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ECONOMICS 3150CLecture 5
November 4
2
Internal and International Trade
• Firms – competitive advantage
• Mobility of factors of production
• Trade costs including information
• Tastes – language, culture
• Market rules – laws (domestic, international), regulations; effectiveness
• Currencies – financial risks
• Domestic policies– Taxes, subsidies, tariffs
– Procurement
– Ownership restrictions
– National interest – politics and trade policies
3
International Trade Theory: Objectives
• Gains from trade
• Patterns of trade
• Volumes of trade
• Intra-corporate vs. inter-corporate/firm
• Protectionism – trade policies
• Free trade agreements – FTA, NAFTA, GATT
4
Critique of Traditional Trade Theory
• Competitive markets – underlying logic flawed
• Imperfect competition – competitive advantage
• Role of technology and risk taking – importance of market structure
• Culture, bureaucracy, hierarchy
• Politics and power – case of the US
• Bottom line: trade theory cannot explain RIM in Canada, Airbus in Europe, HSBC, Arcelor-Mittal in India, Dubai Aerospace, IKEA, etc.
5
Overview
• 2007:– Global GDP: US$ 50 T– Global trade in goods and services: US$ 16 T
• Canada’s trade, by country/region (2007)– Total exports: $463.1 B
• US: $356.1 B (77%)• UK: $14.2 B (3%)• Non-OECD countries: $38.9 B (8%)
– Total imports: $415.0 B• US: $269.8 B (65%)• Non-OECD countries: $65.9 B (16%)
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Overview
• Canada’s trade (2007)– Balance: $48.0 B
• US: $86.3B
• EU: -$3.9 B
• Non-OECD countries: -$27.0
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Overview
• Canada’s trade, by product (2007)– Exports
• Industrial goods and materials (metals and alloys; chemicals, plastics and fertilizer, etc.): $104.4 B (23%)
• Machinery & equipment (includes aircraft): $93.4 B (20%)
• Energy products: $91.6 B (20%)
• Automotive products: $77.3 B (17%)
• Agricultural and fishing products: $34.4 B (7%)
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Overview
• Canada’s trade, by product (2007)– Imports
• Machinery & equipment: $116.6 B (28%)
• Industrial goods & materials: $85.1 B (21%)
• Automotive products: $80.0 B (19%)
• Other consumer products: $54.8 B (13%)
• Energy products: $36.6 B (9%)
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Overview
• 2005: composition of world trade– Manufactured goods – 59%
• Outsourcing – EMS, auto parts/components
• Intra-corporate – multinationals
• Competitive advantage vs. comparative advantage
– Services – 20%• Outsourcing – call centres, programming, IT support, legal,
accounting, medical
• Tradable vs. nontradable – changing over time
• Competitive advantage vs. comparative advantage
– Mining – 14%• Oil and gas dominate
– Agricultural products – 7%
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Basis for Trade
• Gravity Model– T(i, j) = Y(i)Y(j)/D(i, j)– T(i, j): value of trade between country i and j– Y: GDP– D(i, j): distance between country i and j
• 1% increase in distance between two countries is associated with 0.7-1.0% decrease in trade
• Transportation costs, similarities (familiarities) – language, tastes
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Basis for Trade
• Differences in relative prices– [P1/P2]A [P1/P2]B
– Countries differ• Resources• Culture, tastes• Demographics• Incentives/motivation
• Differences in availabilities of products (goods, services)– Companies create competitive advantages
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General Equilibrium: Closed Economy Model
• Objective: maximize production subject to resource and technology constraints production possibility frontier
• Assumptions:– Two factors of production: X1, X2
– Two goods: Y1, Y2
– Full employment
– Given state of technology: T
– No convexities – no economies of scale, no externalities
– No public goods
– Production functions: Y(i) = Fi [X1, X2, T]
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Optimization Solution: 1
• Maximize production:– Max Y1, Y2
– S.t. • production functions [Fi , i = 1,2]
• Maximum availabilities of X1, X2
• Production functions, isoquants
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Optimization Solution: 1
• Maximize production:– Max Y1
– S.t. • Y1 = F1 [X1, X2, T]
• Y2 = 0Y2
• X1 0X1
• X2 0X2
• Box diagram with isoquants
• Production possibility frontier [G(Y1, Y2)]
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PPF
• Efficient production– knowledge of production functions
– producing on frontier of production function
– given state of technology
– full employment
• PPF can also be derived by minimizing costs of producing various quantities of the two products– Min: C1X1 + C2X2
– S.t.• Y1 F1 [X1, X2, T]
• Y1 0Y1
[isoquant and isocosts]
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Optimization Solution: 2
• Optimal level of production of two products: Y1, Y2
• Maximize value of output– Max: P1Y1 + P2Y2
– S.t.: PPF
[PPF and income lines]
• Max utility– Max: U(Y1, Y2)
– S.t.: PPF
• Solution: GE model with perfect competition P1, P2, C1, C2, Y1, Y2
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Changes in Relative Prices
• Equilibrium P2/P1 will change if:
– Change in shape of PPF• Change in relative availabilities of X1, X2
• Change in production functions
• Change in state of technology
– Changes in tastes
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Basis for Trade
• Different relative prices– Different technologies – different p.f., different states of technology
– Different relative quantities of factors of production
– Different tastes – different utility functions
– Absence of perfect competition: monopolistic markets
• Different products– Different factors of production
– Absence of perfect competition
• Low trade costs– Transportation costs
– Trade barriers
– Other – hedging, insurance, etc.
