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Foundations of Modern Trade Theory: Comparative Advantage

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PowerPoint slides prepared by:

Andreea Chiritescu

Eastern Illinois University

Historical Development of Modern Trade Theory

The Mercantilists, 1500–1800

A strong foreign-trade sector

Favorable trade balance

Net payments - gold and silver

Increased spending

Rise in domestic output and employment

Promote a favorable trade balance

Government regulation of trade

Tariffs, quotas, other commercial policies

Static view of the world economy

Historical Development of Modern Trade Theory

The Mercantilists under attack

David Hume’s price-specie-flow doctrine

A favorable trade balance is possible only in the short run

1776, Adam Smith, The Wealth of Nations

World’s wealth is not a fixed quantity

International trade

Increase the general level of productivity within a country

Increase world output (wealth)

Historical Development of Modern Trade Theory

Why Nations Trade: Absolute Advantage

Adam Smith – free trade advocate

Production costs differ among nations

Different productivities of factor inputs

Labor – homogenous

Absolute cost advantage

Uses less labor to produce one unit of output

Historical Development of Modern Trade Theory

Principle of absolute advantage

A two-nation, two-product world

International specialization and trade

One nation - absolute cost advantage in one good

The other nation - absolute cost advantage in the other good

Each nation must have a good that it is absolutely more efficient in producing than its trading partner

Import goods – if absolute cost disadvantage

Export goods – if absolute cost advantage

Absolute advantage; each nation is more efficient in producing one good

TABLE 2.1

Historical Development of Modern Trade Theory

Why Nations Trade: Comparative Advantage

1800, David Ricardo (1772–1823)

Free trade

Mutually beneficial trade can occur whether or not countries have any absolute advantage

Principle of comparative advantage

Emphasized comparative (relative) cost differences

Historical Development of Modern Trade Theory

Principle of comparative advantage

Even if a nation has an absolute cost disadvantage in the production of both goods

The less efficient nation

Specialize in and export the good in which it is relatively less inefficient

Where its absolute disadvantage is least

The more efficient nation

Specialize in and export that good in which it is relatively more efficient

Where its absolute advantage is greatest

Examples of comparative advantages in international trade

TABLE 2.2

Historical Development of Modern Trade Theory

Principle of comparative advantage, simplified model - assumptions:

1. The world consists of two nations

Each – use a single input, produce two commodities

2. In each nation, labor is the only input

Fixed endowment of labor

Labor is fully employed and homogeneous

3. Labor can move freely among industries

Within a nation

But is incapable of moving between nations

Historical Development of Modern Trade Theory

Principle of comparative advantage, simplified model - assumptions:

4. Technology - fixed for both nations

Different nations may use different technologies

All firms within each nation - a common production method for each commodity

5. Costs do not vary with the level of production

Proportional to the amount of labor used

Historical Development of Modern Trade Theory

Principle of comparative advantage, simplified model - assumptions:

6. Perfect competition prevails in all markets

All are price takers

Identical products

Free entry to and exit from an industry

Price of each product = product’s marginal cost of production

7. Free trade occurs between nations

No government barriers to trade

Historical Development of Modern Trade Theory

Principle of comparative advantage, simplified model - assumptions:

8. Transportation costs are zero

Consumers - indifferent between domestically produced and imported versions of a product if the domestic prices of the two products are identical

9. Firms make production decisions in an attempt to maximize profits

Consumers maximize satisfaction through their consumption decisions

Historical Development of Modern Trade Theory

Principle of comparative advantage, simplified model - assumptions:

10. There is no money illusion

When consumers make their consumption choices and firms make their production decisions, they take into account the behavior of all prices

11. Trade is balanced

Exports must pay for imports

Ruling out flows of money between nations

Comparative advantage, U.S. -absolute advantage in producing both goods

TABLE 2.3

David Ricardo, 1772–1823

Leading British economist of the early 1800s

Theories of classical economics

Economic freedom through free trade and competition

Successful businessman, financier, speculator

Stockbroker, loan broker

1819 – 1823, British parliament

Advocated the repeal of the Corn Laws (trade barriers)

