China Center for Economic ResearchPeking University

International Economics:Trade Theory and Policy

Professor Wen Hai

Spring 2003

I.       INTRODUCTION

1. Importance of International Economics

Why should we study international economics?

• Contribution of International Trade to the Nation’s Standard of Living

• Integration of the World Economy

• Problems in the World Economy

2.Structure of International Economics

• International Trade: Theory and Policy (Microeconomics of Open Economy)

• International Finance • (Macroeconomics of Open Economy)

3. Brief History of International Trade

• Brief History of the World Trade– International Trade in Ancient Times– World Trade after the 15th Century– The Emergence of Capitalism and Industrial

Revolution– International Trade after WWII

Brief History of Foreign Trade in China

• A Glorious Period in Ancient China

Isolations after the 16th Century

Open-door Policy under Foreign Warship

Foreign Trade since 1949

5. Basic Analytical Tools

• General Equilibrium Analysis

• Partial Equilibrium Analysis

General Equilibrium Analysis

• Supply-side: Production Possibility Frontier (PPF)

• PPF with Constant Costs• PPF with Increasing Costs

• PPF with Constant Costs

• PPF with Increasing Costs

Qw

Qw

Qc

Qc

Demand-side: Community Indifference Curves (CIC)

– Indifference Curves (review)– Community Indifference Curves

Qw

Qc

CIC1

CIC3

CIC2

Higher social welfare level

General Equilibrium in Isolation(PPF with constant costs)

• Qc

•

CIC0

PPF

QwQw0

Qc0A

Autarky EquilibriumD = S

General Equilibrium in Isolation(PPF with increasing costs)

• Qc

•

CIC0

PPF

QwQw0

Qc0A

Autarky EquilibriumS = D

Partial Equilibrium Analysis Commodity markets in an Open

Economy•

S

D

US ChinaPw/Pc Pw/PcPw/Pc

Qw Qw Qw

.8

1.5Sx

Dm

International Market

Equilibrium with Free Trade

S

D

US ChinaPw/Pc Pw/PcPw/Pc

Qw Qw Qw

Basis for Trade and Gain from Trade

• Basis: lower relative price export• Higher relative price import

• Gain from Trade: • In General Equilibrium Analysis: measured

by increase in social utility level

• In Partial Equilibrium Analysis: measured by consumer surplus , producer surplus, and net welfare change

II. TRADE THEORIES

Main Issues in Trade Theory

• Why do People Trade ？－ Gain from Trade• Basis for Trade? － Pattern of

Trade• Effects of Trade? • Growth and Trade• Trade in Goods and Factor Movement

Framework of Trade TheoryMajor Model s Main

Contributors

Key Assumptions Basi s for Trade

Absolute

Advantages

Adam Smi th

Diff erences i n Absolute

Producti vi ty due to

Diff erent Technology

Classical Models

Comparati ve

Advantages

David

Ri cardo

Labor i s the only i nput Constant Marginal Cost Perfect Competi ti on i n both

Product and Factor Markets Constant Returns to Scale Demand i s gi ven

Diff erences i n Relati ve

Producti vi ty due to

Diff erent Technology

Factor

Endowment

E. Heckscher

B. Ohl in

Neoclassical Models

Specifi c

Factors

Paul

Samuelson

At l east two inputs Increasing Marginal Cost Perfect Competi ti on i n both

Product and Factor Markets Constant Returns to Scale

Diff erences i n Factor-

Endowment of Each Country

and Factor-Intensi ty of

Each Product

Economy of

Scale

Paul Krugman

Economy of Scale (Increasing

Returns to Scale)

Imperfect Competi ti on i n

Product Market

Diff erences i n

Production Scales

Modern Trade Models

Product

Cycle

Raymond

Vernon

Diff erent Stage of

Technology Development

and Factor Intensi ty

The Classical Trade Theories

1. Economic Thought in International Trade before Adam Smith

• Mercantilism: Older than Smith but still Alive Today

2. Adam Smith: Absolute Advantage

a. Basic Assumptions One input: Labor (L)

Two outputs: e.g. Wheat (QW) and Cloth (QC)

Two Countries: e.g. US and China

Different technologies: different productivity of labor

Labor supply is fixed. No international labor movement, but free to move within the country

