opportunity

lnternatlonal Economlcs, I 5th Editlon 29

Chapter 2 The Brrsic Theor''* Lrsirr'g l)emtnul trntl Srrpplr i !

the economics of emigration and irnmigration and the roles.of global cornpanies in the

trans fer of resources, includi n g technol ogy, between countnes'

We are embarking on an extended exploration of international trade' The first box

in this chapter, "Traie Is Important," provides intbrmation that sets the stage tbr our

journey. Tire chapter's second box, "The Trade Mini-Collapse of 2009," shorvs how

trade declined much more thatr general economic activity during the global financial

and economic crisis.

-ilriril.A ftis A s p', 5 u Pj&Y-

Let's review the economics of demand and supply before we apply these .tools-to examine international trade. The product that weuse as an example

is motorbikes' We

assulre th.1t the market for motoibikes is competitive. Although the analysis appears

to be only about a sir,gte product (here, motoibikes), it actually is broader than this'

Demanders rnake declsions about buying this product instead of other products'

Suppliers use resources to produce this product,,ind the resources used in producing

motorbikes are not available to produce other products. What we are studying is actu-

ally one produ$ relative to all other goods and services in the economy'

Demand what determines how much of a product is demandedl A consumer's

problem is to get

as much happiness or well-being (in economists' jargon, utility) as-possible by spend-

ing the lirnited income that the consumer has avlilable. A basic Oeterlin111:]-1t: rnuch a consgmer buys of a product is the person's taste,-preferences, or

oplnlons oI

the product. Given the person's tastes, the price of the product (relative to the prices of

other proclucts) also has a major influence on how rnuch of the product is purchased'

At a liigher price fbr this proiuct, the consumer usually econotnizes and reduces the

quantit purihased. Anothlr major influence is the consumer's income' If the consum-

er's income increases, the consumer buys more of many products, probably including

rnore of this product. 1Th* .onru*er buys more if this product is a normul grlorl' This

is not the only possibiiity-quantity purihased is unchanged if demand is independent

of income, and quantity goes down if the prodrrcl is an infb,rior good. In this text we almost always exatnine oily normal goods, as we consider these to be the usual case')

How much the consumer demands of the product thus depends on a nutnber of

int'luences: tastes, the price of this prodttct, the prices of otherprodttcts' and ittcome'

We rvould like to Ue aUte to picture demand. We do this by tbcusing on one rnajor

determinant, the product's price. After we add up all consumers of the product, rve

use a market demand curve like the demand curve for motorbikes shown as D in

Figure 2.lA.r We have a strong presumptioll that the demand curve slopes downward'

Ari increase in the product's priie (say- from $1'000 per motolbike to $2,000) results

in a decrease in quaptiry demanded (iom 65,000 to 40.000 motorbikes purchased per

year). This is a mbvement along the den1and curve because of a change in the product's

prite.'f he increase in price t"*Iult* in a lower quantity.demande{ as people (somewhat

ieluctantly) switch to substitute products 1e.g., bicycles). or make do with less of the

,nor. **p*nsive product (fbrgo birying a second motorbike of a diffbrent color)'

,The equation for this demand curve is Q, 90.000 ' )sP(ot P ' 3,600 O.04Q"')

a^o ?or

| 1{,,;1;;1*] '. 'Demand and

Supply lor Motorbikes

iii Part One Thc Tficrn rf Intcrnrrtirrntrl Titulc

A. Demand

Price (:'i,lririi

B. Supply

Price ai,':litj

2,000

1,000

2,000

1,000

400

40 6s Quantityii:rr 1:i :,r':.,1 The market dernand curve for motorbikes slopes downward. A lower price results in a larger quantity denranded. The market supply curve for motorbikes slopes upoard. A higher priJe results in a larger guantity supplied.

How responsive is quantity dernanded to a change in pricel One way to measure responsiveness is by the slope of the demand curui lactually, by the inverse of the slope, because price is on the vertical axis). A steep slope indicates low responsive- ness of quantity to a change in price (quantity doeJ not th^nge that much). A flatter slope indicates nrore responsiveness. The slope is a measure Jf responsiveness, but it can also be misleading. By altering the units used on the axes, the demand curve can be made to look flat or steep.

. A measure of responsiveness that is "unit-free" is *litsritlt,,, the percenl changein one variable resulting fiom a I percent change in another variable. T6e i,nii.;eL:s?icity of rir*nrarrr{. is the percent change in q-uantity demanded resulting from a I percent increase in price. Quantity falls when price inqeases (if the dernaid curve slopes downward), so the price elasticity of demind is a negative number (though we often drop the negtttive when we talk about it). lf the priceilasticity is a targe 1"nega_ tive) number (above l;. then quantity demanded is suistantially responsiv. t-o u p,i.. change-demand is elastic.lf the price elasticity is a small lnegativey number lless than l), then quantity demanded is not that responsive-demand is inelustic.

In drawing the demand curve, we assume that other things that can influence demand-income, other prices, and tastes-are constant- If any if the other influences changes, then the entire demand curve shifts.

Consumer Surplus The demand curve shows the value that consumers place on units of the product, because it indicates the highest price that some consunler is willing to pay ior each unit. Yet, in a conrpetitive market, consumers pay only the going marfet piicl for ttrese units. Consumers who are willing to pay more blnefii fronibuy-ing at the nrarket price. Their well-being is increased. and we can measure how much it increases.

To see this, consider first the value that consumers place on the total quantity of the product that they actually purchase. We can measure the i,alue unit by unit. Foi the

.;:

;i.

l:

:i.

lnternational Economlcs, 1 sth Edltlon

Chapter 2 Thc Uusic Thr:orr U-ring l)ernorrl and Srrpplr i i

first motorbike demanded the demand curve in Figure 2.1A tells us that solnebody would be willing to pay a vefy high price (about S3,600F-the price just below where the demand curve hits the price axis. The demand curve tells us that somebody is will- ing to pay a slightly lower price fbr the second motorbike, and so on down the deniand curve tbr each additional unit.

