
A country has an absolute advantage in a good if its workers are more productive in producing it.
Who has an AA here, in what?
Yes, Nigeria and in both goods!
Note: A country certainly can have an AA in both goods, or an absolute disadvantage in both goods.
To anticipate:
We’ll see that comparative advantage is what determines the pattern of trade.
Absolute advantage has no importance at all for the pattern of trade.
But absolute advantage is important for the international distribution of income.
Notion of autarky.
In this model, banning rice imports is effectively the same as shutting down trade completely.
This is a thought experiment called “autarky.”
Comparing autarky with free trade allows us to analyze what trade does.
First, we’ll analyze autarky, then trade, and compare the two.
Autarky equilibrium.
First, look at supply behavior: Relative supply of rice (quantity of rice)/(quantity of cocoa).
As a function of relative price of rice (price of rice)/(price of cocoa).
Gives RS curve.
then all Nigerian farmers will
produce cocoa. In other words:
Next, need relative demand.
Assume that every consumer spends half of her income on rice and half on cocoa.
Equivalently -- Cobb-Douglas utility function with equal weights on the two goods.
This implies that (quantity of rice demanded)/(quantity of cocoa demanded) = 1/(relative price of rice).
This gives the RD curve.
Autarky equilibrium.
In autarky, RS must equal RD in each country.
Yields relative price of rice = 3 in Nigeria.
Budget line for Nigerian farmer.
Income equals 3 times price of cocoa, or 1 times price of rice (per growing season).
Cocoa-axis intercept = income/price of cocoa = 3.
Rice-axis intercept = income/price of rice = 1.
Analysis for America is parallel.
Free trade.
Now, assume that there are no impediments to trade between the two countries.
No tariffs or transport costs: One world price of rice, one world price of cocoa.
Now, we need the world RS curve and RD curve.
The RD curve is easy, since it’s the same as before. Now for the RS curve.
What does trade do to human well-being?
Can tell by looking at budget lines, before and after trade.
The effects of trade: Nigeria
The effects of trade: Nigeria
The effects of trade: Nigeria
The effects of trade: America
The effects of trade: America
The effects of trade: America
Important point about trade:
Utility of all consumers in both countries is higher under trade.
Higher real incomes due to efficiency benefits of specialization along the lines of comparative advantage.
EVEN nutrition is better in Nigeria, although it loses its cereals sector.
(Food self-sufficiency is now 0%, but they eat better.)
What has happened to food consumption in Nigeria?
Budget line has shifted out: Positive income effect
Since rice is a normal good, this pushes for a rise in rice consumption.
Relative price of rice has fallen: Substitution effect.
This also calls for a rise in rice consumption.
Therefore:
-- although Nigeria has lost its rice sector entirely,
Nigerians eat more rice and are better nourished.
So what actually happened?
Period of ban was 1986-95.
Part of Nigeria’s Structural Adjustment Program.
One observation: Huge increase in consumer prices for food.
Food consumption and nutrition: More complicated.
Does this mean the import ban improved nutrition?
Note: danger of post-hoc reasoning.
“A happened; then B happened; therefore A caused B.”
In our case, “The government banned rice imports and then nutrition improved – therefore, rice import bans improve nutrition,” is a post-hoc reasoning.
Many other things were going on at the same time.
Other (more likely) explanations:
Macroeconomic recovery.
Improvement in literacy.
Government programs to help small farmers.
Huge improvement in productivity in cassava (an important root crop).
Question of interest is the counterfactual:
What would have happened to nutrition if everything else had happened as it did but the cereal ban had not occurred?
Bottom line for exercise:
Comparative advantage provides huge argument for allowing countries to specialize in response trade.
Strong argument against national self-sufficiency (in food or anything else).
Where We Are
Another Example
Assumptions
Two countries:
Home (denoted by H)
Foreign (denoted by F)
Two goods:
Wheat (denoted by W)
Cloth (denoted by C)
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Environment: Perfect competition prevails
Implies that price of each good will equal its marginal cost of production.
Marginal cost: The change in total cost that is due to the production of one additional unit of output.
Transportation costs are zero.
Any barriers to global trade are ignored.
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Preferences
Assume that every consumer in each country has identical preferences and spends half of her income on wheat and half on cloth.
Equivalently -- Cobb-Douglas utility function with equal weights on the two goods:
Hence:
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Production Technology
Labor is the only factor of production.
