international economics · slope, or marginal rate of transformation, shows the opportunity costof...

International Economics

Woraphon Yamaka

Chapter 2:Foundations of Modern Trade Theory

Modified form International Economics 9th Edition byRobert J. Carbaugh

Overview

The previous chapter discussed the importance of international trade.

This chapter answers the following questions: (1)What constitutes the basis for trade—that is, why do

nations export and import certain products?

(2) At what terms of trade are products exchanged in the world market?

(3)What are the gains from international trade in terms of production and consumption?

This chapter addresses these questions, first by summarizing the historical development of modern trade theory and next by presenting the contemporary

Carbaugh, Chap. 2

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Historical development of trade theoryMercantilism (During the period 1500–1800)

Regulation to ensure a positive trade balance If a country could achieve a favorable trade balance (a surplus of

exports over imports), it would realize net payments received from the rest of the world in the form of gold and silver.

Such revenues would contribute to increased spending and a rise in domestic output and employment.

Tariffs, quotas, and other commercial policies were proposed by the mercantilists to minimize imports in order to protect a nation’s trade position Critics: 1) It is possible only for short term, this theory will not exist in the

long term. 2) It assumes a static world economy. To the mercantilists, the

world’s wealth was fixed, which is not true. One gain 100% another would loss the same number that is 100%

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Foundations of trade theory

Example: Critics 1

Suppose England achieve a trade surplus that results in an inflow of gold and silver. Because these precious metals constitute part of England’s money supply, their inflow increases the amount of money in circulation.

This increase leads to a rise in England’s price level relative to that of its trading partners. English residents would therefore be encouraged to purchase foreign goods

England’s import increase but exports would decline. As a result, the country’s trade surplus would eventually be eliminated.

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Money supply Domestic Price residents buy foreign goods

import trade surplus

Example: Critics 2

Adam Smith’s The Wealth of Nations (1723–1790) mentioned that the world’s wealth is not a fixed quantity.

International trade permits nations to take advantage of specialization and the division of labor, which increase the general level of productivity within a country and thus increase world output (wealth).

(Absolute Advantage and Comparative advantage) Smith suggested that the world ‘s wealth is dynamic

view Both trading partners could simultaneously enjoy

higher levels of production and consumption with trade. ( Both can gain form trade)

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Carbaugh, Chap. 2

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Source: EHES WORKING PAPERS IN ECONOMIC HISTORY|NO. 93

What happens here?

Historical development of trade theory

Absolute advantage (Adam Smith)Countries benefit from exporting what they make

cheaper than anyone elseBut: nations without absolute advantage do not

gain from tradeComparative advantage (David Ricardo)

Nations can gain from specialization, even if they lack an absolute advantage

Carbaugh, Chap. 2

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Foundations of trade theory

Example8

Comparative advantage

Absolute advantageOutput per labor hour

Nation Wine Cloth

United States 5 bottles 20 yards US absolute advantage clothUnited Kingdom 15 bottles 10 yards UK absolute advantage Wine

Comparative advantageOutput per labor hour

Nation Wine Cloth MRT Wine MRT cloth

United States 40 bottles 40 yards 40/40 yards 40/40 bottlesUnited Kingdom 20 bottles 10 yards 10/20 yards 20/10 bottles

US absolute advantage on Cloth and Wine But: MRT Wine (US) > MRT Wine(UK)

Thus UK comparative advantage on Wine

Ricardo’s Comparative Advantage in money prices

Carbaugh, Chap. 2

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Cloth (yards) Wine (bottles)Nation Labor Wage Quant. Price Quant. Price

US 1 hr $20/hr 40 $0.50 40 $0.50UK 1 hr £5/hr 10 £0.50 20 £0.25UK 1 hr $8 10 $0.80 20 $0.40

*** (Suppose that $1.6 = £1 thus £5 $8 )

US is better in producing Cloth

UK is better in producing Wine

Production possibilities schedule (Extension of Ricardo theory) Ricardo’s law of comparative advantage suggested

that specialization and trade can lead to gains for both nations. His theory, however, depended on the restrictive assumption of the labor theory of value, in which labor was assumed to be the only factor input. However, in practice, labor is only one of several factor inputs. This is not true in the reality

This schedule shows various alternative combinations of two goods that a nation can produce when all of its factor inputs (land, labor, capital, entrepreneurship) are used in their most efficient manner.

The production possibilities schedule thus illustrates the maximum output possibilities of a nation. (Note that we are no longer assuming labor to be the only factor input, as Ricardo did)

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PPF

Mountain Bikes

Bee

rAs the economy shifts resources from beer to mountain bikes: PPF becomes

steeper opp. cost of

mountain bikes increases

As you can see the slope lines are not constant along the PPF

Marginal Rate of Transformation12


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)There are two reasons for constant costs. First, the factors of production are perfect substitutes for each other. Second, all units of a given factor are of the same quality.

Production possibilities schedules: constant opportunity costs

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Which country is the opportunity cost of Autos lower?