By adding up all of the demand curve heights for each unit that is demanded, we see that the whole area under the demand curve (up to the total constrmption qtrantity)

measures the total value to consumers from buying this quantity of motorbikes. For instance, for 40,000 motorbikes the total value to consumers is $ I l2 million, equal to area c + t + u.This amount can be calculated as the sum of two areas that are easier to work with: the area of the rectangle t + u formed by price and quantity, equal to $2,000 X 40,000, plus the area of triangle c above this rectangle, equal to (l/2) X (S3,600 - $2,000) X 40,000. (Recall that the area of a triangle like c is equal to one-half of the product of its height and base.) This total value can be measured as a money amount, but it ultirnately represents the willingness of consumers. if necessary. to forgo consuming other goods and services to buy this product.

The marketplace does not give away motorbikes for fiee, of course. The buyers rnust pay the market price (a money amount, but ultimately the value of other goods and services that the buyers must give up to buy this product). For instance, at a price

of 52,000 per motorbike, consumers buy 40,000 motorbikes and pay $80 million in total (price times quantiry, equal to area t + u).

Because many consumers value the product more highly than $2,000 per motor- bike. paying the going market price still leaves consumers with a negguin in eco- nomic well-being. The net gain is the difference between the value that consumers place on the product and the paynent that they must make to buy the product. This nef gaifi is called ':firtsiirriffr s{-{r'ir'iiir, ffte increase in flre economic wefl-being of consumers who are able to buy the product at a market price lower than the high- est price that they are wilting and able to pay for the product. For a mat*et price of $2,000 in Figure 2.1A, the consulner surplus is the difference betweett the total value to consumers (area c + t + u) and the total payments to buy the product (area t + u). Consumer surplus thus is equal to areac. the area below the demand curve and above the price line. This contribution to the econornic well-being of consumers through the use of this market is $32 rnillion, equal to (l12) x ($3,600 - 52,000) x 40,000.

A major use of consumer surplus is to measure the impact on consumers of a change in market price. For instance, what is the effect in our example if the market price of motorbikes is S1,000 instead of $2,000'l Consumers are better off-they pay a lower price and decide to buy more, How much better offl Consumer surplus increases frotn a smaller triangle (extending down to the 52,000 price line) to a larger triangle (extending down to the $ I ,000 price line). TIrc increu.ra in consumer surplus is area t + (t. This increase can be calculated as the area of rectangle r, equal to (52,000 - S1,000) X 40,000, plus the area of triatrgle r/, equal to (l12) x (52,000 - S1,000) x (65,000 - 40,000). The increase in consumer surplus is 552.5 ntillion. The lower market price results in both an increase in economic well-being for con- sumers who would have bought anyway at the higher price (area t) and an increase in economic well-being for those consumers rvho are drarvn into purchasing by the lower price (area r/).

31

32 lnternatlonal Economics' Vol. I

3 }5?C.;rrt i:r l.sn '.-:.*-:'-- l'.-;.

To understand stories about how trade works, it is useful to know some of the key facts about trade. A good start is a broad overview of the products traded and trade's growing importance.

How large is international trade? What prod- ucts are traded? The table below shows exports by major product categories, for the world over- all and for two broad economic groups of coun- tries, the industrialized (or devetoped) countries and the developing countries.

Exportl ?qge lbjfrions or!-s. oglJal) ,

Total Primary products

Aglricultural Fuels

Ores

Manufactured products Chemicals Machinery and transport equipment Textiles and clothing Other

Services

ln 2009, world trade was nearly $16 trillion, with the industrialized countries contributing about three-fifths of world exports. Most goods are traded across national borders, as are many services, including transportation, computer and information services, as well as insurance, consult- ing, and educational services. For the world, a little more than half of trade is in manufactured products, with the rest of trade split about evenly beWveen primary products and services. By com- paring the details across the columns, we can see

l. E I* s til

#

T.

if * $ * # s ? $

World

1s,753 3,570 1,1 50 1,741

679 8374 1,433 4,243

581

2,113 3,415

lndustrialized co':rllri9s

9,369 1,512

698 482 333

5,'106 1,093 2,524

201 1,288 2,420

Developing Coultries

6.384 2,058

452 1 ?qo

346 3,264

34A 1,719

380 825 s95

Note: Sum of primary products, manufactured products, and iervices does not equal total because of a small amount of unclassified goods.

Source: UNcrAD, UNCTADStat.

lirl.: ' tr:r!,:.

i-r. r'l

Supply What deternrines how much of a product is supplied by a business firm (or other pro- ducer) into a marketl A firm supplies the product because it is trying to earn a profit on its production and sales activities. One int'luence on how much a firm supplies is the price that the firm receives ibr its sales. The other major influence is the cost of producing and selling the product.

For a competitive firm. if the price at which the finn can sell another unit of its product exceeds the extra (or marginal) cost of producing it. then the firrn should supply that unit because it makes a protit on it. The firm then will supply units up to the point at rvhich the price received just about equals the extra cost of another unit. The cost of producing another unit depends on two things: the resources or inputs (such as labot capital. lan4 and rnaterials) needed to produce the extra unit and the prices that have to be paid for these inputs,

33

Chapter 2 Thc ll*iic Theo4' Uslng Dewrnd arrrl SrrPPl) 'i i

that the broad pattern of exporting by'thq ind.us'

iriiiit.J countries has some differences flo.t,,th'

ilffi tJi J.uuropins countries' ll*:l'l',t1:td i"rnailo export relatively less of primary

products'

.rp"ii"irvlr.rs and orei' ln manufactu.red prod-

u.[t, inOutttiulized countries expqrt relatively more

"i ln"r"i.tft, while developing countries.export

rel-

.ii".rv *"i. of textiles and ctothing' lndustrialized

.or^iti.tit. relatively strong in'exporting 5:.t"1tu::' ;;' ;ili;,this kind eJ observatlon-looking.at ii.Oal u,tott product categories--€s

we examlne

why couhtries trade with each other'

How important ts international'Uade in the

*r""r i.t ii uuiio* countries? iThe s1o1j tlule

E :p:I* "t: 1v"19"1i:11i;;:-"t5: 91 9?l** - ",,..-_ _-_

in this box examines ono:Irl€aSur€ ot-tfe itnlo"

tance of trade to a country the ratio of theJum of

;Hft:t *.rl-,'udu (exports plus imports) to the ;ffi;; gtri oottnic Product (GDP' a ::l9'd ffi';i'""";,;iins thesize of a country's

economv)'

These measures are not completely comparable

i;;;;;'-ano: imPorts measure lyll-::1": varues'

,;'nif" dOp measures value added).