TRADE CONFLICTS

David Ricardo, 1772–1823

Interest in economics

Adam Smith’s The Wealth of Nations

Newspaper articles on economic questions

1817, The Principles of Political Economy and Taxation

Laid out the theory of comparative advantage

Advocate of free trade

Opponent of protectionism

TRADE CONFLICTS

Production Possibilities Schedules

Modern trade theory

More generalized theory of comparative advantage

Use a production possibilities schedule

Transformation schedule

Production Possibilities Schedules

Production possibilities schedule

Various alternative combinations of two goods

A nation can produce

When all of its factor inputs

Land, labor, capital, entrepreneurship

Are used in their most efficient manner

Maximum output possibilities of a nation

With constant opportunity costs, a nation will specialize in the product of its comparative advantage. The principle of comparative advantage implies that with specialization and free trade, a nation enjoys production gains and consumption gains. A nation’s trade triangle denotes its exports, imports, and terms of trade. In a two nation, two product world, the trade triangle of one nation equals that of the other nation; one nation’s exports equal the other nation’s imports, and there is one equilibrium terms of trade.

Trading under constant opportunity costs

FIGURE 2.1

Production Possibilities Schedules

Marginal rate of transformation, MRT

The amount of one product a nation must sacrifice to get one additional unit of the other product

Rate of sacrifice = opportunity cost of a product

Absolute value of the slope of production possibilities schedule

For Figure 2.1

Trading Under Constant-Cost Conditions

Constant opportunity costs

Straight line production possibilities schedules

Factors of production

Perfect substitutes for each other

All units of a given factor are of the same quality

Autarky

Absence of trade

Trading Under Constant-Cost Conditions

Basis for Trade

Principle of comparative advantage

Direction of Trade

Specialize and export the good with the lowest opportunity cost

Production Gains from Specialization

Production gains for both countries

Arise from the reallocation of existing resources

Static gains from specialization

Gains from specialization & trade: constant opportunity costs

TABLE 2.4

Trading Under Constant-Cost Conditions

Consumption Gains from Trade

Trade = consumption gains for both countries

Consumption points

Outside domestic production possibilities schedules

Consume more of both goods

Terms of trade

Rate at which a country’s export product is traded for the other country’s export product

Define the relative prices of the two products

Trading Under Constant-Cost Conditions

Domestic rate of transformation

Domestic terms of trade

Slope of the production possibilities schedule

Relative prices that two commodities can be exchanged at home

Terms of trade for exports

More favorable than domestic terms of trade

Trading Under Constant-Cost Conditions

Trading possibilities line

International terms of trade for both countries

Trade triangle for a country

Exports – along the horizontal axis

Imports – along the vertical axis

Terms of trade – the slope

Complete specialization

Produce only one product

Trading Under Constant-Cost Conditions

Domestic cost ratio

Negatively sloped production possibilities schedule

Transform into a positively sloped cost-ratio line

Outer limits for the equilibrium terms of trade

Becomes no-trade boundary

Region of mutually beneficial trade

Bounded by the cost ratios of the two countries

The supply-side analysis of Ricardo describes the outer limits within which the equilibrium terms of trade must fall. The domestic cost ratios set the outer limits for the equilibrium terms of trade. Mutually beneficial trade for both nations occurs if the equilibrium terms of trade lies between the two nations’ domestic cost ratios. According to the theory of reciprocal demand, the actual exchange ratio at which trade occurs depends on the trading partners’ interacting demands.