Full employment, perfect competition,

and constant return to scale

transportation cost

alanced trade

b. Basis for TradeAbsolute advantage in Commodity Production

c.   Determination of the Absolute AdvantageDifferences in technologies

d. Measurements of Absolute Advantage: Productivity or Cost of Production Unit of labor requirement (L) in each unit of output j: aLj= L/Qj -- Comparing aLc to a*Lc and aLw to a*Lw

A Numerical ExampleTable 2-1 Possible Output (L=L*=100)

Rice

(Qr)

Wheet

(Qw)

China 100 50

US 80 100

Table 2-2 Productivity (Qj/L)

Rice

Wheet

China 1.0 0.5

US 0.8 1.0

Table 2-3 Production Cost (aij)

Rice

Wheet

China 1.0 2.0

US 1.25 1.0

Limitation of the Smith ModelTable 2-4 Production Possibility

Rice

(Qr)

Wheet

(Qw)

China 100 50

US 150 100

e. Pattern of Production and Trade

A country should specialized in and export the product that it has absolute advantage, and import the product that it does not have absolute advantage in production.

In this case, US should export wheat and China should export rice.

3. Davis Ricardo: Comparative Advantage

a. Basic Assumptions

(the same as the Smith Model)

b. Basis for Trade

Comparative Advantage in Commodity Production

c.   Determination of the Comparative Advantage

Differences in relative technologies

d. Measurements of Comparative Advantage:

-- Relative productivity

-- Relative production cost:

aLw /aLr vs. a*Lw /a*Lr

-- Opportunity cost:

Qr /Qw vs. Q*r /Q*w

-- Relative Price (exchange rate adjusted)

Pw /Pr vs. P*w /P*r

A Numerical ExampleTable 2-5 Relative Productivity

Rice (Qr/L)/(Qw/L)

Wheet (Qw/L)/(Qr/Qw)

China 2.0 0.5

US 0.8 1.25

Table 2-6 Relative Cost

Rice aLR/aLW

Wheet

aLW/aLR

China 0.5 2.0

US 1.25 0.8

Table 2-7 Relative Productivity(based on Table 2-4)

Rice

Wheet

China 2.0 0.5

US 1. 5 0.67

Limitation of the Smith ModelTable 2-4 Production Possibility

Rice

(Qr)

Wheet

(Qw)

China 100 50

US 150 100

e. Pattern of Production and Trade

A country should specialized in and export the product that it has comparative advantage, and import the product that it does not have comparative advantage in production.

In this case, US should export wheat and China should export rice.

f. Gain from Trade: General Equilibrium AnalysisEquilibrium Relative Prices and Comparative Advantage （ PPF with constant costs)

Pr/Pw < P*r/P*w

QrQ*r

Qw

Q*w

Pr/Pw

P*r/P*w

China US

General Equilibrium with Free Trade （ PPF with constant costs)

QrQ*r

Qw

Q*wPr/Pw

P*r/P*w

The Gains from Trade

QrQ*r

Qw

Q*w

Pr/Pw

P*r/P*w

CIC0

CIC1

China US

S0,D0

1.2 Comparative Advantage in the Hechscher-Ohlin Model

a. Basic Assumptionsa.      • Two inputs (factors): Labor (L) and Land (T)• Two outputs: Cloth (Qc) and Food (QF)

• Production Functions: Qc = Qc (Tc, Lc), labor-intensive

QF = QF (TF, LF), land intensive

At any given factor price ratio w/r, TF /L F > Tc /Lc

• Two Countries, e.g. US and China    Different proportion of factor endowment:

(T/L)US > (T/L)China;

US is a T-abundant country, China is a L-abundant country• Full Employment, Perfect Competition, and Constant return to

Scale

b: Basis for Trade • Comparative advantage

Different relative factor endowments (different proportion) different relative factor prices

different relative production costs different relative prices of products

Comparative advantage in producing and exporting the product that uses its abundant recourse intensively (lower relative cost)

c. Pattern of Production and TradeA country should produce more and export the product that uses its abundant recourse intensively, and import the product that uses its scarce recourse intensively. In this case, US should export wheat and China should export cloth.

2. Economies-of-Scale and Imperfect Competition Model

2.1. Modern Trade Facts

a. Rise of Intra-industrial TradeIntra-industrial Trade Index:

T = 1- (|X - M|/X + M)

b.  Development of Trade among Developed Countries.