Still, they pro'

;#";;t;nJi" *tY of comParins the impor ir"i"""i-aiio.tacross time and across

countri es' '"t'i'"r" iiu-i t.* observations abo.ut wna111; *. i" inii lable' First' for each of the :ol:tt'"t iil*lt i^'in"-i.ir. t.ni tor most other countries)' ;;;ffi;l trade- has

:become more important'

;;;;;;;l;;;;asine impoitance is one part o{ the

ffi"cl's ;i gi;uii'uiion--in which risine inter-

I"iio*r tr*sactions increasingly link together ;r,"i'ljo-*en relatively separate national econ- ,ffi;';;io-.ttuo" tends to be more important il'ff;;ls-'witn smaller economies (such as i"""i;'t"o benmark) and somewhat le* impor- ;r f*;;ry large economies (such as the United ,;;;;;; iupin)' rhird, both china and rndia l;ilil; i'-o' n"ios mostrv :roj'9 P-T:' t" .u.n"rnor" open and involved' The experiences

"i iili"l1"o lndia in the past several decades

are

r.-uaf,"i.f ot. to the approach we will.take^in Part

i:i*.si.tg a national economv :vith 1:'} trade

;";';;; diawins out what.wilt happen when the country opens uP to free trade'

United States Canada lapan France United Kingdom Australia Denmark Lhrna lndia Korea

Brazil

1 1.1

42.4 20.3 31.1 43.6 25.8 s7.3

5.3 8.0

37.7 14.9

25.1 59.1

24.8 48.0 57.8 40.3 90.9 47.1 45.8 9s.9 22.6

**--lif",.*"iir.ur lt-*tv i*tt lo unutionul Fi nunc isl S'/'irnd!'

we would like to be able to picture supply, and we do so by focusing on

how the

price of the product ;f;; quantity '-eifiil' etttt *t add up all producers of the

product. we use . *;;;il;piy *'*'ri;;ht supp! cttrve S for motorbikes in

ilu.* i.n,.*: -,:j', p'.,,i'i'J ll"' ry *#tJ'iT;; ;';.nU1y,111;tJil?H',1: il-"'xfr'mffi i'.?;*T,8Jf :"'ffi ffi ;;#i!:::*::iu"J*ropervear) Thisisamovementalongthesupplycurve.[nacompetitiveindustry,anadditional motqrbike is suppliJ ii'tfr. pri.. i.celueJ covers

thi extra cost of producing and

selling this additionri*"ii. irroditional unitr.un be produced only at a rising extra

or marginal cost. then o ii,grr* price is ..;"ty to draw out additional quantity sup-

plied. The supply .,,*-'Jtn' out to be the 'u*t u' the cutve sh'owing the nrarginal

tost ofproducing each unit'

/Tlre equation for this supply curve is Q' 10'000 | 25P br P' 400 r 0'04Q')'

lnternatlonal Economlcs' 15th Edltlon

34 .lef..aiicflal :{5rr53r(t - i'c '

Part One fhe Tficon of lnrt'nr,rtiurr,rl Tiralc

The global crisis that began in 2007 and deep- ened in late 2008 spread well beyond financial markets. The crisis caused the'first large-scale downturn in world trade in more than half a century ending decades in Which, nearly year after year, international trade grew faster than world productioni FirsL let's look at the growth of trade over decades; then we'll examine the unexpected m ini-collaPse.

The diagram shows world exporti' of goods and services and world production of goods and services. Each is adjust€d for price, ihflation, so we are seeing what happened to the quantity or volume, Each is measured as an index number, with its value set,to be equal to 100 in 1960. Using the indexvalues; we can see how each has changed during the past half century'

Lookkrg at the entire time period, the explo' sive growth of world exports is clear. Since 1960, world production has, increased by a factor of 6 (from the initial l00 in 1960 to nearly 600 in 2010). Since l960,'woirld trade has ihcreased by a factor of over 19, lhis is another way to see what we highlighted in the previous box-the increas- ing importance of trade.

The diagram also shows the surprising recent decline of world trade. Starting in late 2008, world trade declined by about 11 percent. The trade decline was much larger than the 2 percent

decline in world production. Why was the trade decline so large? Two specific features of current trade patterns matter. First, a relatively large part of trade isrin durable goods like machinery and automobiles. ln a crisis'driven recession, purchases of durables are very likely to be post- poned or canceled, and trade in these products collapses. Second,, trade increasingly' involves global supply chains in which'materials and com- ponents are traded across borders before 'final assembly. Thus, a decrease of; Sat, $100 in sales of a final good can result in a decrease of several hundred dollars in the cumulated value of the trade in materials, components, and the final good itself. For both of these reasons, the crisis- recession decline in world production and final sales led to a magnifiedrdecline in woild trade.

' The collap.se in world trade in,2009 resur. rected memories of the Great Depression of the 1930s, when'trade declined by 25 percent during ,6. 16ur yeais from 1929to 1933. Fortunately for

How responsive is quantity supplied to a change in the market price? One way to

measure reiponsiveness is by the slope of the supply curve. Quantity supplied is more

responsive if the slope is fiatter. A "unit-free" measure is the i;rirr: +l;3";1i1ilv r-"rf lupply-the percent increase in quantity supplied resulting from a I percent increaie in rnarket price. Quantity supplied is not that responsive to price-supply is inelastic-if the price elasticity is less than 1, Quantity supplied is substantially responsive-supply is elastic-if the price elasticity is greater than I'

in drawing the supply curve, we assume that other things influencing supply are constant. These other things include the conditions of availability of inputs and the technology that determines what inputs are needed to produce extra utlits of the prod-

uct. Ifany ofthese other influences changes, then the entire supply curve shifts.

