2. why do we trade? - part i

TU-91.2043 International Economics

by

Hannele Wallenius

Aalto University School of Science

Department of Industrial Engineering and Management

2. WHY DO WE TRADE?- Part I

International Economics

Hannele Wallenius

Six Valuable Lessons of Trade Theory

1. Free trade can raise aggregate economic efficiency and aggregate economic welfare.

2. Free trade will benefit a country even if it is less efficient than all other countries in every industry.

3. Some people will suffer losses with free trade.4. A domestic firm may lose out in international

competition even if it is the lowest cost producer in the world.

5. Trade protection may be beneficial for a country.6. Although trade protection can be beneficial, the

case for free trade remains strong.


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2. Why Do We Trade? - 2.1 The Law of Comparative Advantage 3

Index of Openness*

Some countries trade extensively, others very little.

How can this be understood and explained?

* Ratio of exports +

imports to GDP

multiplied by 100


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France

Italy

United Kingdom

Greece

Spain

Finland

Portugal

Romania

Croatia

Sweden

Germany

Poland

Austria

Denmark

Bulgaria

Slovenia

Czech Republic

Belgium

Netherlands

Estonia

Hungary

Slovak Republic

Ireland

Luxembourg

0.0 50.0 100.0 150.0 200.0

28.328.629.830.231.6

38.239.342.042.943.845.646.1

53.554.3

68.474.777.2

82.882.9

86.188.8

93.0105.3

203.3

Exports of goods and services in EU(% of GDP in 2013)


Source: World Development Indicators


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2. Why Do We Trade? 5

Major Concerns of Trade Theory?

The classical theory of international trade is concerned with the following three questions:

1. What are the gains from trade?¨ In other words, if countries benefit

from international trade, where do the gains come from, and how are they divided among the trading countries?


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Major Concerns of Trade Theory? continued

2. What is the structure/pattern of trade? ¨ In other words, which goods/services

are exported, and which are imported?

¨ What are the fundamental laws that govern international allocation of resources and the flow of trade?

3. What are the terms of trade?¨ In other words, at what prices are the

exported and imported goods exchanged?


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Why Do We Trade?


PS/PTPS/PT

QS QS

P0

P0

Finland China

International difference in autarky* price of a product S in two countries:

* Autarky = closed economy = no international trade allowed in a country

With trade prices start to equalize.

NSSA

NSSB

NDSA

Country A Country B

NDSB

PS/PT = relative price of product S

NSS/ = national supply/demand

NSD


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Because country A has a lower autarky (relative) price of S, it is said to have a comparative advantage in S and a comparative disadvantage in T and by same logic, country B has a comparative advantage in T and comparative disadvantage in S

If trade would be allowed, consumers in country A would like to buy product S from country B, and prices would start to equalize

Why Are the Prices Different?1. Differences in technology or productivity2. Difference in resource endowments3. Difference in demand



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Understanding the Gains from International Trade

Nations (or firms in different nations) trade with each other because they benefit from it!

We can divide the different trade theories in four categories...


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Different Trade Theories

1. Early Trade Theory: Mercantilists

2. Classical Trade Theory: Ricardian Model (section 2.1)

3. Modern Trade Theory: Heckscher-Ohlin Model (section 2.2)

4. Alternative Approaches to Trade Theory (section 2.3)


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1. Early Trade Theory: Mercantilists

¨ Until mid-eighteenth century, it was believed that the purpose of international trade was to keep exports greater than imports and pile up gold, and when/if deficits were created they believed that imports had to be restricted

¨ Mercantilists assumed trade to be a zero-sum game since they assumed that fixed amounts of goods and of gold existed in the world and that trade merely determined their distribution among the various nations


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¨ But in the 1740s, David Hume explained that as quantity of money (gold) changes, so also does the price level, and the nation's real wealth is unaffected

¨ In 1770s, Adam Smith argued that import restrictions would reduce the gains from specialization and make a nation poorer. He used absolute advantage to explain the benefits of trade

Theories 2 - 4 will be now discussed in more detail ...


