International Economics Prof. D. Sunitha Raju Basics of International Trade Theory

International Economics

Prof. D. Sunitha Raju

Basics of International Trade Theory


The International Economy : Introduction

1. Firm/Industry Competitiveness • relative prices

2. A country’s international competitiveness

• relative productivities


Trade Theory : Discussion Issues

1. What is the basis for trade between countries?

2. How are gains from trade defined/ measured.

3. Can theory explain the pattern of global trade flows.


Developments in Trade Theory

1. Mercantilism• Wealth measured by stock of precious

metals• When net exports rise, accumulation of

wealth takes place Gain for some nations at the cost of others

• In the long run, not sustainable


Absolute Advantage (Adam Smith)

• Unless all trading nations gain, trade will not take place

• Cost differences determine the movement of goods between countries

• Countries produce and exchange of commodity in which they have absolute advantage which leads to specialization

Nations gain from trade and policy of laissez-faire maximises

output and welfare


Absolute Advantage: Basic Assumptions

a) Labour is the only factor of production and is homogenous

b) Cost and price of good depends on the labour required to produce it


Absolute Advantage: Illustration 1

• US will export wheat and import cloth from UK

→ export 6W & import 5C (gain ¼ man-hour)

• UK will export cloth and import wheat

→ export 5C and import 6W

→ gains from trade• 6W = 30C• Supply 5C to USA & gains 25C or 5 man-hours

US UK

Wheat (bushels/man-hour) 6 1

Cloth (Yards/man-hour) 4 5

International Economics US UK

Wheat (bushels/man-hour) 6 1

Cloth (Yards/man-hour) 4 2

• US has absolute advantage in both wheat & cloth

• UK has absolute disadvantage in both wheat & cloth

Can trade take place?

Absolute Advantage: Illustration 2


Principle of Comparative Advantage(Ricardo)

• Comparison of relative advantage or disadvantage between countries

• US has 6 to 1 advantage in wheat and 2 to 1 advantage in textiles (over UK)

• UK has greater disadvantage in wheat than in cloth.Wheat : 1 to 6

Cloth : 1 to 2

Comparison of relative cost differences for Trade to take place


Comparative Advantage: Basic Assumptions

• The world consists of two nations

• Labor is the only input

• Labor is fully employed and homogenous

• Labor can move freely among industries within a nation, but is incapable of moving between nations

• All firms within each nation utilize a common production method for each commodity

• Costs do not vary with the level of production

• Transportation costs are zero


Comparative Advantage: Resource Cost

US

• Domestically, 6W can be produced if 4C is given up (opportunity cost)

• 1C costs 1 W and 1W costs C

UK

• 2C can be produced if 1W is given up• 1C costs ½ W and 1W costs 2C

Therefore, cloth is relatively cheaper in UK and wheat in

USA

3

2

2

1


Comparative Advantage: Gains from Trade

US (cloth)

• Import of cloth takes place if 6W can be exchanged for greater than 4C

if 1C is less than 1½ W

UK (cloth)

• Export of cloth takes place if 2C can be exchanged for greater than 1W

If 1C is greater than ½ W

Both US & UK gain if the price of cloth (in terms of wheat) is 1W


Labour input Wheat (Bushel) Cloth (Yards)

Quantity Price Quantity Price

US 1 hr 6 $3.33 4 $5

UK 1 hr 1 £5 2 £2.5

UK* 1 hr 1 $8 2 $4

Assume• Wage rate in US = $20/hour• Wage rate in UK = £ 5/hour

Translating comparative advantage into Costs

* Exchange rate = 1£ = 1.60$


Commodity

A B C D E

United States $1 $4 $9 $15 $20

United Kingdom £1 £2 £3 £4 £5

A B C D E

U.K. cost (£1=$3) $3 $6 $9 $12 $15

Trade with more than Two Commodities

• Goods produced in each country ranked on the basis of their domestic cost

At an exchange rate of £1 = $3, the British costs convertedinto dollars become:

Production Costs in Two Countries with Five Goods


Examples of Comparative Advantages in International Trade

Speciality Resulting from Natural Advantages

Speciality Resulting from Acquired Advantages

Canada Lumber Hong Kong Textiles

Israel Citrus fruit Japan Automobiles, consumer electronics

Italy Wine South Korea Steel, ships

Jamaica Aluminum ore Switzerland Watches

Mexico Tomatoes United States Jetliners, computer software

Saudi Arabia Oil United Kingdom Financial services

United States Wheat, corn


Where Does U.S. Comparative Advantage Lie?