Producer Surplus The supply curve shows the lowest possible price at which some producer would be willing to supply each unit. Producers actually receive the going market price for these units. Producers who would have been willing to supply at a lorver price benetit tiom selling at the market price. Indee4 we can measure how much their well-being increases.

rn o rllthh F

Source: World Bank. Wortd Development lndicators'

the world, and {or us, the recent decline in trade was a mini-collapse, and robust trade growth

lntematlonal Economics, I 5th Edltlon

Chapter 2 The l}uic Tfieory Using l)rnr'rntl rrnd '\r4rplr i l

returned beginning in mid'2009 and continuing in 2010.

35

oo il o r.o (tl

xo :ct

1,900

1,700

1,500

1,300

1,100

| 900 700

500

300

100 83('r 6lo lltco coor oro(oOl lfl o <)Foor\tN

To see this. consider first the total (variable) costs of producing and selling the total

quantity that is actually supplied. we can measure this cost unit by unit' For, the tirst

motorbike supplied into tt'te rnarket, the supply cufve^in^Figure 2.1B tells us that some

producer would te *itilng to supply this foiabout $400, the price iust above where

the supply curve hits the axis. Thii amount jttst covers the extra cost of producing and

selling this first unit. The supply curve tells us that some producer is rvilling to supply

the second motorbike for a itigtrtty higher price, because the extra cost of the second

unit is a little higher, and so on. By adding uf all of the supply curve heights for each unit supplied-w9 {nd tfal

the whole area under the supply curve (up to the total quantity supplied) is the total

cost of producing ancl selling'this quantity of motorbikes. For instance' the total cost

of producing f S$OO motorbfkes is equal io area ; in Figure 2.1B^ This total cost can be nreasured as a nloney amollnt. buf tbr the whole economy it ultirnately represents

an\,ii.ii.1r.j;iiririi:; r-<i",i--the value of other goods and services that are ngt produced

because resources are instead used to produce this product (motorbikes)'

The total revenue feceived by producers is the product of the nlarket price and,tltl

quantity sold. For instance, at a price of S1.000 perrnotorbike-, producers sell l5'000

motorblkes, so rhey receive Sl5 inillion in total reventte (equal to area e * z\.

Volume of World Trade and World Production. 1960-2010

i l

36 ,,i flt.rlibn iE mdt*s-vd'I

Part One

: ,.,iliii: i./ The Market for

Motorbikes: Dernand and

SuPPIY

The Theory oi Intenrtttirrnal ?irtle

Because producers would have been rvilling to suppq

siojle motorbikes at a pnce

below 51.000, "tti"i"gittt glYrs m:;;ffi;; "itt

rinits results in a net gain

in their ..ono*,,-*rii--u.i"e. r1.-1r"'g.i"'itlte difference between

the revenues

received and the #;;j;;;?red. rhis ?fi'*t'"'lF;1 lxcrlrtrer titrl"lus'

the

increase ln tt e ecolio"rii.'*.iil.i,u of p,"oitttt who are able to sell

the product at

a market prt.. niJi,.i ttran ttre lowest p#. ;#;;"fOliu"t Otawn out

their supplv'

For a marke, or,.?"oi ti,iioii r" n*#;.;u;:';;;;il.'..r surDlus is the

difference

between total revenues (area e *.2\u"l;;;';rt, (ur.".e' Producer

surplus is thtts

equal to area e'it-*u uuove the '"p;i;';;; and !9r9y'

the urice line' Producer

surplus in this.or. i, i+.s *'rion,.o;i't";iiiil-iisi,o9o - d+ool x l5'000'

A nrajor ",. "i p,"0".", **pru, i- i" ;;;;'" ihe impact on

producers of a change

in market pri.r. iJ.i-"1*.., r^ir.,.ii, trc';ffiiiiiii d:!-:

p'iit it $2'000 instead or

S1,000? noOu.*r-r'ur;;ffi of-,fr.V r...ive a higher.price and decide

to produce

u na,. * *o,, p,oi""; ;ih r': ::*::i.l[fr ,lr'U','j * 11:f, [Ti'U$i iil: ii. Sf

'OOO price line) to a larger trranl

in.r.e,se,n proour"i'r;-rpil;i, .quur io"ol*l';;;, ; tsz'boo - sl'b00) x l5'000

plus (l/2) x ($2.fi' : iitddi" too.b"o6'- ii,oooi' *r.,ithLquals

s27'5 million' rhe

higher market #; *J; in'both an-increase in economic *ttt-ueing tbr

producers

who would t ave suppfied anyway u,.rt. io*., price

(area w) and an increase in well-

being for p*d";;#;i:il;iil;'al units supplied (area r')'

A National Market with No Trade

re nroduct and s in Fi

tf D in Figue 2.tA represents the ,;;r;;;demand tor the orodttct

and s in Figure

2.lB represeno-ir,.-ruii rnal supply, il; .o*uint tryt^eitit. the single

picture for

the national ,urf.., for this product, fiffi;;rieu".z'z' ritt'tttt

is no international

trade, then .0"iilffir""*,li* I 'n. pn.. ti *1i".rt 111*tt'

clears domesticallv'

with national quantity demanded.quui* ouiional quantiry'*ppfitO'

In Figure 2'2 this

:-.

i

QuantitY 1; | ;;,. , ..:; r-r{i: i

tr:ffi:;**;;;'* surPlus equal to area

/r'

^-'l and crrnnlv curves' In this exanrple'

rhe market for rnotorbikJcan be pictured.u:lf:tfi:r1::lt:"Xlfi:'":ffies eqrr'ibrium at a

;l'.W n; ;::':*$t::ll[iil'$::t'1 iil ;; "4"" I *a p u rc h as e cr d u r i n g t he t i rne

period (e e, a vear) u*"lll::::::i:':l-; '""'Jil;J;;;;;;;J'"rprus eqtrar to area c and

lnternatlonal Economlcs, I 5th Edition 45

\Uhv Everybody Tiades: Comparative Advantage Cihapter 2 exarnined international trade focusing on a sirtgle product. That analysis

helped allswer some ntajor questiotts about international trade but only indirectly

adciressed some others. For an industry with expanding production, where do the addi-

tional resottlces come ft'orn'? For a shrinking indnstry, rvhat happens to the l'esotlfces

1o longer needecl'l If consunrers increase or decreasc the quantity demancled of one produci, what effect does this have op denrald fbr other products'?