Equilibrium terms-of-trade limits

FIGURE 2.2

Trading Under Constant-Cost Conditions

Equilibrium Terms of Trade, John Stuart Mill (1806–1873)

Add the intensity of the trading partners’ demands

Determine the actual terms of trade

The theory of reciprocal demand

Trading Under Constant-Cost Conditions

Theory of reciprocal demand

Within the outer limits of the terms of trade

Actual terms of trade are determined by the relative strength of each country’s demand for the other country’s product

Production costs determine the outer limits of the terms of trade

Reciprocal demand determines what the actual terms of trade will be within those limits

Trading Under Constant-Cost Conditions

Theory of reciprocal demand

Best applies when both nations are of equal economic size

The demand of each nation - noticeable effect on market price

If two nations are of unequal economic size

The relative demand strength of the smaller nation will be dwarfed by that of the larger nation

Domestic exchange ratio of the larger nation will prevail

The small nation can export as much of the commodity as it desires

Trading Under Constant-Cost Conditions

The importance of being unimportant

For two nations engaged in international trade

Same size, similar taste patterns

Gains from trade – shared equally between them

One nation is significantly larger than the other

Larger nation - fewer gains from trade

Smaller nation - most of the gains from trade

strong possibility that the larger nation will continue to produce its comparative-disadvantage good because the smaller nation is unable to supply all of the world's demand for this product

Babe Ruth and the principle of comparative advantage

George Herman Ruth (1895–1948)

1914 – 1920, Boston Red Sox, 158 games

Left-handed pitcher

Pitching record: 89 wins and 46 losses

23 victories in 1916

24 victories in 1917

Babe Ruth

Absolute advantage in pitching

Comparative advantage in hitting

TRADE CONFLICTS

Babe Ruth and the principle of comparative advantage

1920 – 1934, New York Yankees, Babe Ruth

Ended his pitching career - 2.28 earned run average

Switched to only hitting

Dominated professional baseball

Teamed with Lou Gehrig

Greatest one-two hitting punch in baseball

1927 Yankees - the best in baseball history

Record of 60 home runs

TRADE CONFLICTS

Babe Ruth and the principle of comparative advantage

1920 – 1934, New York Yankees, Babe Ruth

1923, Yankee Stadium – nicknamed “The House That Ruth Built”

Baseball Hall of Fame, 1936

Win four World Series

Most renewed franchise

TRADE CONFLICTS

Trading Under Constant-Cost Conditions

Terms-of-Trade Estimates

Commodity terms of trade

Barter terms of trade

Measure of the international exchange ratio

Measures the relation between the prices a nation gets for its exports and the prices it pays for its imports

Trading Under Constant-Cost Conditions

Improvement in a nation’s terms of trade

Rise in its export prices

Relative to its import prices

A smaller quantity of export goods sold abroad

Required to obtain a given quantity of imports

Deterioration in a nation’s terms of trade

Rise in its import prices

Relative to its export prices

Purchase of a given quantity of imports

Sacrifice of a greater quantity of exports

Commodity terms of trade, 2008 (2000 = 100)

TABLE 2.5

Dynamic Gains From Trade

Dynamic gains from international trade

More efficient use of an economy’s resources

Higher output and income

More saving, More investment

Higher rate of economic growth

Higher productivity

Economies of large-scale production

Increased competition

Changing Comparative Advantage

Patterns of comparative advantage change over time

Productivity increases

Production possibilities schedule changes

More output can be produced - with the same amount of resources

Producers - need to hone their skills to compete in more profitable areas

If productivity in the Japanese computer industry grows faster than it does in the U.S. computer industry, the opportunity cost of each computer produced in the United States increases relative to the opportunity cost of the Japanese. For the United States, comparative advantage shifts from computers to autos.

Changing comparative advantage

FIGURE 2.3

Trading Under Increasing-Cost Conditions

Increasing opportunity costs

Concave production possibilities schedule

Bowed outward from the diagram’s origin

Inputs are imperfect substitutes for each other

MRT rises

Absolute slope of the production possibilities schedule

Increasing opportunity costs lead to a production possibilities schedule that is concave, viewed from the diagram’s origin. The marginal rate of transformation equals the (absolute) slope of the production possibilities schedule at a particular point along the schedule.