Industry Revealed Comparative Advantage Ratio

Agricultural products +0.77 Greatest Comparative Advantage

Greatest Comparative Disadvantage

Chemicals +0.21

Machinery +0.02

Telecommunication equipment

-0.01

Medical equipment -0.02

Industrial supplies -0.28

Civilian aircraft -0.29

Automotive -0.42

Consumer goods -0.51

Steel -0.51

Petroleum -0.82


Competitiveness under Varying Production Condition

1. Production under Constant Cost

2. Production under Increasing Cost


Production Possibilities Schedule (PPS)

• PPS shows various combinations of 2 goods that a country can produce when all inputs (land, labour capital & Entrepreneurship) are used most efficiently.

• Under constant cost conditions, relative cost of producing one good in terms of other remains same

MRT = cloth

wheat


Production Possibility Frontier

Production Possibility Schedules for Wheat and Cloth in the United States and the United Kingdom

United States United Kingdom

Wheat Cloth Wheat Cloth

180 0 60 0

150 20 50 20

120 40 40 40

90 60 30 60

60 80 20 80

30 100 10 100

0 120 0 120



Relative Commodity Price under Constant Cost

US:

30 W = 20 C

1 W = or 20 C30

23 C

20 C =

30 W

1C = 30 W or20

1.5 W

International Economics UK:

10 W = 20 C

1 W =20 C10

or 2 C

20 C = 10 W

C =10 W20 or 1 W

2Relative price of wheat lower in US than in UK

Relative price of cloth lower in UK than in US

Difference in relative prices reflects comparative advantage

(specialization)


Consumption/Demand Issues

• Consumer demand is underlined by tastes/ preferences or utility

• How much of the goods produced will be consumed depends on consumer preferences

– Consumer Indifference Curve

– Slope of the Indifference Curve represents consumers’ trade off between two goods, i.e. Marginal Rate of Substitution


Slope = ∆ Y/∆ X = MRSA

UA

2

AU

A1

U0

YA

0 XA

Indifference Curves


Equilibrium in Autarky

• Consumption utility maximized subject to the constraints of Production Possibility Frontier

Slope = -(bLX/bLY) = MRTB

Slope = MRSB

YB

YB

XB0 XB

UB B

2

UB1

UB0

LB/ bLY


Gains from Trade


What Would Country A Do Under Free Trade?

∙

∙ ∙Exports of X

A LA /aLX

Slope = -(PX/PY)tt

Slope = -(aLX/aLY) = MRTA = -(Px/PY)A

Imports of Y

LA /aLY

YA

AC

∙A0 XA

U2 A

U1

A


Trading under Constant Costs

Basis for Trade

• Slopes of the production possibilities schedules give the relative cost of one product in terms of other

• Differences in relative costs provide the basis for mutually favourable trade

Production gains from Specialisation

• A country will specialise in the production of the good in which it has comparative advantage

• A country will trade part of this production for the good in which it has comparative disadvantage

(a)

(b)

International Economics Consumption gains from Trade

• Consumption alternatives limited by the domestic production possibilities schedules

• The exact consumption will be determined by the tastes & preferences

• Specialization & free trade care achieve post-trade consumption outside domestic production possibilities schedules trade results in consumption gains for both countries

Terms of Trade

• Domestic terms of trade represents the relative prices at which goods are exchanged at home

• A country will exports/import goods internationally if the terms of trade are more favourable than domestic terms of trade

(c)

(d)


Changing Comparative Advantage

1. Technological improvements

2. Trade restrictions

3. High Transaction Costs

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International Economics Prof. D. Sunitha Raju Basics of International Trade Theory