Full analysis of international tracle requires consideration of the entire economy. yet the entire ecgnomy is very conrplex--it corrsisfs of thousands of products arrd the

I'arious resogrces peeded to produce them. Fortunately, we can gailt uiajor insights by

consiclering an econonty conrposed of iust two products, For internatiottal trade. otle

prodlct .on b* exporteci arrd the other inrported. This tu,o-prodtrct econonly caPftlres

an essential t'eature of international trade: A country tends to be a net exporter of sottle

products and a net importer of others. 'Ihis chapter begini our exanrination of the geueral equilibriurn of a two-prodrrct

ecolrolnli. We fbcui on thc. first of our ti-rur basic trade cluestions: Why do crortntries tracle'l Iir fact. rvhy cloes everybody-everv c<ltttrtry as well as every person-find it u,o;thwhile to procluce and export (sell) some things and to intport (buy) other tlrings'l

\\t proceecl in three steps: L We star.t q,ith Adam Snrit6's original explanation. rvhich he developed as he battleti

rrercitrtti list thinking. 2. We then see that Davicl Ricardo s principle of comparative advantage allows Lts

to explain tracle better than most people's inruition and better than Adant Srnith's

ori-ei nal explanatiort.

3. We begin our cleveloprnent ol tools fbr arnalyzing a two-product ecottotlry.'fhe pr.oduction-possibility curve slnnnrarizes national production capabilities. We

can usd it to shoiv hirv trading basecl on conrparative advantage catl etthance tlte rvell-being of a cotttttry.

46 lnternational Economics - Vol. I

', : Part One Thc Titrry of lrrrenrtrtionrl Tittlc

As you read this chapter, pay attention to the basic messdge: the power of conrpara-

tive aivantage. lf you think that the tiamework is much too simple, don't despair' Subsequent ihapters will build on the key insights of this chapter by adding more realistic features to the economy.

A*AF/l s{\nlTH'S THfi*ftY ilF AffisCILuTfi Al}V*\i\iTAfifi

In the late t8th and early lgth centuries, t'irst Adam Smith and then David Ricardo

explored the basis for intirnational trade as part of their efforts to.make a case for free

trade. Their writings were responses to the doctrine of mercantilism prevailing at the

time. (See the box "Mercantilism.") Their classic theories swayed policymakers for a

whole century, even though today we view them as only special cases of a mol€ basic,

and more powerful, theory of trade. ln his iqealth o.l'Nationy, Adam smith promoted free trade by comparing nations

to householcls. Every household finds it worthwhile to produce o.nly some of the products it consumes, and to buy other products using the proceeds from what the household can sell to others. The same should apply to nations:

It is the maxirn of every prudent master of a family, never to attempt to tnake at home what

it rvill cost . . . lnole to make than to buy. The tailor does not attempt to make his own shoes,

but buys them from the shoenlaker . ' ' What is prudence in the conduct of every private family, can scarce be folly in that of

a great kingdom. If a foreign country can supply us with a commodity cheaper than we

ourselvescanmakeit'betterbuyitofthenrwithsomepartoftheproductofourown industry, employed in a way in which we have some advantage'

An example can show Smith's reasoning. The trvo "counffies" in the example are

the United States and the rest of the world. Tlie two products are wheat and cloth (perhaps broadly representing agricultural products and manufactured products). Each

proOuit is produced using one resource called labor. (Smith focused on labor because

ire thoughi that all "valJe" was determined by and measured in hours of labor. In this resfect he was imitated by David Ricardo and Karl Marx, who also believed that

labor was the basis for all value. We don't have to take this literally-we can consider "labor" to be a bundle ofresources used to produce products')

Suppose that the United States is better than the rest of the world at producing wheat, and the rest of the world is better than the United States at producing cloth. It is probably not a surprise that international trade can create benefits, because the United State; can focuion producing what it does best (wheat) and export it, and the rest of the rvorld can focus on producing what it does best (cloth) and export it. Let's look at this more closely.

What do we mean by "better at producing"? We can indicate each country's ability

to produce each produit in one of two equivalent ways. First, we can measure iah*t proclr"retivli;,-ihe number of units of output that a worker can produce in one hour. Second. *. .un look at the number of hours that it takes a worker to produce one unit of output-rhis is just the reciprocal of labor productivity. Here are some numbers for our example:

t!!i:rtL'*iirirsti't was the philosophy that guided

European thinking about international trade ln

iliu-i.*t.r c"ntriius before Adam Smith pub- iiin Jn it we a tth of N ati o ns in 177 6' M ercanti I ists

"[*"4 international trade as a source of major

n"nuiiat to a nation' Merchants engaged in ir.d".