Production possibilities schedule; increasing-cost conditions

FIGURE 2.4

Trading Under Increasing-Cost Conditions

Increasing-Cost Trading Case

One country specializes in producing one good

The other country specializes in producing the other good

Specialization continues in both nations until

Relative cost of one good is identical in both nations

One country’s exports of one good are precisely equal to the other country’s imports of the good

Same domestic rates of transformation

With increasing opportunity costs, comparative product prices in each country are determined by both supply and demand factors. A country tends to partially specialize in the product of its comparative advantage under increasing cost conditions.

Trading under increasing opportunity costs

FIGURE 2.5

Trading Under Increasing-Cost Conditions

Production gains

More of each good is being produced

Consumption gains

Both countries consume more of at least one good

The trade triangle

Exports, imports, and terms of trade

Same for both countries

Gains from specialization and trade: increasing opportunity costs

TABLE 2.6

Trading Under Increasing-Cost Conditions

Partial Specialization

Each country specialize only partially

In the production of the good in which it has a comparative advantage

Increasing costs - mechanism that forces costs in two trading nations to converge

Basis for further specialization ceases to exist

Both nations will produce some of each good

Trading Under Increasing-Cost Conditions

Partial Specialization

Not all goods and services are traded internationally

Differing tastes for products

Most products are differentiated

The Impact of Trade on Jobs

Extent to which an economy is open

Influences the mix of jobs within an economy

Can cause dislocation in certain areas or industries

Little effect on the overall level of employment

Increased international trade tends to neither inhibit overall job creation nor contribute to an increase in the overall rate of unemployment. As seen in the figure, the increase in U.S. imports as a percentage of GDP over the past several decades has not led to any significant trend in the overall unemployment for Americans.

The impact of trade on jobs

FIGURE 2.6

Comparative Advantage Extended to Many Products and Countries

More Than Two Products

Comparative advantage

Rank the goods by the degree of comparative cost

Each country exports the product(s)

Has the greatest comparative advantage

Each country imports the product(s)

Has greatest comparative disadvantage

Cutoff point between exports and imports

Relative strength of international demand

When a large number of goods is produced by two countries, operation of the comparative-advantage principle requires the goods to be ranked by the degree of comparative cost. Each country exports the product(s) in which its comparative advantage is strongest. Each country imports the product(s) in which its comparative advantage is weakest.

Hypothetical spectrum of comparative advantages, U.S. and Japan

FIGURE 2.7

Comparative Advantage Extended to Many Products and Countries

More Than Two Countries

Multilateral trading relations

Bilateral balance should not pertain to any two trading partners

Trade surplus

With trading partners that buy a lot of the things that it supplies at low cost

Trade deficit

With trading partners that are low-cost suppliers of goods that it imports intensely

When many countries are involved in international trade, the home country will likely find it advantageous to enter into multilateral trading relations with a number of countries. This figure illustrates the process of multilateral trade for the United States, Japan, and OPEC.

Multilateral trade: U.S., Japan, and OPEC

FIGURE 2.8

Exit Barriers

Open trading system

Channeling resources from uses of low productivity to those of high productivity

Competition

High cost plants exit

Low cost plants operate in the long run

Exit Barriers

Restructuring of inefficient companies

Long time

Cling to capacity

Existence of exit barriers

Various cost conditions -make lengthy exit a rational response by companies

Hinder the market adjustments

Empirical Evidence on Comparative Advantage

The Ricardian model

Nations export goods - their labor productivity is relatively high

Testing the Ricardian model

G.D.A. MacDougall, 1951

Export patterns of 25 separate industries; United States and United Kingdom, 1937

20 industries fit the predicted pattern

Balassa and Stern

Also supported Ricardo’s conclusions

Empirical Evidence on Comparative Advantage

Testing the Ricardian model

Stephen Golub

Relative unit labor costs and trade for United States

United Kingdom, Japan, Germany, Canada, Australia

Relative unit labor cost helps to explain trade patterns for these nations

Limitations of the Ricardian model

Labor is not the only factor input

Production and distribution costs

Differences in product quality

The figure displays a scatter plot of U.S./Japan export data for 33 industries. It shows a clear negative correlation between relative exports and relative unit labor costs. A rightward movement along the figure’s horizontal axis indicates a rise in U.S. unit labor costs relative to Japanese unit labor costs; this correlates with a decline in U.S. exports relative to Japanese exports, a downward movement along the figure’s vertical axis.

