european economics issues lecture 2 why do we trade?

European Economics Issues

Lecture 2

Why do we trade?Some parts of this lecture are drawn from material in Chapter 23.1 of Sloman (2009). Some parts of this lecture are drawn from material in Chapter 23.1 of Sloman (2009).

For the remainder the primary source should be these notes. They are a simplified For the remainder the primary source should be these notes. They are a simplified treatment of material covered in more detail in Markusen & Melvin, The Theory of treatment of material covered in more detail in Markusen & Melvin, The Theory of

International TradeInternational Trade

Why Do We Trade?Why Do We Trade?

• Why individuals and countries trade: Why individuals and countries trade:

• Would we trade if everyone were identical?Would we trade if everyone were identical?

• Yes?/No?/Maybe?Yes?/No?/Maybe?

• OneOne EXAMPLE EXAMPLE

• Assume Same Production Capability, BUT Assume Same Production Capability, BUT Different TastesDifferent Tastes

• Suppose that we could all produce equal Suppose that we could all produce equal numbers of apples and orangesnumbers of apples and oranges

• BUT…….BUT…….

• I only like Oranges and you only like ApplesI only like Oranges and you only like Apples

Equilibrium before tradeEquilibrium before trade

O

Ora

ng

es

Apples

10

10

•Production

set of both

Economies

•Production

set of both

Economies


O

Ora

ng

es

Apples

10

•Production

set of both

Economies

•Production

set of both

Economies

•My

Consumption

Set

•My

Consumption

Set


O

Ora

ng

es

Apples10

•Production

set of both

Economies

•Production

set of both

Economies

•Your

Consumption

Set

•Your

Consumption

Set

Trade when production same + Trade when production same + tastes differtastes differ

O

Ora

ng

es

Apples

20

1020

10

U Sell Oranges buy Apples

I Sell Apples buy Oranges

What is key assumption?What is key assumption?

• Same Production PatternSame Production Pattern• Equal Apples & OrangesEqual Apples & Oranges• But Different TastesBut Different Tastes• Same Production capability, Different TastesSame Production capability, Different Tastes• If free to produce whatever we want (to match If free to produce whatever we want (to match

production and tastes) then no trade even if tastes production and tastes) then no trade even if tastes differdiffer

• So need some restriction on production for trade: So need some restriction on production for trade: • In reality production capabilities are often not the In reality production capabilities are often not the

same:same:– Some production fixedSome production fixed– Soil, natural resources, oil, minerals etcSoil, natural resources, oil, minerals etc

DifferentDifferent Story Story

• Same Tastes in each country, (both Same Tastes in each country, (both countries like Textiles and Computers)countries like Textiles and Computers)

• But have different TECHNOLOGY But have different TECHNOLOGY

• Suppose technology is such that Labour in Suppose technology is such that Labour in Developed Country more productive than in Developed Country more productive than in Underdeveloped countryUnderdeveloped country

Pre-trade production and consumption possibilitiesPre-trade production and consumption possibilities

Computers (Millions)

Tex

tiles

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

Less developedCountry, population 500

Less developed country Developed country

Textiles (kilos m)

Computers (m)

Textiles (kilos m)

Computers (m)

a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400



Textiles (kilos m)

Computers ( millions)

Textiles (kilos m)

Computers ( millions)

a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b Less developedcountry




Textiles (kilos m)

Computers (millions)

Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b

c

d

e

f

Less developedcountry


Workers can produce 1000 Kilos of textiles

OR

500 Computers

•Or anything in

between

•Or anything in

between



Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b

c

d

e

f



Workers can produce 1000 Kilos of textiles

OR

500 Computers

So can produce in the ratio of 2 Textiles for

1 Computer

So can produce in the ratio of 2 Textiles for

1 Computer



Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b

c

d

e

f



So can produce in the ratio of 2 Textiles for 1

Computer

Or it takes 2 units of textiles to purchase 1 unit

of computers



Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b

c

d

e

f



Formally we say….

the RELATIVE price of Computers

in terms of Textiles

(not money!!) is

Pc/Pt=2/1



Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)