"tpu.ially those selling exporti' were

oood-hence the name mercantilism' But mer'

iantitists also maintained that government regu-

irii"^'"i,t"dg.'wds necessary to: provide the i.rg;" ."io"al benefits' Trad'e merchants would serie, tneir own interests and not the

national

i"id"i ,l" the absence of government guidance''t'ti-.unrtul belief of mercantilism was that

nuiioJ well-being, or wealth ''*35 [35sd on

".ii"^ir holdirigs of golo and silver (specie or

;;il;;l' civen -tnis

view of national wealth'

"rp"i,iwere viewed as good and imports (.9xceot

toi ,u* materials not produced at home) were seen as bad. lf a country sells (exports).more

to

;;;.i; buyers than th! {oreigners sell-to the .o""iw (the country's imports), then theforeign- .it n.""',o pay for'the excess of their purchases Uv snippinq gold and silver to the country'

The

I'"i" il-q"io and silver increases the country's ir"ii-u"i"q, according to the mercantitist belief'

;;-0"* t;; undesirable because they reduce the lo"n,wt ability to accumulate these precious metals. lmports were also feared because

they

rishl""a te available to the country in time of *.i. f n addition, gold and silver accruing to the n.tion.t rulers could be especially valuable

in

n"iplng to maintain a large military for the coun-

try.' aaied on mercantilist thinking, governments

(tl imposed an array of taxes and prohibitions l;rig;"J to limit imports and (2) subsidized and encouraged exports'-t'J".",r't.:of

its peculia{ emphasis on gold

and sitver, mercantilism viewed trade as a zero-

sum activity-one country's gains come at the

u"punr" of some other countries' since a surplus

in international trade for one country must be a

;;ii.ii i"; ;"me bther(s)' rhe focus on promotine urpotlf .nO limiting imports also provided

major

lntetnatlonal Economlcs, 1 sth Edltlon 47

Chapter 3 Why Et'enlrutly Tiirrles: (irntlxrrtrtile Alluntug'' .t:'

benefits for domestic producer interests (in both

il;;i;g and import-competing industries)' .-"-oalrri stniart and economists after hirn

""i;;J out tn.t the mercantilists' push for

ffi;"=;to*r-.no tt*tr imports turns social

"ti"ti*i"t upside down' Here are the key

points

that refute mercantilist thinking:

r National well-being is based on the. a.bility to' :;;;;;. products iand other "99ods" su^ch as i.rtt"'.rio- a clean- environment) now 11-d

in

I tnulutur". lmports are part of the expanding ,

^"ii""li consumption that a nation seekt

not

.', an evil to be suPPressed. . tne importance of national production and-

;;;;;;:ontY indirect: TheY Provid.e- the iniome to buy products to ionsume'

Exports

;;"i desira-bte on their own; rathel exports are useful because they

pay for impgrts'

. Trade f reely transacted between countries. gen-

;#;;ffi."iuitv' n tn addition, even the goal of aequiring

gold

;;;il;;.n be self-defeatins if this a.cquisi- il; ;;p;^;; the:domestic moneY suPPlY and LlOtio ootestic inflation of product

prices-an

"rout.nt first expounded by David Hume even

beiore Smith did his writing'"'';il;;;n the propositions of the mercantilists

nuu"'l""n t"futed, and countries no longer focus

""'piri^g:,p gold and silver' mercantilist thinking

ir "!w

**n ative today' lt now has a sharp focus orr-emptoyment' Neo-mercantilists

believe that

&;;t-; good because they create jobs in the

country. lmpor6 are bad because they take jobs

;;;i"*;ntryand give them to foreigners' Neo- meicantitists continue to depict trade as a

zero-

"- ,"tf,V' There is no recognition that trade can

Iri.s s;'";,o atl countries (inctuding mutual gains

in employment as prosperity rises throughout the

*Jai.' rut."anti I i;t thinkin g' though misguided' ,titt o"trO"s discussions of international

trade in

countries all over the world'

48 lnternatlonal Economlcs - Vol. I

Part One Ti,: Thctrrl o/ Lrternirtionrrl Ti rtle

ln the United States

ln the Rest of the world

Productivity: Units of cloth per labor hour Units of wheat per labor hour

Labor hours to make: 1 unit of cloth 1 unit of wheat

In this numerical example, the United States has an ililscll{-it* advrrt{.,rq;r.: in pro- ducing wheat, because the U.S. labor productivity in wheat is higher than the rest of the world's labor productivity in wheat. Similarly, the rest of the world has an absolute advantage in producing cloth.

If there is no ffade, then each country will have to produce both products to satisfli its demand for the products. If the countries then open to free lrade, each can shift its labor resoulces toward producing the good in which it has the absolute advantage. Total world production increases. In the United States, shi.fting one hour of labor results in a decrease of 0.25 unit of cloth and an increase of 0.5 unit of wheat. In the rest of the world, shifting one hour of labor results in a decrease of 0.4 unit of wheat and an increase of I unit ofcloth. For each product, production using labor that has high productivity replaces production using labor that has low productivity.

International trade makes these shifts in production possible even if consumers in each country want to buy something different fiorn wtrat is produced in the country. For instance, in the United States the apparent shortage of (or apparent excess demand for) cloth (as cloth production decreases) is met by imports of cloth fiom the rest of the world. The United States pays for these imports of cloth by exporting some of the extra wheat produced.

Thus, Adam Smith showed the benefits of free trade by showing that global pro- duction efficiency is enhanced because trade allows each country to exploit its abso- lute advantage in producing some product(s). At least one country is better ofT with ffade, and this country's gain is not at the expense of the other country. In many cases both countries will gain from trade by splitting the benefits of the enhanced global production.

Smith's reasoning was fundamentally correct, and it helped to persuade some gov- ernments to dismantle inefficient barriers to international trade over the 100 years after he wrote Weulth of'Nutions. Yet his argument failed to put to rest a fear that oth- ers had already expressed even before he wrote. What if our country has no absolute advantage? What if the foreigners are befter at producing everything than we are'l Will they want to trade I If they do, should we want to?