Relative exports & relative unit labor costs: U.S./Japan, 1990

FIGURE 2.9

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Comparative advantage

Weakened if resources can move to wherever they are most productive

Relatively few nations with abundant cheap labor

No longer shared gains

Some nations win and others lose

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Major change in the world economy

Strong educational systems

Millions of skilled workers in developing nations, China and India

As capable as the most highly educated workers in advanced nations

Much lower cost

Inexpensive Internet technology

Many workers to be located anywhere

New political stability

Technology and capital to move more freely around the globe

U.S. occupations regarded as highly likely to go offshore

TABLE 2.7

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Advantages of Outsourcing

Reduced costs and increased competitiveness

New exports

Repatriated earnings

Job losses tend to be temporary

The creation of new industries and new products

More lucrative jobs for Americans

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Outsourcing and the U.S. Automobile Industry

Early 1900s, Ford Motor Company – Model T: 700 parts

Gains of large-scale mass production

Gains of a high degree of specialization within a single plant

More sophisticated cars and competition

Ford – outsource production

Keep strategically important tasks & production in-house

Noncore tasks purchased from external suppliers

Outsourcing of Boeing 787 Dreamliner triggers machinist’s strike

2007, Boeing 787 Dreamliner, $150 million

3 Japanese firms, 35% of the design and manufacturing work

Boeing - final assembly in three days

Italy, China, and Australia

GLOBALIZATION

Outsourcing of Boeing 787 Dreamliner triggers machinist’s strike

Gains from globalization

Decrease the time required to build its jets by more than 50 percent

Decrease costs - Foreign suppliers to absorb some of the costs of developing the plane

Spreading the risk

Engineering talent and technical capacity

Maintain close relationships with its customers

GLOBALIZATION

Outsourcing of Boeing 787 Dreamliner triggers machinist’s strike

Boeing’s suppliers fell behind

Production -more than a year behind schedule

Language barriers

Some contractors outsourced chunks of work

Boeing’s union workforce

Anger and anxiety

Fear of losing their jobs to outsourcing

Strike in 2008

Nearly 27,000 machinists walked off their jobs

GLOBALIZATION

Producing the Boeing 787: how Boeing outsources its work

TABLE 2.8

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Outsourcing and the U.S. Automobile Industry

Increasing numbers of parts and services – noncore

Today - about 70% of a typical Ford vehicle

Parts, components, and services purchased from external suppliers

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Burdens of Outsourcing

Americans who lose their jobs or find lower-wage ones

Wages of low-skilled American workers

High school education or less

Decreased in real terms

Decreased relative to the wages of skilled workers (college education or higher)

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Technological change and outsourcing

Declining demand for low-skilled American workers

Outsourcing of high-skilled jobs

Shift demand to cheaper substitutes in Asia

May yield economic benefits for the nation

Losers – the displaced workers

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Address the plight of the displaced worker

Generous severance packages, insurance programs

Revamp the U.S. education system

Prepare workers for jobs that cannot easily go overseas

Revise the tax code

Reward firms that produce jobs that stay in the United States

Does Comparative Advantage Apply in the Face of Job Outsourcing?

Some U.S. Manufacturers Prosper by Keeping Production in the United States

Increase the skill level

Perform tasks more efficiently

Cost-cutting programs to improve competitiveness

Gained efficiencies

Contracting single suppliers of packing materials and components

Wheat

MRT

Autos

100

Export Price Index

Terms of trade =

Import Price Index