Note: constant opportunity costs is the cost of the product that the country given up

Trading under constant opportunity costs

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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 gain

Suppose that the terms of trade agreed on is a 1:1 ratio, whereby 1 auto is exchanged for 1 bushel of wheat. Based on these conditions, let line ttrepresent the international terms of trade for both countries. This line is referred to as the trading possibilities line

Production gains from specialization under constant opportunity costs (Example)

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Autos Wheat Autos Wheat Autos Wheat

US A 40 40 B120 0 80 -40Canada A’ 40 80 B’ 0 160 -40 80World 80 120 120 160 40 40

Before After Net GainSpecialization Specialization (Loss)

Suppose the world has two courtiers (US and Canada)US is good in producing Autos, but Canada is good at wheat. This example show that when US and Canada specialize inthe product of its comparative advantage.The world’s wealth increase

Consumption gains from trade: constant opportunity costs (Example)

Carbaugh, Chap. 2

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US A 40 40 C 60 60 20 20Canada A’ 40 80 C’ 60 100 20 20World 80 120 120 160 40 40

Before After Net GainTrade Trade (Loss)

Assume that the United States and Canada achieve a terms-of-trade ratio that permits both trading partners to consume at some point outside their respective production possibilities schedules (Figure in slide 13)

Form BC

Carbaugh, Chap. 2

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Dynamic Gains From Trade18

• The previous analysis of the gains from international trade stressed specialization and reallocation of existing resources—the so-called static gains from specialization.

• However, these gains can be dwarfed by the effect of trade on the country’s growth rate and thus on the volume of additional resources made available to, or utilized by, the trading country. These are known as the dynamic gains from international trade as opposed to the static effects of reallocating a fixed quantity of resources.

Trade can also generate dynamic gains by stimulating economicgrowth. There are many success stories of growth through trade. However, the effect of trade on growth is not the same for all countries. In general, the gains tend to be less for a large country such as the United States than for a small country such as Belgium.

Dynamic Gains From Trade

Carbaugh, Chap. 2

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International trade more efficient use of an economy’s resources, higher output and income more saving more investment higher rate of economic growth

International trade allows small and moderately sized countries to establish and operate many plants of efficient size expand their production and employ more specialized labor and equipment

International trade open trade forces inefficient firms to exit the industry high competion allows more productive firms to grow raise the averageindustry efficiency

Example

Changing comparative advantage under constant opportunity cost (due to productivity)

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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.

Suppose that the MRT of automobiles into computers initially equals 1.0 for the US and 2.0 for Japan. The United States thus has a comparative advantage in the production of computers and a comparative disadvantage in auto production. Then both nations experience productivity increases in computers but no productivity change in automobiles.

Shift due to computer productivity change

How US’s computer industry cope with this problem?

Carbaugh, Chap. 2

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• To cope with changing comparative advantages, computer producers are under constant pressure to reinvent themselves

• Intel, Motorola, and Texas Instruments abandoned the dynamic-random-access-memory (DRAM) business and invested more heavily in manufacturing microprocessors and logic products

• A fact of economic life is that no producer can remain the world’s low-cost producer forever. As comparative advantages change, producers need to hone their skills to compete in more profitable areas.

Production possibilities schedule under increasing opportunity cost

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Increasing opportunity costs

Under increasing costs, the slope of the concave production possibilities schedule varies as a nation locates at different points on the schedule. Because the MRT equals the production possibilities schedule’s slope, it will also be different for each point on the schedule.

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High skill

High skill

Low skill

High skill

Low skill

low skill

High skill

low skill

Wheat Autos

Trading under increasing costs: US

Carbaugh, Chap. 2

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E1A=3W

Trading under increasing costs: Canada

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1W=0.33A

1W=1A

1W=3A

Production gains from specialization: increasing opportunity costs (Example)

Carbaugh, Chap. 2

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US A 5 18 B 12 14 7 -4Canada A’ 17 6 B’ 13 13 -4 7World 22 24 25 27 3 3

Before After Net GainSpecialization Specialization (Loss)


The process of specialization continues in both nations until the relative cost of autos is identical in both nations and U.S. exports of autos are precisely equal to Canada’s imports of autos. Likewise U.S. import of wheats are precisely equal to Canada’s export of wheats.

Carbaugh, Chap. 2

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High skill

High skill

Low skill

High skill

Low skill

low skill

High skill

low skill

Wheat Autos

Consumption gains from trade: increasing opportunity costs (Example)

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US A 5 18 C 5 21 0 3Canada A’ 17 6 C’ 20 6 3 0World 22 24 25 27 3 3

Before After Net GainTrade Trade (Loss)


Form BCUS : Assume that the United States prefers to consume the same number of autosas it did in the absence of trade. It will export 7 autos for 7 bushels of wheat from point B, achieving a post-trade consumption point at C.

Canada holds constant its consumption of wheat, it will export 7 bushels of wheat for 7 autos form point B’ and achieve a post-trade at C’.

international economics · slope, or marginal rate of transformation, shows the opportunity costof...

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