That fear existed in the minds of many of Smith's English contemporaries, who worried that the Dutch were more productive than they at making anything. The fear reappears often. In the wake of World War II, many nations thought they could not possibly compete with the highly productive Americans at anything and wondered how they could gain fiom free trade. Today sorne Americans have the same fear in reverse: Aren't fbreigners getting better at rnaking everything that enters international

0.2s 0.5

1.0 0.4

1.0

2.5 4.0 2.0

lnternatlonal Economlcs, I sth Edition 49

Chapter 3 Whr Euer.rlxr,lr Tint['s: (--onltrtrrtlfit'c Atlt'rnlkrge ] '

trade, and won't the United States be hurt by free tradel We hrrn next to tl're tlteory

that first answered these f-ears and established a fundamental principle of interna-

tional trade.

ni { r - ft it il {}' { -f

H r {} RY S F { $ M FA {q A !- i V 8 "1

* vgt i\i "l-/-1..{ fi

David Ricardo's main contribution to our understanding of international trade was to

show that there is a basis for benet'icial tlade whether or not countries have atty abso-

lute advantage. His contribution is based on a careful examination of oppottunity cost'

fhe *ppcx"uni{V cusf of producing more of a product in a country is the amount of produition ofthe other product thatls given up. The opportunity cost exists because

production resources must be shift'ed from the other prodr.rct to this product. (We

already used,this idea in the discussion of absolute advatttage. rvhen we shifted labor

fiom producing one product to producing the other product')

Ricardo's tititlngt in the early 19th century demonstrated. the B*ixr<-lpseq'*i r$rnpa.rativgl adul*rtaqsf A country will export the goods and services that it can produce at a low opportunity cost and import the goods and services that it would otherwise produce at a high opportunity cost'

The key word here isionpirutiue, meaning "relative" and "not necessarily abso- lute." Even if one country is absolutely more productive at producing everythitrg and the other country is absolutely less proiuctive, they both can gain by trading with each

other as long as their relative (dis)advantages in rnaking dilTerent goods are different'

Each countiy can benefit from trade by exporting products in which it has the greatest

relative advantage (or least relative disaclvantage) and importing products in rvhich

it has the least relative advantage (or the greatest relative disadvantage). Ricardo's -, approach is actually a double comparison-between countries and betrveen products.

Ricardo drove irome the poini with a simple numerical example of gains fiom hading rwo products (cloth and wine) between two countries (England and Portugal).

Here is a similar illustration, using wheat and cloth in the United States and the rest

of the world:

Productivity: Units of cloth per labor hour Units of wheat per labor hour

Labor hours to make: 1 unit of cloth 1 unit ol wheat

ln the United States

0.25 0.5

4.0 2.0

ln the Rest of the World

1.0 0.67

1.0 1.5

Fferc, one country has inferior productivity in both goods. The United States has abso-

lute disadvantagit in both goods-lorver productivity or larger nunrbers of hours to

produce one unir of each good. What products (if any) will the United States export or import'l Can trade bring net national gains to both countries'l

50 lnternational Economlcs - Vol' I

,1

i

i Part One Tfic T[.rrrry tf lrtrcrnrrcionrrl Tlirilt'

Asintheabsolute.advantagecase'wec.anbeginby.irnaginingthetwocoulltries separately with no truo. u.t*.'.n inem. Eactr couritry

will hdve to proditce both prod-

ucts to nleet local Oelnan,t, t'ir,f',. nuo products' Wt'tut *itt the prodtrct prices be in

each country't With no troO*, tt.'pri.es bf th" 1*o proclucts rvithirt each country will

be determined by conciitions ,uitliin each country. To keep our focus on real values

a^d activities, we are g.tng to try to ignore llloney for as lbng as we can' Rather than

looking at molley prices f Ooiiu* p.t c"loth. tr'it oidotlu" per wheat rtnit)' we will use

the r't::;;:'.i:'' ;)ii' ;'-th€ 'otio offnt product price to another product price' ltis as

if

we are in a world lvithout money, a rvorld of barter betrveen rcal prodtrcts like rvheat

*t:::1il. like S'rith, believed that. in competitive tnarkets.

producr prices reflect

thecostsofthelaborneededtoproducetheprodtrcts.withrrotrade"fourlioursof labor in the unitecl States c;;;fice. either2 wheat units or

I cloth unit' The price

of I cloth unit is then 2 *rr.rt "li" in the united states' (TWo wheat units

is also the

opporhrnity cost of produ.lng'.rotrt ln the United States-product prices reflect

costs')

In the resr of the world on. riouiolabor could pioJu.. 1 cloth unit or 2/3 wheat unit'

Theprice(andtheoppo*ni,v.."'ll.iacloth'trnitis0.6Twheaturritintherestof the world. Thr.rs. within til;; isolated econonties, natiortal prices

rvould follow the

relative labor costs of cloth and wheat:

ti tne united States ln the Rest of the world

With no international trade:

Price of cloth Price of wheat

2.0 wlc 0.5 clw

0.67 Wlc 1.5 ClW

we will use the notation l/ to refer to wheat units and c to refer to cloth units' The

relative price of clott, ir-ir,.uru..d as wheat ;;i; p* unit_of cloth (w/c), ald the rela-

tive price ol rvheat ;"C;t N"te that there is realty onty one ratio in each country

because the price or *nLut i, iurt the reciprocal of the price of cloth'

Now let trade be possible between trr. unit.o Staies and the rest of the world'

Sornebody will notici itt. Oiff.r.nce bet'"ee-'-iiit nutionul prices for each good and

will try to profit rro''"r"'uiOifft'*ntt' The principtt it. tl*{:-aud universal: As long as

prices differ in *o pfu.., iUV,no.* than airy cost of transporting between the places)'

there is a rvay to protit tlilough ,,,.i-rqi.r::*,:aLrvi"g at the low price in one place and

r.ifing at the high price in the other place'

perl.raps the first ;;r;;;;".ruiit. think of sending cloth to the United States in

exchange for U.S. *ir.ui.t""rider the urUii*gt proflt that.the person cotrld make'

She acquires ctoth irtril'r.ri orthe rvorldli"fiL "p 0.67 ty for each cloth unit' She

.Wekeepmoneyhidinginthewingsthrougrori.mostofPartslandll,allowingittotakecenterstage

only in ihe more rracroeconoli. pu,o t' aci ". t'"ttuy upptu's briefly in the box later

ir this chapter

ritled ,.what tf Tracle DoesniiBulanc.?,' ard aga.r

. i'rl.pi* s, bothiimes to help us think about how

exchanqe rates relate to real prices like the ",..''l',:a, ",r,, i", unit of cloth"

prices used here' Part ll

srvitche! to \,vhat look like ordinary money prrcet,, such as dollars per bicycle in chapter