Each country has a fixed amount of labor available, which is fully employed and homogeneous within the country.
Labor is completely mobile among industries within each country and completely immobile between countries.
Total labor supply available at home: L = 25
Total labor supply available at foreign: L* = 75
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In Home: One worker can produce 4 bushels of wheat or 2 yards of cloth.
In Foreign: One worker can produce one bushel of wheat or one yard of cloth.
The Marginal Product of Labor is the extra output obtained by using one more unit of labor.
In Home: MPLW = 4, MPLC = 2
In Foreign: MPL*W = 1, MPL*C = 1
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Opportunity Cost
Opportunity cost of producing Wheat in Home is ? yard of Cloth.
Opportunity cost of producing Wheat in Foreign is ? yard of Cloth.
Opportunity cost of producing Cloth in Home is ? bushels of Wheat.
Opportunity cost of producing Cloth in Foreign is ? bushel of Wheat.
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Comparative advantage
Therefore, Home has a comparative advantage in .....
....Wheat.
and a comparative disadvantage in ....
....Cloth.
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Contrast with absolute advantage.
Who has an AA here, in what?
? has an absolute advantage in Wheat.
? has an absolute advantage in Cloth.
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Home
Home
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Autarky equilibrium
First, look at supply behavior: Relative supply of wheat:
(quantity of wheat)/(quantity of cloth).
As a function of relative price of wheat:
(price of wheat)/(price of cloth).
Gives Relative Supply (RS) curve.
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then all Home workers will
If 2PW < PC
produce cloth. In other words:
then workers are indifferent.
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RSH
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Next, need relative demand.
We know that
This implies that (quantity of wheat demanded)/(quantity of cloth demanded) = 1/(relative price of wheat)
In other words:
This gives the Relative Demand (RD) curve.
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RD
Note that this curve is
rectangular hyperbola
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Autarky equilibrium.
In autarky, RS must equal RD in each country.
Yields relative price of wheat = ? in Home.
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RSH
RD
Autarky equilibrium in Home
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Home worker’s autarkic budget line
Cloth, QC
Wheat, QW
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4
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2
Budget line
Indifference curves
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The tangency of the home worker’s budget line and the home worker’s indifference curve gives us how much each worker in autarky consumes from each commodity.
Since each worker is identical and there are 25 workers in Home, the total production and consumption of cloth and wheat are given by:
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RSH
RD
Autarky equilibrium in Home
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RSF
RD
Autarky equilibrium in Foreign
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Foreign worker’s autarkic budget line
Cloth, QC
Wheat, QW
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Indifference curves
Budget line
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What is the total production and (therefore) consumption of cloth and wheat in Foreign under autarky?
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RSF
RD
Autarky equilibrium in Foreign
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Free Trade
Now, assume that there are no impediments to trade between the two countries.
No tariffs or transport costs: One world price of wheat, one world price of cloth.
Now, we need the world RS curve and RD curve.
The RD curve is easy, since it’s the same as before (since each consumer = worker in both countries has the same preferences by assumption-4). Now for the RS curve.
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RSWorld
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RSWorld
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Both countries produce only Cloth
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1
Home produces Wheat
Foreign produces Cloth
RSWorld
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RSWorld
1
Both countries produce only Wheat
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RSWorld
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RD
Free Trade Equilibrium
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Effect of Trade on Home worker
Cloth, QC
Wheat, QW
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4
1
2
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1.5
Income (which is 4*PW) divided by
the price of cloth (which is PC):
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Effect of Trade on Foreign worker
Cloth, QC
Wheat, QW
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Income (which is PC) divided by
the price of wheat (which is PW):
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Additional Insights:
The role of absolute advantage
Absolute advantage has NO ROLE AT ALL in determining the pattern of trade.
On the other hand, absolute advantage determines the international distribution of income (= wage in this case).
Home real wage is given by:
4 bushels of wheat or
Foreign real wage is given by:
1 yard of cloth or
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Hence, home workers earn more than foreign workers as measured by their ability to purchase either good.
This fact reflects Home’s absolute advantage in the production of both goods.
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The effect of size differences
Suppose that we increase the size of foreign work force from L* = 75 to L* = 80 . As we do so, the maximum amount of cloth that the foreign economy can produce increases. As a result, the world relative supply curve (and thus the free trade equilibrium) changes as follows:
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RD
RSWorld
RSWorld