23.10.

2009

Introduction
• Basis for trade
Chapter 2 – Why do nations export and import?
• Terms of trade

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• Gains from international trade
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Foundations of Modern – Specific to production and consumption

Trade Theory:
Comparative Advantage

Modern Trade Theory

Historical Development Continued
Historical Development
• The Mercantilists • Criticism of Mercantilist policies
– Concern: Regulation of domestic and – David Hume’s price-specie-flow doctrine
international affairs to promote national • Favorable trade balance possible only in the short
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interests run; over time it would automatically be eliminated

– Solution: Strong foreign-trade sector – Adam Smith’s “The Wealth of Nations”
• Favorable trade balance • Challenged the static view of wealth
– Advocated government regulation of trade • Dynamic view
– International trade increases the level of productivity
within a country, which in turn increases world output

Why Nations Trade?

Why Nations Trade?
Absolute Advantage Continued

• Adam Smith • Principle of absolute advantage

– Free trade and international division of labor – Import goods in which a nation has an
– Cost differences govern movement of goods absolute cost disadvantage
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– Productivities of factor inputs represent the major

– Export those goods in which it has an
determinant of production cost
absolute cost advantage
– Determination of competitiveness from the supply
– (Example: Table 2.1)
side of the market
– Concept of cost: Labor theory of value
• Labor is the only factor of production and is homogeneous
• Cost depends on labor requirements

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Back
Why Nations Trade? Continued

• David Ricardo: Comparative advantage

– Mutually beneficial trade can occur even
when one nation is absolutely more efficient in
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the production of all goods
• Less efficient nation: Specialize in and export the
good in which it is relatively less inefficient
• More efficient nation: Specialize in and export that
good in which it is relatively more efficient
– Examples of comparative advantages (Table 2.2)

Back Why Nations Trade? Continued

• Assumptions of Ricardo’s model:

– Two nations, two good economy
– Labor is the only input
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– Labor can move freely among industries

within a nation but is incapable of moving
between nations
– Level of technology is fixed for both nations
– Costs do not vary with level of production and
are proportional to the amount of labor used

Why Nations Trade? Continued Back

• Assumptions of Ricardo’s model (cont.):

– Perfect competition prevails in all markets
– Free trade occurs between nations
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– Transportation costs are zero

– Firms make production decisions to maximize
profits; consumers maximize satisfaction
through consumption decisions
– There is no money illusion
– Trade is balanced, no flows of money
between nations
• Comparative-advantage principle (Table 2.3)

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 23.10.2009

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Production Possibilities Schedules

• Used to explain comparative advantage
– Shows production combinations of two goods
when all factor inputs are used most efficiently
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– Illustrates the maximum output possibilities
– Marginal rate of transformation (MRT)
• Amount of one product a nation must sacrifice to
get one additional unit of the other product

Trading Under Constant-Cost Trading Under Constant-Cost

Conditions Conditions Continued

• Principle of comparative advantage under • Basis for trade and direction of trade
constant opportunity costs – Relative costs (Figure 2.1)
– Basis for trade and direction of trade • Point A – U.S: 40 autos and 40 bushels of wheat
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l
– Gains from trade • Point A – Canada: 40 autos and 80 bushels of
wheat
• Two reasons for constant costs: • Relative cost of producing an additional auto
– Factors of production are perfect substitutes – 0.5 bushels of wheat for the United States
for each other – 2 bushels of wheat for Canada

– All units of a given factor are of the same – Direction of trade

quality • United States specializing in and exporting autos
• Canada specializing in and exporting wheat

Trading Under Constant-Cost

Conditions Continued Back

• Production gains from specialization

– Refer (Figure 2.1)
– United States moves from production point A
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to B, totally specializing in auto production

– Canada totally specializes in wheat
l l
production by moving from A to B
• Summary of production gains (Table 2.4a)

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 23.10.2009

Trading Under Constant-Cost Trading Under Constant-Cost

Conditions Continued Conditions Continued

• Consumption gains from trade (Figure 2.1) • Consumption gains from trade (Figure 2.1)
– Specialization and trade – Trade triangle: The triangle BCD showing the U.S.
• Achieve consumption points outside domestic production • Exports (along the horizontal axis),
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possibilities schedules • Imports (along the vertical axis), and
– Terms of trade: Rate at which its export product is • Terms of trade (the slope)
traded for the other country’s export product – Consumption gains from trade for each country and
• Determines the set of posttrade consumption points the world as a whole (Table 2.4b)
• Defines the relative prices at which two products are traded – Complete specialization
– Trading possibilities line: Line tt represents the • Exception: One of the countries is too small to supply the
international terms of trade for both countries other with all of its needs

Trading Under Constant-Cost Back

Conditions Continued

• Distributing the gains from trade

– Domestic cost conditions (Figure 2.2)
– Domestic cost ratios set the outer equilibrium
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terms of trade
• Domestic cost-ratio line: The no-trade boundary
– International terms of trade has to be better
than or equal to the rate defined by domestic
price line
– Region of mutually beneficial trade is
bounded by cost ratios