8' Even

there, horrrever, the pricei i".oli,*. 16g6h tc ic r;'ih money' As in Chapter 2' tlre dollars are

really units of all productiointitnun the one be'q c cl:;r'ed (e g" motorbikes)'

lnternatlonal Economlct Isth Editlon

Chapter 3 S/hy Elerrlxrif Titrr'les: ()lnpsrutiue '{tlttrrrtrrge 11

then ships this cloth to the United States and sells it there for 2.0 W pet cloth rrnit. To keep things simple, we will usually assume that the cost of transporting ptoducts

between the iountries is zero.2 Therefore, by buying low (at 0'67) and selling high (at

2.0), she can make an arbitrage profit of 1.33 W for each cloth unit that she exports tiom the rest of the world (and imports into the United States). Somebody else could

profit by acquiring wheat in the Uriited States at the low price of 0.5 C per wheat unit,

stripping the'whea:t to rhe rest of the worl4 and selling it for the higher price of 1.5 C

tl;lfi:lltlg or profitable internarionat trade will start pushing the two sepamte

national ptice rotiot toward a new worldwide equilibrium. As people remove cloth

from the rest of the world by exporting it, cloth becomes more expensive relative to' rvheat in the rest of the world. Meanwhile, cloth becomescheaper in the United States;

thanks to the additional supply of cloth imported from the rest of the world. So, cloth

tends to get more expensive w-here it was cheap at first, and cheaper where it was more

expensive. (A similar process occurs for wheat.) The tendencies continue until the two national relative prices become one world

equilibrium relative price. Normal ffade on an ongoing basis will be conducted at this

equilibrium relative price. What will the eqoitibriom international price be1' W'e cannot say for sure without

knowing how strongly the two countries demand each of the two products. We do know something-t[e equilibrium international price ratio must fall within the range of the trvo price ratios that prevailed in each country before trade began:

: 2.0 WC > lnternational price of cloth > 0.67 WC t

or. equivalently.

0.5 C/W s International price of wheat < 1.5 C/W

Why? Consider what would happen if this wete not true. For instance, consider an international price of only 0.4 I,y/C. At this low price of cloth, the rest of the world would want to import cloth and export wheat because the price of cloth on the inter- national market is}ow below the cost of producing cloth at horne (0.67 ll'lC). No deal could be made, though. At this low cloth price the United States would also want to import cloth and e*port wheat. No equilibrium is possible, and the cloth price would be pushed up as a result of the excess demand for cloth. (similar reasoning applies to show the taCt of an equilibrium if the cloth price is above 2 WC.Y The only way tbr the two sides to agree on fiading is to have the cloth price somewhere in the range 0.67 to2.0 ll//C.

rThe assumption of zero transport costs is relatively harmless. lf transport costs are positive but not too

large, they ieduce the gains from trading but do not reverse any of our major conc|'rsions. ln addition,

in J worli with many products, high transport costs for some pioducts could prevent any trade in those products. For instance. many services are nontraded products because the cost of getting the seller

and buyer together are too high. (No Canadian or American would travel to China just to get a cheap

haircut.) Yet other services can be and are traded at low cost, especially if the service is "transported"

electronically. For instance, the author of this book recently completed consulting research for the

European Union in which all communication, including the delivery of completed work, was

conducted by e-mail arrd telephone. l

51

52 lnternatlonal Economlcs - Vol. I

,;!r Part One The Theory of Inttrrrrrrion,rl Trrrtle

Suppose that the strengths of demand tbr the products. which we will exatnine more closely in the next chapter, lead to an equilibrium international cloth price that has the convenient value of | ,V/C. Then both collntries gain from international trade. The United States gains:

' It produces a unit of wheat by giving up only 0.5 unit of cloth. ' It can export this ivheat unit and receive I unit of cloth.

The rest of the rvorld gains:

' It produces a unit of cloth by giving r,rp only 0.67 unit of rvheat. ' It can export this cloth unit and receive I unit of wheat.

How do absolute advantage and comparative advantage relate to each otherl There are two parts to the answer. First. Srnith's example of each country having an absolute advantage in one product is also a case of comparative advantage. Our detailed analy- sis of cornparative advantage could be applied to the numerical example of absolute advantage in the previous section.

Secon{ comparative advantage is more general and powerh.ri. What nlatters is that the two countries have different price ratios if there is no trade. A country rvill have a comparative advantage even if it has no absolute advantage. The basis tbr trade and the gains fiom trade arise tiom differences betlveen the countries in opportunity costs of the goods. In our nurnerical example of comparative advantage. the opportunity cost of a unit of rvheat within the United States (0.5 C/W) is lower tharr this opportunity cost in tlre rest of the world (1.5 C/W\. The United States rvill export wheat. even though it has an absolute disadvantage in producing both wheat and cloth.

So is conrparative advantage everything? Not exactly. Wbile absolute advanta-ee does not determine the lrade pattern in cases like this, it is a key to differences in liv- irrg standards. Having an absolute disadvantage in all products means that the country is less productive than other countries are. Lorv-productivity countries have low real wages and are poor countries. High-productivity countries have high real wages and are rich countries. See the box titled'Absolute Advantage Does Matter."

ti:i{Asl-}ii':i *i'.i5TAri'i L #sT5 At.i* i }*t fi f ffi {} [,] t: {T I * flj - }}{"1 5 S i *i t I i' Y { {.i $EV i:

Ricardo's numerical illustration succeeded in proving the principle of comparative advantage. We can also show Ricardo's comparative advantage using diagrams indi- cating what each country can produce and consume.

Figure 3.1 pichrres production. consumption, and trade for the United States and the rest of the world. Let's examine national production first. Each country can use its resources (labor) to produce various amounts of the two products, rvheat and cloth. To show what a nation is capable of prodr"rcing requires a curve (or line) that shows all of these possibitities. For example. consider that the United States has 100 billion hours of labor available during the year, and that labor productivities are as shorvn in the Ricardian numerical example (0.5 rvheat urtit per hour and 0.25 cloth unit per hour). Then, the United States can nrake 50 billion rvheat units per year if it produces only