0

200

400

600

800

1000

0 200 400 600 800 1000

a

b

c

d

e

f



Or alternatively

the RELATIVE price of Textiles

in terms of Computers in the LDC is

Pt/Pc=1/2

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)



Developed Country can produce in the ratio of 2

Computers for 1 K of Textiles

Or it takes 1 units of textiles to purchase 2 unit of computers

SO it takes 1/2 units of textiles to purchase 1 unit of computers


Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)



So the RELATIVE Price of a 1 computer in

terms of textiles in the Developed Country is

Pc/Pt=1/2


Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)



OR the RELATIVE Price of a 1 unit of texties computer in terms of

computers in the Developed Country is

Pt/Pc=2/1


Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

0

200

400

600

800

1000

0 200 400 600 800 1000



Textiles (kilos m)


Textiles (kilos m)


a b c d e f

1000 800 600 400 200 0

0 100 200 300 400 500

g h I j k l m

1200 1000 800 600 400 200 0

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)


gh

ij

kl

m


Developedcountry

Slope 2/1 Slope 1/2


0

200

400

600

800

1000

0 200 400 600 800 1000


Tex

tiles

(ki

los

m)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)


gh

ij

kl

m


Developedcountry

Slope 2/1 Slope 1/2


Developed countries relative pre-trade price = Pc /Pt=1/2

Less-Developed countries relative pre-trade price = Pc /Pt= 2


Tex

tiles

(ki

los

m)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)


gh

ij

kl

m


Developedcountry

Slope 2/1 Slope 1/2

So C is relatively cheap in the Developed countries (it has a comparative advantage in Computers)

And relatively expensive in the Less-Developed countries whereas Textiles are relatively cheaper. (The LDC is LESS BAD at Textiles and therefore

Textiles are its comparative advantage)

0

200

400

600

800

1000

0 200 400 600 800 1000

Effect of trade on consumption possibilitiesEffect of trade on consumption possibilitiesT

extil

es (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 10000

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400


Tex

tiles

(ki

los

m)



Slope 1/1 Slope 1/1

Possibilities have clearly risen

So can’t be worse off!!

0

200

400

600

800

1000

0 200 400 600 800 1000


Tex

tiles

(ki

los

m)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)


gh

ij

kl

m


Developedcountry

Slope 2/1 Slope 1/2

If there is no trade (the country is in Autarky) then the production possibility frontier in each case also

represents the consumption possibilities. The bundle each consumes will depend on tastes but

production and consumption will be the same.

0

200

400

600

800

1000

0 200 400 600 800 1000


Tex

tiles

(ki

los

m)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)


gh

ij

kl

m


Developedcountry

Slope 2/1 Slope 1/2

If we now allow free trade between the two countries, the free trade price must lie between the

two sets of AUTARKY prices

FTt

FTC

P

P

0

200

400

600

800

1000

0 200 400 600 800 1000


Tex

tiles

(ki

los

m)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)


gh

ij

kl

m


Developedcountry

Slope 2/1 Slope 1/2



2

12

FTt

FTC

P

P

0

200

400

600

800

1000

0 200 400 600 800 1000


Tex

tiles

(ki

los

m)

a

b

c

d

e

f0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Tex

tiles

(ki

los

m)


gh

ij

kl

m


Developedcountry

Slope 2/1 Slope 1/2



1FTt

FTC

P

PSuppose

0

200

400

600

800

1000

0 200 400 600 800 10000

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400

Effect of trade on consumption possibilitiesEffect of trade on consumption possibilities


Tex

tiles

(ki

los

m)

Tex

tiles

(ki

los

m)



1FTt

FTC

P

PSuppose

Effect of trade on consumption possibilitiesEffect of trade on consumption possibilitiesT

extil

es (

kilo

s m

)

0

200

400

600

800

1000

0 200 400 600 800 10000

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 2400


Tex

tiles

(ki

los

m)



Slope 1/1 Slope 1/1

Possibilities have clearly risen

So can’t be worse off!!

