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Copyright ©2000, South-Western College Publishing
Lec 1:
Introduction
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Trade
Theory
Subject Outline
FinanceTrade
Policy
International
Economics
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Trade
TheoryStudy Guide 1
Mercantilism
Absolute Advantage
Comparative Advantage
Heckscher-Ohlin Stolper-Samuelson
Factor Price Equalisation
Rybzcynski
Immiserising Growth
Trade
Theory
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• Theory used to explain and predict.
• What is International Trade?
• Why do nations trade?
• What are the gains from trade?
• Who gains from trade?
Trade Theory
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Trade
Policy
Tools of the Trade Policy Analysis
Tariffs
Other TradePolicies Regional Trade
Agreements
International ResourceMovements
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Finance
Study Guide 3
Weeks 9-12
Exchange Rates
Exchange ratetheorems
Interest Arbitrage
Current AccountDeficit
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Trade
TheoryStudy Guide 1
Comparative Advantage
Heckscher-Ohlin Stolper-Samuelson
Factor Price Equalisation
RybzcynskiTrade
Theory
Mercantilism
Absolute Advantage
Week 1
Immiserising Growth
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• Mercantilism - zero sum game - one nation gains at the expense of the other.
• Adam Smith - both nations can gain from trade.
• Absolute Advantage - each nation should specialise in production of the good which it is most efficient at producing.
Trade Theory Why do Nations Trade?
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• Perfect Competition in Product and Factor Markets (P=MC)
• Each Country has a fixed endowment of resources that are fully used and are homogeneous
• Technology is Unchanging
• No Transportation Costs or barriers to trade
• Factors of Production are perfectly mobile between industries but are immobile between countries
• 2x2x1
Trade Theory Why do Nations Trade?
Assumptions
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Trade Theory Why do Nations Trade?
Mercantilism
The way for a nation to become rich
and powerful is to export more than
to import
Thomas Munn (1571-1641)
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Trade Theory
Imports
Exports
Imports
Exports
ENGLAND FRANCE
Why do Nations Trade?
Mercantilism
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Introduction
Adam Smith (1723-1790)
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Introduction
David Ricardo (1772-1823)
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Copyright ©2000, South-Western College Publishing
International EconomicsBy Robert J. Carbaugh
7th Edition
Chapter 2:
Foundations of modern trade theory
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Carbaugh, Chap. 2 15
Historical development of trade theory
• Mercantilism
• positive trade balance
• Absolute advantage (Adam Smith)
• Countries benefit from exporting what they make cheaper than anyone else
• Comparative advantage (David Ricardo)
• Nations can gain from specialization, even if they lack an absolute advantage
Foundations of trade theory
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International Trade Theories:
Mercantilism (1500 – 1750):
1. International trade is a zero-sum game:
Static view of world resources:
One’s gains = Other’s losses
2. Wealth: Acquisition of precious metals—gold or silver
Well-being = Accumulating gold
3. Economic growth =Enhancement of power with strong
army, strong navy and merchant marine, and enlargement
of foreign colonies.
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4. Productive = maintaining and increasing the power
5. Regulations or restrictions on importable activities
6. Favorable positive trade balance:
Exports > Imports Inflows of specie (gold)
Money supply increases
Stimulates output and
employment
Economic growth
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Mercantilism :
Role of the government and
domestic economic policy
• Control the use and exchange of precious metals (Bullionism)
•High tariffs, quotas on imports of consumption goods
•Tax exemptions and subsidies to exports
•Allows trade monopolies and monopsonies
•Pursues low wage policies
•Encourage large family, providing financial incentives for
marriage and stimulate population growth
•Emphasis the important of the merchant class
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David Hume (1752):
Price-Specie-Flow Mechanism
Accumulate specie with internal automatic repercussions.
Assumptions:
1. Link between money and price:
MV = PV; Full employment; Fixed velocity of money
2. Demand for trade goods is price elastic:
Stable equilibrium in trade sector.
3. Perfect competition: product and factor markets
Link between prices and wages (W).
4. Gold standard exists:
Gold is directly linked to money and specie.