 

1.4 Equilibrium Relative Prices and Comparative Advantage （ PPF with increasing costs)

Pw/Pc < P*w/P*c

QaQ*a

Qc

Q*c

Pw/Pc

P*w/P*c

1.5 General Equilibrium with Free Trade （ PPF with increasing costs)

QwQ*w

Qc

Q*c

Pw/Pc

P*w/P*c

1.6 The Gains from Trade（ PPF with increasing costs)

QwQ*w

Qc

Q*c

Pw/Pc

P*w/P*c

• Changes in an export market

S

D

Qw

Pw/Pc Effects of Free Trade

Price:Production:Consumption:Welfare Changes:

P.S. +(a +b)C.S. - anet: + b

a b

P0

P1

• Changes in an import market

S

D

Qw

Pw/Pc Effects of Free Trade

Price: Production: Consumption: Welfare Changes:

P.S. - cC.S. + (c + d)net: + d

c dP1

P0

A

B

C

S

Gain from Exchange and from Specialization

CIC0

CIC0’

CIC1

A: autarkyB: consumption throughExchange of existing productsC: consumption after specialization and free tradeS: production after specialization and free trade

Gain from exchange: CIC0 CIC0’Gain from specialization:CIC0’ CIC1

Production: A S;Consumption A C

1.7 Trade based on Differences in Tastes

Qw

Qc

2.4 The Terms of Trade

TOT = Px / Pm

Px/PmTOT= Px/Pm S

DQx

Qx

Qm

2.2. Economies-of-Scale Model

a. Economies of Scale: external and internal External Economies of Scale

External economies of scale occur when the average cost (AC) of output depends on the size of the industry, but not necessarily on the size of any one firm. An industry where economies of scale are purely external will typically consist of many small firms and be perfectly competitive.

Internal Economies of ScaleInternal economies of scale occur when the average cost of output depends on the size of an individual firm, but not necessarily on that of the industry. Internal economies of scale give a cost advantage over small and lead to an imperfectly competitive market structure.

b. Monopolistic-Competitive Firm with Internal Economies-of-Scale

• Equilibrium of a Monopolistic Competitive Firm in a Closed Economy

Q

P, C ($)

Dhome

MR0

AC

MC

Q0

P0

• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Short Run, Case 1: P )

Q

P, C ($)

Dhome

MR0

AC

MC

Q0

P0

Dtotal

MR1Q1

P1

AC1

• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Short Run, Case 2: P )

Q

P, C ($)

Dhome

MR0

AC

MC

Q0

P0

Dtotal

MR1Q1

P1AC1

• Equilibrium of a Monopolistic Competitive Firm in an Open Economy (with Trade in Long Run)

Q

P, C ($)

Dhome

MR0

AC

MC

Q0

Dtotal

MR2Q2

P2 = AC2

P0 = AC0

3.2 Economy-of-Scale & Intra-Industrial TradeUS US

Q car

Q car

Japan Japan Q truck

Q truck

AC AC

AC AC

30

15

3. Dynamic Comparative Advantage: the Product-Cycle Model

  3.1  Change in Pattern of Trade (Dynamic Pattern)

             Export

Import

US

Japan

China

Color TV

3.2 The Product Cycle Theory: Change in Factor Intensity

Technological cycle of a new product:• Stage 1: Innovation

(High technology; cost of research: R&D intensive product)

• Stage 2: Tech. Diffuses(Technology becomes less important - standardized, cost of capital and skilled labor: capital and skilled-labor intensive product)

• Stage 3: Tech. Stagnates(Technology embodied in purchasable equipment, cost of less skilled labor: labor intensive product)

3.3 Dynamic Changes in Comparative Advantage

• Stage 1: R&D intensive product

R&D and scientists abundant country such as the US has comparative advantage

• Stage 2: Capital and skilled-labor intensive product

Capital and Skilled labor abundant countries such as Japan and Germany have comparative advantage

• Stage 3: Labor intensive productLabor abundant countries such as China have comparative advantage

C. EFFECTS OF TRADE ON INCOME

Effect of Trade on Income in the H-O Model1. Effects of Trade on Factor Prices in Each Country 1.1 Short-Run (no factors are mobile among sectors)