0

400

800

1200

1600

2000

2400

0 400 800 1200 1600 2000 24000

200

400

600

800

1000

0 200 400 600 800 1000

Effect of trade on consumption possibilitiesEffect of trade on consumption possibilities


Tex

tiles

(ki

los

m)

Tex

tiles

(ki

los

m)



Imports

600

Exports600

Exports600

x

y

•Imports

600

•Imports

600

• Developed Country is better at producing both Textiles AND Computers

– It has an absolute advantage in both

– Initially c = 1600 t = 400

– But it has a comparative advantage in producing computers

– Specialise in producing 2400 computers

– Exports 600c, Imports 600t: c = 1800 t = 600

– Less Developed Country initially t = 200, c = 400,

– If it now produces textiles = 1000

– Exports 600t, Imports 600c: t = 400 c= 600,

– DC gains 200c and 200t, LDC gains 200c and 200t

• Developed Country is better at producing both Textiles AND Computers

– It has an absolute advantage in both

– Initially c = 1600 t = 400

– But it has a comparative advantage in producing computers

– Specialise in producing 2400 computers

– Exports 600c, Imports 600t: c = 1800 t = 600

– Less Developed Country initially t = 200, c = 400,

– If it now produces textiles = 1000

– Exports 600t, Imports 600c: t = 400 c= 600,

– DC gains 200c and 200t, LDC gains 200c and 200t

THE ADVANTAGES OF TRADETHE ADVANTAGES OF TRADE

• 1. Production (& technology) the same but fixed - tastes different = TRADE

• 2. Production, technology the same, but can produce any combination you want = No Trade

• 3. Technology Different, tastes same - Trade

– absolute advantage & comparative advantage

• 4. NEXT: Technology the same, tastes the same but endowment of resources (e.g Capital & Labour or skilled labour) different.

• 1. Production (& technology) the same but fixed - tastes different = TRADE

• 2. Production, technology the same, but can produce any combination you want = No Trade

• 3. Technology Different, tastes same - Trade

– absolute advantage & comparative advantage

• 4. NEXT: Technology the same, tastes the same but endowment of resources (e.g Capital & Labour or skilled labour) different.


O

Te

xtile

s

Computers

Suppose Computers need mostly capital and textiles need mostly labour, and

suppose Developed country has mostly capital and the less

developed country has mostly labour


O

Te

xtile

s

Computers

Suppose initially each country put exactly half

their workers in to producing computers and

textiles

DC

LDC

Labour abundant LDCLabour abundant LDC

O

Te

xtile

s

Computers

LDC

If capital and labour were used in the same ratio in both industries then if I want to produce more T

or more C then move in a straight line either wayalong the production

frontier


O

Te

xtile

s

Computers

LDC

But if Textiles are more labour intensive then can produce more,

And if computers are capital intensive cannot

produce as much

So Production frontier looks like…


O

Te

xtile

s

Computers

LDC

Alternative explanation:

As we move down from the spot, to produce more

computers we are allocating more capital &

workers

but since capital is relatively scarce, capital

per worker is lower, so not getting much extra

production.


O

Te

xtile

s

Computers

LDC

AND….

As we move UP from the spot, to produce more textiles, we are

allocating more workers and capital

but workers per machine is rising, so can produce more.

Capital abundant Developed CountryCapital abundant Developed Country

O

Te

xtile

s

Computers

LDC

For DC

Textiles are more labour intensive so

produce……. LESS

DC

Capital abundant Developed CountryCapital abundant Developed Country

O

Te

xtile

s

Computers

LDC

And since Computers are more capital

intensive can produce……. MORE

So Production frontier looks like…

DC

O

Te

xtile

s

Computers

LDC

Assume initially that each country produces & consumes at the dots

DC

TradeTrade

O

Te

xtile

s

Computers

LDC

DC

Note in LDC Computers will be RELATIVELY expensive,

e.g, Pc /Pt = 2/1

while in DC they will be relatively cheap e.g. Pc /Pt =1/2

O

Te

xtile

s

Computers

LDC

Now suppose we allow free trade……. And

have a common price that lies in between

DC

O

Te

xtile

s

Computers

LDC

Now suppose we allow free trade……. And

have a common price that lies in between

DC

LDC EXPORT

IMPORT

DC EXPORT

DC IMPORTS

Trade when have different factor endowmentsTrade when have different factor endowments

• Even if technology and tastes are the same, Even if technology and tastes are the same, different factor endowments means different different factor endowments means different production possibilities. production possibilities.

