2000 word report (international trade)

3001iba___lecturenotes_2.pptx

Home >Business & Finance homework help >Economics homework help >2000 word report (international trade)

© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password‐protected website for classroom use

3001IBA Lecture Notes Week 2 Text: Carbaugh R J (2013), International Economics, 14th Edition Foundations of Modern Trade Theory: Comparative Advantage

Learning Objectives

History of Trade Theories:

Mercantilists (1500-1800)

Absolute Advantage – Adam Smith (1776)

Define principle of Comparative Advantage (CA)

Explain the basis for trade

Analyze the (comparative static) gains from trade with constant & increasing opportunity costs

Discuss the dynamic gains from trade

Consider the limitations of CA

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

Principle of comparative advantage, simplified model - assumptions

1. The world consists of two nations

Each uses a single input, produces 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

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

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

Principle of comparative advantage, simplified model - assumptions

7. Free trade occurs between nations

No government barriers to trade

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

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 i.e. exports must pay for imports

This rules out flows of money between nations

Comparative Advantage - Example Assume 2 countries each producing 2 goods

The U.S. can produce twice as much wine as the U.K. but four times as much cloth. Therefore the U.S. should specialize in producing cloth while the U.K. specializes in producing wine.

Production Possibilities Schedules

Modern trade theory

- More generalized theory of comparative advantage

- Use a production possibilities schedule PPS

-- Transformation schedule

Production Possibilities Schedules

Production possibilities schedule shows

Various alternative combinations of two goods

a nation can produce

- When all of its factor inputs

-- Labour (L), capital (K), [generally assume these 2] and land, entrepreneurship, (technology) are used in their most efficient manner

- Maximum output possibilities of a nation

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

In graph (a) the MRT in the US equals 0.5 because wheat output falls by 20 (e.g. from 60 to 40) when auto output rises by 40 (e.g. from 0 to 40). In graph (b) the MRT in Canada equals 2.0 because wheat output falls by 40 (from 80 to 40) when auto output rises by 20 (from 40 to 60)

So 1 additional auto in the U.S. => loss of 0.5 bushel of wheat

Whereas 1 additional auto in Canada => loss of 2 bushels of wheat

Since the U.S. has a lower opportunity cost of auto production, it will be mutually beneficial for the U.S. to produce autos and trade them to Canada for wheat.

Trading under constant opportunity costs

FIGURE 2.1

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

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

TRADE CONFLICTS

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

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

Outsourcing: Pros & Cons

Pros

reduced costs and increased competitiveness for domestic companies

increased exports to countries in which new jobs are created

higher level of repatriated earnings reinvested into domestic economy

Cons

reduced employment in specific industries

lower wages, particularly for unskilled workers

National Competitive Advantage: Porter’s Diamond

Existing theories of international trade can be argued to be too narrow and inadequate. Porter’s theory focuses on explaining the success of a particular industry of a country. Rather than Comparative Advantage, the theories of Porter [Michael E. Porter (1990), The Competitive Advantage of Nations, New York: Free Press] and others focus on Competitive Advantage, which refers to industries (groups of firms) producing goods and services of greater value than their international competitors, where value is determined by a range of attributes in addition to lower relative costs of production/higher relative factor abundance. Many countries with similar relative factor endowments have competitive advantages in different industries – e.g.s: Switzerland excels in precision instruments (such as watches), Germany in chemical industry, and Japan in household electronic products.

Four attributes promoting or impeding the creation of competitive advantage:

Factor Endowments such as skilled labour or the infrastructure (power for IT industry) necessary to compete in a given industry

Demand Conditions—nature of home demand for the industry’s products

Related and Supporting Industries—supplier industries and related industries that are internationally competitive

Firm Strategy, Structure and Rivalry—conditions in the country determining how firms are created, organized and managed and the nature of domestic rivalry.

National Competitive Advantage: Porter’s Diamond

Challenges of Globalization

Rapid increases in international economic activity, including the communications revolution, has reduced the intra-country significance of Porter’s Diamond – factors above still important but globally, not just domestically. E.g.; Demand conditions attribute – the nature of international demand for the industry’s products is important also.

Porter’s Diamond

Criticism on Porter's national diamond model resolves around a number of assumptions that underlie it. As described by Davies and Ellis:

"sustained prosperity may be achieved without a nation becoming 'innovation-driven', strong 'diamonds' are not in place in the home bases of many internationally successful industries and inward foreign direct investment does not indicate a lack of 'competitiveness' or low national productivity".

Porter generalised from the American case; for developing countries the model may be wrong.

Michael E. Porter (1990), The Competitive Advantage of Nations, New York: Free Press

Wheat

MRT

Autos

100

Export Price Index

Terms of trade =

Import Price Index

Factor

Endowments

Firm Strategy,

Structure and

Rivalry

Demand

Conditions

and

Supporting

Industries

Factor Endowments

Related and Supporting

Industries

Firm Strategy, Structure and Rivalry

Demand Conditions