Return to factors: W = P x MPL,

R = P x MPT

In the short run, returns to factor are determined by changes in Product Price. No changes in marginal productivity of factor

Price of export product increases, both factors in the export sector gainPrice of import-competing product decreases, both factors in the import-competing loss

1.2 Long-Run (all factors are able to move among sectors)

The Stolper-Samuelson (S-S) TheoremFree trade raises the return to the factor used intensively in the rising-price sector (export sector) and lowers the return to factor used intensively in the falling-price (import competing sector)

Magnification Effect

Changes in returns to factors are greater than the changes in product prices

2. Effects of Trade on Factor Prices in Both Countries

The Factor Price Equalization Theorem

Under the assumptions of H-O model, free trade will

equalize not only commodity prices but also factor prices.

All labors will earn the same wage rate and all units of

capital (or land) will earn the same profit (or rental returns)

in both countries regardless of the factor supplies or the demand patterns in the two countries.

Effect of Trade in the Specific Factor Model

1. Basic Assumption of the Model   Three inputs (factors):

Mobile factor: Labor (L)

Specific Factors: Capital (K) and Land (T)

Two outputs: Manufacture (QM)

Food (QF)

Production Functions: QM = f (K, LM)

QF = f (T, LF)

Full Employment: LM+ LF = L

Perfect Competition and Constant return to Scale

2. Production possibility Frontier in the Specific Factors Model

2.1 The Production Function

Lm

QmQm(K, Lm)

2.2 The Marginal Product of Labor

Lm

MPLm

2.3 Production Possibility Frontier

Qm

Qf

PPF

Lf

Lm

3. The Allocation of Labor and

Determination of Wage

3.1 Allocation of Labor

Pf MPLfPmMPLm

Lf Lm

W W

W*

3.2 Effects of Price Changes

• An Equal Proportional Change in Prices

P’f MPLf

PmMPLm

Lf Lm

W W

W*

Pf MPLf

W*’

P’mMPLm

• An Equal Proportional Change in Prices

No changes in labor allocation

no changes in output

Nominal Wage (W)

Profit (RK)

Rent (RT)

In real term, not affected

• A Change in Relative Price (say Pf 10%)

P’f MPLf

PmMPLm

Lf Lm

W W

W*

Pf MPLf

W*’

• A Change in Relative Price (say Pf 10%)

LM and LF QM and QF

W (< 10%), RT (> 10%), RK

In real term, T gainsK losesL is ambiguous (depending on using what price to

measure)

3.3 Effects of International Trade

• Trade and Relative PricesBefore trade: (PF/PM)A < (PF/PM) J

After trade: (PF/PM)A = (PF/PM) world = (PF/PM) J

Relative Price of Export • Income Distribution (same effect of relative price

change)Specific factor in export sector gains

Specific factor in import sector loses

Ambiguous effects on mobile factor

3.4 Effects of Economic Growth

• A Change in Capital Stock

Pf MP’Lf

PmMPLm

Lf Lm

W W

W*

Pf MPLf

W*’

• K

the same effects as PM on Labor

allocation, production, and nominal returns to factors.

However, the returns to labor in real terms increase since there is no price change

• A Change in Labor Supply

L , labor and output in both sectors ,

L loses, both K and T gain

PmMPLm

Lf Lm

W W

W*

Pf MPLf

W*’

D. GROWTH AND TRADE

Growth and Trade in the H-O Model

1. Definition of Growth and Types of Growth

1.1 Increases in factor endowments and Factor-saving technological progress

1.2 Biased economic growth:

Export Expanding (EE) Growth

vs. Import Replacing (IR) Growth

2. Effects of Growth in a Small Country2.1 IR Growth

Qw

Qc

S1

D2

D1

S2

TOT

2.2 EE Growth

Qw

Qc

S1

D2

D1

S2

TOT

The Rybczynski Theorem

The Rybczynski Theorem postulates that at constant commodity prices, an increase in the endowment of one factor will increase by a greeter proportion the output of the commodity intensive in that factor and will reduce the output of the other commodity.

3. Effects of Growth in a Large Country3.1 IR Growth

Qw

Qc

S1

D2

D1

S2

TOT

3.2 EE Growth

Qw

Qc

S1

D2

D1

S2

TOT

3.3 A Special Case in the EE Growth

- Immiserizing Growth

Qw

Qc

S1

D2D1

S2

TOT