• Again this creates possible Again this creates possible comparative comparative advantagesadvantages and hence benefits from trade. and hence benefits from trade.

• In the example, both countries gain by producing In the example, both countries gain by producing more of the good in which they have the abundant more of the good in which they have the abundant factor and engaging in trade.factor and engaging in trade.

• This was probably believed to be the dominant This was probably believed to be the dominant source of gains from trade in the original EU.source of gains from trade in the original EU.

Comparative Advantage or Why might prices Comparative Advantage or Why might prices differ – Summary 1-5?differ – Summary 1-5?

• 1. Different tastes 1. Different tastes – (same Technology & Factors)(same Technology & Factors)

• 2. Different technology or physical capabilities2. Different technology or physical capabilities– (Patented R&D, Land/Minerals)(Patented R&D, Land/Minerals)

• 3. Differences in Factor Endowments3. Differences in Factor Endowments– Labour/Capital/Skilled labourLabour/Capital/Skilled labour

• 4. Differences in Taxes - 4. Differences in Taxes - – e.g. Corporation tax, alcohol, cigs, petrole.g. Corporation tax, alcohol, cigs, petrol

• 5. (Differences in) competition5. (Differences in) competition– (Monopoly pushes prices up)(Monopoly pushes prices up)

• 6. One Special case: Can trade even if we are 6. One Special case: Can trade even if we are identicalidentical

– Increasing Returns to ScaleIncreasing Returns to Scale

Returns to ScaleReturns to Scale

• Constant returns to scale Constant returns to scale – Double the factory, double the workforce, double the Double the factory, double the workforce, double the

machinery -------- Get double the productionmachinery -------- Get double the production• Increasing returns to scale Increasing returns to scale

– Double the factory, double the workforce, double the Double the factory, double the workforce, double the machinery -------- Get MORE THAN DOUBLE the machinery -------- Get MORE THAN DOUBLE the productionproduction

• Why might this happenWhy might this happen– Internal EconomiesInternal Economies– More efficient work practice and specialisation of More efficient work practice and specialisation of

workersworkers– Bigger buying power for materials or better distribution Bigger buying power for materials or better distribution

networksnetworks– External EconomiesExternal Economies– Government invests in training or infrastructureGovernment invests in training or infrastructure

Identical technology, endowments and Identical technology, endowments and tastes BUT increasing returns to scale.tastes BUT increasing returns to scale.

O

Ae

rop

lan

es

Computers

Identical technology, endowments and tastes BUT increasing Identical technology, endowments and tastes BUT increasing returns to scale. returns to scale.

O

Ae

rop

lan

es

Computers

Germany & UK

Initially both Germany and UK produce Aeroplanes and

computersNow suppose UK

specialises in Aeroplanes

and gains increasing returns

to scale


O

Ae

rop

lan

es

Computers

Germany & UK

Similarly, Germany specialises in Computers

Overall EU(?) Production Frontier

now moves out

and gains increasing returns to scale

O

Ae

rop

lan

es

Computers

Germany & UK

Now Germany exports Computers and imports

Aeroplanes

German Exports

IMPORTS

UK

Exports

While the UK exports Aeroplanes and imports

Computers

UK IMPORTS


Identical technology, Identical technology, endowments and tastes BUT endowments and tastes BUT increasing returns to scale.increasing returns to scale.

O

Ae

rop

lan

es

Computers

Germany & UK

So Even when identical specialisation and

Trade allows welfare gains

German Exports

IMPORTS

UK

Exports

UK IMPORTS

european economics issues lecture 2 why do we trade?

Documents

production fixedsoil

countries trade

consumption possibilitiesless

different technology

different tastessuppose

tastes differso

different tastesif free

equal numbers of apples