Trading Under Constant-Cost Trading Under Constant-Cost

Conditions Continued Conditions Continued

• Equilibrium terms of trade • Terms-of-trade estimates

– Commodity terms of trade (barter terms of trade)
– Mill’s theory of reciprocal demand
• Within the outer limits of the terms of trade, the
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actual terms of trade is determined by the relative

strength of each country’s demand for the other
country’s product (Figure 2.2) • Improvement: Rise in export prices relative to import prices
over a time period
– Importance of being unimportant • Deterioration: Rise in import prices relative to export prices
• Larger nation attains fewer gains from trade while over a time period
the smaller nation attains most of the gains – Commodity terms of trade for selected countries (Table
2.5)

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 23.10.2009

Back
Dynamic Gains from Trade
• Effect of trade
– Higher output and income resulting in savings
and consequent investments
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– Better supplier match for imports
– Economies of large-scale production
– Increased competition
• Impact on productivity, quality, and prices

Changing Comparative Advantage Back

• Comparative advantage can vanish if

productivity growth lags
– Pressure on producers to reinvent themselves
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• Case: Semiconductor industry in the U.S.

– Production possibilities schedules, for
computers and automobiles, of the U.S. and
Japan under constant opportunity cost (Figure
2.3)

Trading Under Increasing-Cost Back

Conditions
• Increasing opportunity costs
– Concave production possibilities schedule
(Figure 2.4)
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– Principle of diminishing marginal productivity

– Supply factors as well as demand factors
have to be considered

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 23.10.2009

Increasing-Cost Trading Case Back

• Process of specialization continues in both

nations (Figure 2.5) until:
– The relative cost of autos is identical in both
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nations
– U.S. exports of autos precisely equal
Canada’s imports of autos, and conversely for
wheat
– Production gains from specialization (Figure 2.6a)
– Consumption gains from trade (Figure 2.6b)

Partial Specialization
Back

• Reason for partial specialization

– Increasing costs constitute a mechanism that
forces costs in two trading nations to
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converge
– When cost differentials are eliminated, the
basis for further specialization ceases to exist
• Highly probable that both nations will produce
some of each good

Impact of Trade on Jobs Impact of Trade on JobsContinued

• Standard trade theory • Principle of comparative advantage
– Extent to which an economy is open: – Trade influences the mix of jobs
• Influences the mix of jobs • Shifting of workers and capital to more productive
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• Can cause dislocation in certain areas or industries industries

• Has little effect on the overall level of employment

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 23.10.2009

Comparative Advantage Extended

to Many Products Back

• More than two products

– Rank goods by degree of comparative cost
(Example: Figure 6.7)
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• Each country exports the product(s) in which it has
the greatest comparative advantage
• Each country imports the product(s) in which it has
greatest comparative disadvantage
– Cutoff point between exports and imports
• Depends on the relative strength of international
demand for the various products

Comparative Advantage Extended Back

to Many Countries
• More than two Countries
– Advantageous for a country to enter into
multilateral trading relationships (Figure 2.8)
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• Surpluses with trading partners that buy its exports

• Deficits with trading partners that supply low-cost
items imported
– Bilateral agreements that balance exports and
imports would:
• Reduce volume of trade and specialization
• Hinder movement of resources to their highest
productivity

Empirical Evidence on
Exit Barriers
Comparative Advantage Continued
• Exit barriers hinder the necessary market • Ricardo’s theory: Limitations
adjustments – Labor is not the only factor input
– Various cost conditions make lenghty exit a • Allowance should be made for production and
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rational response distribution costs where appropriate

– Case: U.S. steel industry – Differences in product quality also explain
• Nature of labor costs and benefits trade patterns in certain industries
• Penalties for terminating contracts
• Expenses associated with writing off assets
• Environmental costs
• Low realization on sale of assets

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Comparative Advantage: Job

Advantages of Outsourcing
Outsourcing
• Movement of factors of production around the • Reduced costs and increased competitiveness
globe • Creation of new export requirements
– Weakens comparative advantage • Other contentions:
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– Developments that caused major changes:
– Home companies will become less competitive if they
• Strong educational systems produce skilled workers in
cannot outsource jobs
developing nations, who work at lower cost
• This will weaken the economy and threaten more jobs
• Internet technology
• New political stability that permits free movement of – Job losses tend to be temporary
technology and capital – Creation of new industries and products leading to
– Workers in Home will encounter direct world more profitable jobs for home economy
competition at almost every job category

Burdens of Outsourcing
• Loss of jobs
– Declining demand for low-skilled workers
– Shift of demand for high-skilled workers to cheaper
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substitutes in developing countries

• Risks to wages
– Declining wages of low-skilled workers both in real
terms and relative to the wages of skilled workers