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Price-Specie-flow Mechanism:
Trade surplus vis-à-vis Trade Deficit
Exports > Imports Exports < Imports
Step 1 : Net inflow of specie Net outflow of specie
Step 2 : Money supply increase Money supply decrease
Step 3 : Prices and wages
increase
Prices and wages
decrease
Step 4 : Increase in imports &
Decrease in exports
Decrease in imports and
Increase in exports
until until
Exports = Imports Exports = Imports
Country A Country B
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Adam Smith (1723 – 1790)
Laissez faire and free trade is a positive-sum game:
Nation’s wealth production capacity not
holdings of gold
Economic growth free environment and self-interest
and competition
Productivity gains division of labor and specialization
of labor
Mutual beneficial exchange and free trade
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Copyright ©2000, South-Western College Publishing
2
Foundations of modern trade theory
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Carbaugh, Chap. 2 23
Historical development of trade theory• Mercantilism
• positive trade balance
• Absolute advantage (Adam Smith)
• Countries benefit from exporting what they make cheaper than anyone else
• Comparative advantage (David Ricardo)
• Nations can gain from specialization, even if they lack an absolute advantage
Foundations of trade theory
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Carbaugh, Chap. 2 24
Absolute & Comparative Advantage
Comparative advantage
Absolute advantage: each nation is more efficient in
producing one good
Output per labor hour
Nation Wine Cloth
United States 5 bottles 20 yards
United Kingdom 15 bottles 8 yards
Comparative advantage: the US has an absolute
advantage in both goods
Output per labor hour
Nation Wine Cloth
United States 40 bottles 40 yards
United Kingdom 20 bottles 10 yards
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Carbaugh, Chap. 2 25
Ricardo’s Comparative Advantage in money prices
Comparative advantage
Cloth (yards) Wine (bottles)
Nation Labor Wage Quant. Price Quant. Price
US 1 hr $20/hr 40 $0.50 40 $0.50
UK 1 hr £5/hr 10 £0.50 20 £0.25
UK 1 hr $8 10 $0.80 20 $0.40
(at $1.6 = £1)
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Carbaugh, Chap. 2 26
Transformation schedules
• Generalizes theory to include all factors, not just labor
• Shows combinations of products that can be made if all factors are used efficiently
• Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another)
Comparative advantage
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Carbaugh, Chap. 2 27
Marginal Rate of TransformationComparative advantage
0
10
20
30
40
50
60
70
0 20 40 60 80 100 120 140
Autos
A
B
C
Slope = MRT = 0.5
Wh
eat
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Carbaugh, Chap. 2 28
Transformation schedules: constant opportunity costs
United States
0
20
40
60
80
100
120
140
160
0 40 80 120
Autos
Canada
0
20
40
60
80
100
120
140
160
0 40 80 120
Autos
Comparative advantage
Slope = 0.5 = MRT
Slope = 2.0 = MRT
Wh
eat
Wh
eat
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Carbaugh, Chap. 2 29
Supply schedules: constant opportunity costs
0
0.5
1
1.5
2
2.5
3
0 40 80 120 160
Autos
Comparative advantage
S Canada
0
0.5
1
1.5
2
2.5
3
0 20 40 60 80 10
0
12
0
14
0
16
0
Wheat
S US
S US
S Canada
Bu
sh
els
of
wh
eat
per
au
to
Au
tos p
er
bu
sh
el o
f w
heat
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Carbaugh, Chap. 2 30
Trading under constant opportunity costs
United States
0
20
40
60
80
100
120
140
160
0 20 40 60 80 10
0
12
0
14
0
16
0
Autos
Comparative advantage
A
B
C
D
E
F
Trading
possibilities line
(terms of trade 1:1)
Canada
0
20
40
60
80
100
120
140
160
0 20 40 60 80 10
0
12
0
14
0
16
0
Autos
A’
B’
C’D’
Trading
possibilities line
(terms of trade 1:1)
Wh
eat
Wh
eat
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Carbaugh, Chap. 2 31
Production gains from specialization: constant opportunity costs
Comparative advantage
Autos Wheat Autos Wheat Autos Wheat
US 40 40 120 0 80 -40
Canada 40 80 0 160 -40 80
World 80 120 120 160 40 40
Before After Net Gain
Specialization Specialization (Loss)
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Carbaugh, Chap. 2 32
Consumption gains from trade: constant opportunity costs
Comparative advantage
Autos Wheat Autos Wheat Autos Wheat
US 40 40 60 60 20 20
Canada 40 80 60 100 20 20
World 80 120 120 160 40 40
Before After Net Gain
Specialization Specialization (Loss)
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Carbaugh, Chap. 2 33
Complete specialization under constant opportunity costs
0
0.5
1
1.5
2
2.5
3
0 40 80 120 160
Autos
Comparative advantage
S Canada
0
0.5
1
1.5
2
2.5
3
0 40 80 120 160
Wheat
S US
S US
S Canada
Aw
Aa
Aa’
Aw’
Bu
sh
els
of
wh
eat
per
au
to
Au
tos p
er
bu
sh
el o
f w
heat
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Carbaugh, Chap. 2 34
Changing comparative advantage
United States
0
100
0 50 100 150
Computers
MRT = 1.0
Japan
0
80
0 40 80 120 160
Computers
MRT = 2.0
Comparative advantage
MRT = 0.67MRT = 0.5
Au
tos
Au
tos