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Basis for Trade
• Bottom Line: firms produce goods – Firms need info on products (characteristics, p.f.); technology – Agents need info on relative and absolute prices and access to
distribution channels in foreign countries
• Value chain: production of final product entails various intermediate stages – examples: gasoline at retail; laptops; autos; cell phones; aircraft – Trade in intermediate products– Trade in intermediate services
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Comparative Advantage Models
1. Single Factor, Ricardian Model• Assumptions:
– One factor of production: X1
– Two goods: Y1, Y2
– Constant returns to scale [Y = F(X1), δ=1]
– PF: Yi = i1 X1 [i1: units of product i per unit of factor of production 1]
• Resulting PPF:– Y1/ i1 + Y2/ 21 0X1
– Opportunity cost of Y1 in terms of Y2: 21/ 11
– No adjustment problems since sole factor of production can move costlessly and instantaneously between products
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Single Factor Ricardian Model
• Utility maximization optimal production and consumption point, P1, P2– Slope of straight line PFF:
• P2/P1 11/ 21
– Relationship between relative prices and opportunity costs
22
Single Factor Ricardian Model
• Two countries, two products, one factor of production– Conditions for pre-trade relative prices to differ [i.e. {P1/P2}A
{P1/P2}B]
• Different production functions: i1(A) i1(B)
• Different tastes will not produce different relative prices
• Comparative advantage– Country has comparative advantage in product with lower relative
opportunity cost
– Country A has comparative advantage in product 1 if • [21/ 11 ]A < [21/ 11]B
• {P1/P2}A < {P1/P2}B
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Single Factor Ricardian Model
• Trade between A and B will equalize relative prices {P1/P2}A = {P1/P2}B
– Equilibrium relative prices post-trade between original pre-trade ratios
– If A is large country and B a small country, equilibrium relative prices post-trade closer to pre-trade ratio in A
• Specialization – small country, not necessarily for large country– Transportation costs– Protection of industries
• Terms of trade: price of exported product relative to price of imported product– For country: P1/P2
24
Single Factor Ricardian Model
• Gains from trade– Consumption, production – pre-trade and post-trade
– Exports, imports
– Higher level of utility, higher level of real income/GDP
• Equilibrium in currency market will result in current account balance = 0– Total value of exports = total value of imports
– D/S of country’s currency depend upon current account transactions only
– For Country A: P1AEX(Y1) = P2BIM(Y2)E*
– With no trade costs: P1A = P1BE* and P2A = P2BE*
25
Single Factor Ricardian Model
• Conclusions:– Extreme degree of specialization
– No impact on distribution of income within each country – no losers (full employment, one factor of production)
– Gains from trade
– No explanation of differences in production functions and relative and absolute productivities
– Volumes of exports and imports not determined
26
Extension of Ricardian Model
• Many products (i = 1, N), one factor of production
• Assumptions:– Constant returns to scale
– Perfect competition: Pi = MCi
– MCi = P(X1)/i1
• Allocation of production in two country world (A, B)– Product i produced in country with lower MC
– Produced in A: {P(X1)E/ i1}A < {P(X1)/ i1}B
{[P(X1)]AE /[P(X1)]B} < {i1}A / {i1}B
– Produced in B: {[P(X1)]AE /[P(X1)]B} >{i1}A / {i1}B
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Extension of Ricardian Model
• Order the products 1 to N so that {11}A / {11}B < {21}A / {21}B < …….. < {N1}A /
{N1}B
• All products 1 through K are produced in B and exported by B:{[P(X1)]AE /[P(X1)]B} > {K1}A / {K1}B and
{[P(X1)]AE /[P(X1)]B} < {K+11}A / {K+11}B
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Extension of Ricardian Model
• Products K+1 through N are produced and exported by A– Not all products may be traded – depends upon
trade costs non-traded products – Specialization, but if B is a large country, B
also may produce, but not export some or all of the products 1 through K
– Assumes that E is at equilibrium level so that value of A’s exports = value of B’s imports
– If value of E changes so too does cut-off point “K”