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2. Why Do We Trade? continued

2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage

2.2 Modern Trade Theory:Heckscher-Ohlin Model

2.3 Alternative Trade Theories: Results from Practical Evidence


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Economic Basis for Trade

What are the factors that determine how countries will specialize in international trade?

David Ricardo (On the Principles of

Political Economy, 1819), developed the theory of comparative advantage...


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Economic Basis for Trade continued

Specialization and free trade will benefit all trading partners (= real wages will rise), even those who may be absolutely less efficient producers.

According to this theory,


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Absolute vs. Comparative Advantage

Although comparative advantage is a simple concept, experience shows that it is a surprisingly hard concept for many people to understand (or accept).


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Absolute vs. Comparative Advantage continued

Indeed, Paul Samuelson — the Nobel laureate economist who did much to develop the model of international trade — has described comparative advantage as the best example he knows of an economic principle that is undeniably true yet not obvious to intelligent people.


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Definition: Absolute Advantage

The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does.


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Absolute Advantage - an Illustration

Suppose country A and country B produce wheat, but that A's climate is more suited to wheat and its labor is more productive.

Country A will therefore produce more wheat per acre than country B and use less labor in growing it and bringing it to the market.

Country A thus enjoys an absolute advantage over country B in the production of wheat.


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Definition: Comparative Advantage

The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other products than it could be in the other country.


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Comparative Advantage - an Illustration

• Suppose that countries C and D both produce wheat and corn and that C enjoys an absolute advantage in the production of both - that is, C's climate is better than D's, and fewer of C's resources are needed to produce a given quantity of both wheat and corn

• C and D each need to choose between planting land with wheat and corn


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Comparative Advantage - an Illustration continued

• To produce more wheat, either country must transfer land from corn production and vice versa

• Suppose that in country C, a bushel of wheat has an opportunity cost of two bushels of corn. At the same time, suppose that producing a bushel of wheat in country D requires to give up only one bushel of corn D enjoys a comparative advantage in producing wheat


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Example 1: Gains from Mutual Absolute AdvantageAssume

a) two countries with fixed amount of land (100 acres) and land yields given in the table below

b) only two products produced (wheat and cotton),

c) preferences for food and clothing are such that both countries consume equal amounts of wheat and cotton.

PPF:s before trade: New Zealand Australia

Wheat 600 (6 x 100) 200 (2 x 100)

Cotton 200 (2 x 100) 600 (6 x 100)


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Example 1: Continued

Wheat

Cotton

New Zealand

(150, 150)

Cotton

Australia

Wheat

(150, 150)

When there is no trade, the allocation of resources will be such that both countries will produce 150 bushels of wheat and 150 bales of cotton.

W: 25 acres x 6 bu/acre

C: 75 acres x 2 bales/acre

W: 75 acres x 2 bu/acre

C: 25 acres x 6 bales/acre

PPF

600

600200

200


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¨ Expanded possibilities after trade:If countries realize that they should specialize (Australia in cotton and New Zealand in wheat) and trade, both countries could gain

¨ Both are now specializing: Production

New

Zealand Australia

Consumption

New

Zealand Australia

Wheat 600 0 300 300

Cotton 0 600 300 300


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Cotton

Australia

Wheat

(300, 300)

Wheat

Cotton

New Zealand

(300, 300)

In this situation 300 bushels of wheat is traded for 300 bales of cotton:

600

200 600

200


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¨ Trade enables both countries to move beyond their previous resource and productivity constraints

both countries (after trade) can consume beyond their production possibilities (PPFs)!


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Example 2: Gains from trade when one country has a double absolute advantage

• Production Possibilities and Consumption in a Closed Economy (same assumptions as before):

New Zealand Australia

Wheat 600/300 100/75

Cotton 600/300 300/75


Wheat 6 bushels 1 bushels

Cotton 6 bales 3 bales

NZ: 50 x 6 = 300 both wheat and cotton.A: 75 x 1 = 75 wheat25 x 3 = 75 cotton


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• When countries realize that they can benefit from specialization and trade:

Production Stage 1

New

Zealand Australia

Stage 2

New

Zealand Australia

Wheat 300 0 450 0

Cotton 300 300 150 300

Only partial specialization:

75 x 6 = 450 and 25 x 6 = 150


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• Consumption after trade: Stage 3

• When countries specialize they will maximize their combined output and use resources more efficiently: both countries are better off than they were before the trade (closed economy consumptions were 300, 300 and 75,75)

both have moved beyond their own production possibilities


Wheat 350 100

Cotton 350 100

If 100 bu of wheat from NZ is traded to 200 bales of cotton from Australia


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International Equilibrium with Increasing Costs• Next we will extend the classical model of

trade to the more general case of increasing opportunity costs and introduce demand by means of social indifference curves

Increasing Opportunity Cost

Food

Clothing

PPF

Indifference Map and Consumer Equilibrium

Food

Clothing

I’’I’

I’’’

a) Product specific factors.

b) Different industries use factors in different proportions.


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General Equilibrium in a Small Open Economy


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Specialization Based on Comparative Advantage and the Resulting Gains from Trade

America Britain

Figure 1 (a) Figure 1 (b)

1. Assume such a domestic price ratios that E (in US) and E* (in UK) are consumption and production in autarky (= no trade).

2. After trade consumption takes place at S and S*.


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Specialization Based on Comparative Advantage and the Resulting Gains from Trade continued

• Figure 1: In autarky, America produces and consumes at E, and Britain at E*. With trade, America shifts production from E to Q and consumes at S by exporting VQ units of food to Britain in exchange for VS units of British clothing. America is better off with trade because S lies on a higher indifference curve than E. Indeed, in our illustration, America consumes more food and more clothing at S than at E. Britain shifts production from E* to Q* and consumption from E* to S*. Britain’s welfare increases also. Trade triangles SVQ and Q*V*S* are identical.


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Same Production Technique in Both Countries, Trade Based on Different Taste

Food

Clo

thin

gAmerica

Britain

Figure 2

In autarky US produces and consumes at A and UK at B. After free trade both will produce at Q but consume at A’ and B’, respectively.

Different indifference curves!

Again both countries can consume beyond their production possibilities.


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Trade Based on Different Taste continued

• Figure 2: Trade based on different tastes. America and Britain share the same production frontier MN. In autarky, America produces and consumes at A, and Britain at B. With free trade, both countries produce at Q, but America consumes at A’ and Britain at B’. Trade triangles A’VQ and QSB’ are identical.


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2. Why Do We Trade? - 2.2 Modern Trade Theory: Heckscher-Ohlin Model

37

2. WHY DO WE TRADE?

2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage

2.2 Modern Trade Theory: Heckscher-Ohlin Model

2.3 Alternative Trade Theories: Results from Practical Evidence


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38

What are the ultimate determinants of comparative advantage?

• Ricardo did not bother to answer this question

• He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology), but he did not explain the basis for these differences. Implicit reason in his example was climate...


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39

What are the ultimate determinants of comparative advantage? continued

¨ It remained to Heckscher and Ohlin to offer an explanation for comparative advantage

¨ And this theory has become, since 1930s, the orthodox explanation of the ultimate cause of international trade

Eli Heckscher (1879 - 1952)

Bertil Ohlin(1899-1979)


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40


¨ Their basic idea is:

1. Commodities differ in their factor requirements

2. Countries differ in their factor endowments


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41


A country has comparative advantage in those commodities that use its abundant factors intensively.

• This is why labor-abundant countries, such as India and China export footwear, rugs, textiles, and other labor intensive commodities; and land-abundant countries, such as Argentina, Australia, and Canada, export meat, wheat, wool, and other land-intensive commodities


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42

The Basic Assumptions of the Heckscher-Ohlin Model:

1. Number of countries, factors, and commodities are all two (often referred to as the 2 x 2 x 2 model)

2. Technology is the same in both countries

3. Constant returns to scale4. Strong factor intensity5. Incomplete specialization


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43

The Basic Assumptions of the Heckscher-Ohlin Model continued:

6. Perfect competition

7. Factors are perfectly mobile within each country but perfectly immobile between countries

8. Tastes are largely similar between countries

9. Free trade

10. Transportation costs are zero


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44

Heckscher-Ohlin Theorem with a Single Technique

• The structure of trade, in general, can be traced back to differences in

factor endowments, technology, and tastes

• Since Heckscher-Ohlin theory assumes that technology and tastes are similar between countries, it attributes the comparative advantage to differences in factor endowments


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45

Heckscher-Ohlin Theorem with a Single Technique continued

In summary, the capital-abundant country exports the capital-intensive commodity, and the labor-abundant country exports the labor-intensive commodity.


