The Trade Theory

International Economics

International Trade

International Finance

International Trade

A definition:

• A study of trade (of goods and services) between nations and its economic implications

Why nations trade: gains from trade

The Trade theory

Factor movements

Free trade versus protection

International Finance

A definition:

• A study of the financial dimension of international economic transactions among nations

Balance of payments

Exchange markets and exchange rates

The international monetary system

International monetary institutions

The Basic Theory of Trade

• Absolute advantage in production

• Comparative advantage and the gains from trade

• Trade as a means to economic efficiency

• Trade as a way of life

• Trade and economic interdependence

• Trade and economic growth

Early Thinking about Trade

• Mercantilism

• David Hume and the specie-flow mechanism

• Adam Smith (1776)

Adam Smith’s View on Trade• "It is the maxim of every prudent master of a

family, never to attempt to make at home what it will cost him more to make than to buy.”

Adam Smith

• The opportunity to trade what one has (or can produce) for what he/she does not have (or cannot produce easily) makes it rational for each person to specialize in the production of what she can produce most efficiently (least costly.)

• Specialization and trade among regions and countries are based upon the same principle as among individuals.

Trade and “Absolute Advantage”• A nation (or country) has absolute advantage in the

production of a good if, compared to another country, it uses less resources to produce it.

Example: If US uses 15 hours of labor to produce one unit of tomatoes and Mexico uses 10 hours to produce the same amount of tomatoes, Mexico has absolute advantage in the production of tomatoes.

Total labor: US: 240 , Mexico: 240 Under autarky:

Labor needed Output Produced

Mexico U.S. Mexico U.S.

Tomatoes: 10 hrs 15 hrs 12 8

Corn: 8 hrs 4 hrs 15 30

===================================

World’s output of tomatoes: 20

World’s output of Corn: 45

After specialization and trade: Mexico U.S. Total World’s Output

Tomatoes 24 0 24

Corn 0 60 60

Gains from trade: 24 - 20 = 4 units of tomatoes

60 - 45 = 15 units of corn• Terms of trade: The number of units of the

imported good received for each unit of the exported good

• Relative price: Price of one good in terms of another

Relative Price Relative price of one unit of corn in US before trade:

4/15 = .266 unit of tomato(Note:Relative price of one unit of tomato in terms of corn = 15/4 = 3.75 units of corn)

Relative price of one unit of corn in Mexico before trade:

8/10 = .80 unit of tomato (Note:Relative price of one unit of tomato in terms of corn = 10/8 = 1.25 units of corn)

Terms of Trade: .266 <=====> .80

Terms of Trade: A graphical AnalysisT T

0 0C C

16

60

24

30

AA

US Mexico

TT

TT

Production under autarky: A

Terms of trade after trade: TT = .50

Mex Price under autarky = .8US Price under autarky: .26

-Slope = relative price

= MRT

(Marginal Rate of Transformation)

240/10

240/8

Indifference Curves• An indifference curve is a curve showing all the

combinations of two goods from which a consumer derives the same level of utility.

• A consumer is indifferent along any given indifference curve.

• The farther an indifference curve is from the point origin the higher level of utility it represents.

• The indifference curves in an indifference map never cross

• A social indifference curve?

A Social Indifference MapU1 U2 U3 U4

U5

C

T

0

U5>U4>U3>U2>U2

Slope = MRS

MRS = -------

ΔUc

ΔUt

Mexico Under AutarkyT

C0

a

b

c

At “a” MRS>relative cost/priceAt “c” MRS<relative cost/priceAt “b” MRS = relative cost/price MRT

U1

U2U3U4

Terms of Trade: A graphical AnalysisT T

0 0C C

16

60

24

30

AA

US Mexico

TT

TT

t

y

y

US imports = Mexico’s exports = t w

US exports = Mexico’s imports = w y

30

12

Terms of Trade: A graphical AnalysisT T

0 0C C

16

60

24

30

AA

US Mexico

TT

TT

Production under autarky: A

Terms of trade after trade: TT = .50

Mex Price under autarky = .8US Price under autarky: .26

-Slope = relative price

David Ricardo and Comparative Advantage Again consider US and Mexico.

Mexico U.S. Mexico U.S.

Rugs 10 hrs 8 hrs 12 15

Computers 40 hrs 10 hrs 3 12

Labor needed for one unit Output produced

•US Relative price computers in terms of rugs = 10/8 = 1.25

•Mexico’s Relative price computers in terms of rugs = 40/10 = 4•US has comparative advantage in computers but Mexico in rugs.

•US has absolute advantage in both goods!

The Ricardian Trade Model

30

24

24

60 0

Rugs Rugs

Cmp Cmp

TT

TT

A

A

1.25

4

U2

U1

U1

U2

c

fg

c

fg

US Mexico

k

h

Productivity, Wage, and PriceAssume the only input used in production is labor,

Marginal cost of producing good X is:

W

MCx = ------- = ax. W ; ax = 1/MPL

MPL

If Px = MC

Px Py

Wage = W = ---------- or W = ---------

ax ay

In autarky under competitive conditions where uniform laboris the only input:

Wx= Wy

Px Py

===> ---------- = ---------

ax ay

Px ax

===> --------- = --------- = MRT

Py ay

Trade and WageRecall: Pr

Wr = -------

ar

Pc

Wc = -------

ac

After complete specialization and trade,

the price of “export” will go up. ==> W will go up.

The Effects Trade on Prices and Wages

After specialization and trade:

In US:• The output of computers will go up• The output of rugs will go down• Price of computers will go up• Price of rugs will go down• The wage will go up

Note: US is now producing only computers and

recall: W = P/a

After specialization and trade:

In Mexico:

• The output of computers will go down

• The output of rugs will go up

• Price of computers will go down

• Price of rugs will go up

• The wage will go up Note: Mexico is now producing only rugs and recall: W = P/a

Demand and Supply in Autarky

Rug Market in US Rug Market in Mexico0 0

Pr/Pc Pr/Pc

4/5

S

1/4

S

D D

Import

Export

Q Q

International Market for Rugs

S

D

0

Q

Pr/Pc

4/5

1/4