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46

Example 1: Factor Endowments and Production-Possibilities

One country Required inputs per unit of output

Labor Capital

Cloth, Y 4 1

Steel, X 2 3

Endowments 900 600


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Steel

Cloth

200150 450

600

150

225

Labor constraint

Capital constraint

E

G

M

H

0

J

•

•

•

•

•

Figure 3

Labor Capital

Cloth, Y 4 1

Steel, X 2 3

Endowments 900 600

JEH is the PPF


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48


• Figure 3: Derivation of the production-possibilities frontier. If the economy had an unlimited supply of capital (labor), it would be able to produce along the labor constraint JG (capital constraint MH). When the supplies of both factors are limited, both constraints become binding and the production frontier coincides with the heavy kinked line JEH. Because steel is capital intensive relative to cloth, the capital constraint is steeper than the labor frontier.


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Figure 4

Steel

Cloth

Figure 4

Since same tastes in both countries, only one set of communal indifference curves.

Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but consumes at C*.


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• Figure 4: Production frontiers JQH and J*Q*H* reflect the fact that America is endowed with more capital than Britain, while Britain is endowed with more labor than America. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but shifts consumption to C*. Trade triangles CQV and Q*C*V* are identical. America exports steel, and Britain cloth.


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51

Heckscher-Ohlin Theorem with Many Techniques

Steel

ClothBefore trade, America produces and consumes at R, and Britain at R*. With free trade, America produces at Q and consumes at C, and Britain at Q* and C*, respectively.

Figure 5


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Heckcher-Ohlin Theorem with Many Techniques

• Figure 5: Production frontier JH of America (the capital-abundant country) is skewed along the axis for steel (the capital-intensive commodity); and the production frontier J*H* of Britain (the labor-abundant country) is skewed along the axis for cloth (the labor-intensive commodity). Before trade, America produces and consumes at R, and Britain at R*. With free trade, America produces at Q and consumes at C, and Britain at Q* and C*, respectively. Trade triangles CQV and Q*C*V* are identical, America exports steel, and Britain cloth.


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53

Derivation of Offer Curves and the International Equilibrium

Figure 6 (a) Figure 6 (b)

Food America’s exports of food

Am

eric

a’s

imp

ort

s o

f cl

oth

ing

Clo

thin

g

In autarky (p = 2) US produces and consumes at E.

At p = 3, America shifts production to Q and consumption to S. And at p = 4, R and K, respectively.


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54

Derivation of Offer Curves and the International Equilibrium continued

• Figure 6: Derivation of America’s offer curve. At the Autarkic relative price of food (p), assumed to be equal to 2, America produces and consumes at E in panel (a), and trades at the origin of panel (b). At p=3, America shifts production to Q and consumption to S in panel (a), and trades at S in panel (b). Similarly, at p=4, America produces at R and consumes at K in panel (a), and trades at K in panel (b). Trade triangles SVQ and KGR are identical to triangles SJO and KLO, respectively. The locus of all trade points (such as S and K) in panel (b) is America’s offer curve.


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55

International Equilibrium

Figure 7

FoodAmerica’s exportsBritain’s imports

Clo

thin

gA

mer

ica’

s im

port

sB

ritai

n’s

expo

rts

Here the offer curves of two trading countries define the international equilibrium at K.


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56

Derivation of Offer Curves and the International Equilibrium continued

• Figure 7: International equilibriumInternational equilibrium occurs at K, where the offer curves intersect. America exports OL units of food to Britain and imports OL* units of clothing from Britain. The slope of terms-of-trade line TOT3 gives equilibrium terms of trade OL*/OL.


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End of Fun!

On next lecture:

2. WHY DO WE TRADE?- Part II

2. why do we trade? - part i

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