TU-E1160 International Economics by Hannele Wallenius Aalto University School of Science Department of Industrial Engineering and Management 2. WHY DO WE TRADE? - Part I

International Economics Hannele Wallenius Six Valuable Lessons of Trade Theory 1.Free trade can raise aggregate economic efficiency and aggregate economic welfare. 2.Free trade will benefit a country even if it is less efficient than all other countries in every industry. 3.Some people will suffer losses with free trade. 4.A domestic firm may lose out in international competition even if it is the lowest cost producer in the world. 5.Trade protection may be beneficial for a country. 6.Although trade protection can be beneficial, the case for free trade remains strong.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage3 Index of Openness* Some countries trade extensively, others very little. How can this be understood and explained? * Ratio of exports + imports to GDP multiplied by 100

International Economics Hannele Wallenius Exports of goods and services in EU (% of GDP in 2014) 2. Why Do We Trade? The Law of Comparative Advantage4 Source: World Development Indicators An other measure of openness is also used: Exports/GDP; see your text book tables.

International Economics Hannele Wallenius 2. Why Do We Trade?5 Major Concerns of Trade Theory? The classical theory of international trade is concerned with the following three questions: 1. What are the gains from trade?  In other words, if countries benefit from international trade, where do the gains come from, and how are they divided among the trading countries?

International Economics Hannele Wallenius 2. Why Do We Trade?6 Major Concerns of Trade Theory? continued 2. What is the structure/pattern of trade?  In other words, which goods/services are exported, and which are imported?  What are the fundamental laws that govern international allocation of resources and the flow of trade? 3. What are the terms of trade?  In other words, at what prices are the exported and imported goods exchanged?

International Economics Hannele Wallenius Why Do We Trad e? 2. Why Do We Trade? The Law of Comparative Advantage7 P S /P T QSQS QSQS P0P0 P0P0 Finland China International difference in autarky* price of a product S in two countries: * Autarky = closed economy = no international trade allowed in a country With trade prices start to equalize. NS S A NS S B ND S A Country A Country B ND S B P S /P T = relative price of product S NS S / = national supply/de mand NS D

International Economics Hannele Wallenius nBecause country B has a lower autarky (relative) price of S, it is said to have a comparative advantage in S and a comparative disadvantage in T and by same logic, country A has a comparative advantage in T and comparative disadvantage in S nIf trade would be allowed, consumers in country A would like to buy product S from country B, and prices would start to equalize Why Are the Prices Different? 1.Differences in technology or productivity 2.Difference in resource endowments 3.Difference in demand 2. Why Do We Trade? The Law of Comparative Advantage8

International Economics Hannele Wallenius 2. Why Do We Trade?9 Understanding the Gains from International Trade Nations (or firms in different nations) trade with each other because they benefit from it! four We can divide the different trade theories in four categories...

International Economics Hannele Wallenius 2. Why Do We Trade?10 Different Trade Theories 1.Early Trade Theory: Mercantilists 2.Classical Trade Theory: Ricardian Model (section 2.1) 3.Modern Trade Theory: Heckscher-Ohlin Model (section 2.2) 4.Alternative Approaches to Trade Theory (section 2.3)

International Economics Hannele Wallenius 2. Why Do We Trade?11 1. Early Trade Theory: Mercantilists  Until mid-eighteenth century, it was believed that the purpose of international trade was to keep exports greater than imports and pile up gold, and when/if deficits were created they believed that imports had to be restricted  Mercantilists assumed trade to be a zero-sum game since they assumed that fixed amounts of goods and of gold existed in the world and that trade merely determined their distribution among the various nations

International Economics Hannele Wallenius 2. Why Do We Trade?12  But in the 1740s, David Hume explained that as quantity of money (gold) changes, so also does the price level, and the nation's real wealth is unaffected.  In 1770s, Adam Smith argued that import restrictions would reduce the gains from specialization and make a nation poorer. He used absolute advantage to explain the benefits of trade. Theories will be now discussed in more detail...

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage13 2. Why Do We Trade? continued n 2.1 The Law of Comparative Advantage: Absolute vs. Comparative Advantage n 2.2 Modern Trade Theory: Heckscher-Ohlin Model n 2.3 Alternative Trade Theories: Results from Practical Evidence

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage14 Economic Basis for Trade What are the factors that determine how countries will specialize in international trade? David Ricardo ( On the Principles of Political Economy, 1819 ), developed the theory of comparative advantage...

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage15 Economic Basis for Trade continued Specialization and free trade will benefit all trading partners (= real wages will rise), even those who may be absolutely less efficient producers. According to this theory,

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage16 Absolute vs. Comparative Advantage Although comparative advantage is a simple concept, experience shows that it is a surprisingly hard concept for many people to understand (or accept).

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage17 Absolute vs. Comparative Advantage continued Indeed, Paul Samuelson — the Nobel laureate economist who did much to develop the model of international trade — has described comparative advantage as the best example he knows of an economic principle that is undeniably true yet not obvious to intelligent people.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage18 Definition: Absolute Advantage The advantage in the production of a product enjoyed by one country over another when it uses fewer resources to produce that product than the other country does.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage19 Absolute Advantage - an Illustration Suppose country A and country B produce wheat, but that A's climate is more suited to wheat and its labor is more productive. Country A will therefore produce more wheat per acre than country B and use less labor in growing it and bringing it to the market. Country A thus enjoys an absolute advantage over country B in the production of wheat.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage20 Definition: Comparative Advantage The advantage in the production of a product enjoyed by one country over another when that product can be produced at lower cost in terms of other products than it could be in the other country.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage21 Comparative Advantage - an Illustration Suppose that countries C and D both produce wheat and corn and that C enjoys an absolute advantage in the production of both - that is, C's climate is better than D's, and fewer of C's resources are needed to produce a given quantity of both wheat and corn. C and D each need to choose between planting land with wheat and corn.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage22 Comparative Advantage - an Illustration continued To produce more wheat, either country must transfer land from corn production and vice versa. Suppose that in country C, a bushel of wheat has an opportunity cost of two bushels of corn. At the same time, suppose that producing a bushel of wheat in country D requires to give up only one bushel of corn D enjoys a comparative advantage in producing wheat.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage23 Example 1: Gains from Mutual Absolute Advantage Assume a) two countries with fixed amount of land (100 acres) and land yields given in the table below, b) only two products produced (wheat and cotton), c) preferences for food and clothing are such that both countries consume equal amounts of wheat and cotton. PPF:s before trade:

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage24 Example 1: Continued Wheat Cotton New Zealand (150, 150) Cotton Australia Wheat (150, 150) When there is no trade, the allocation of resources will be such that both countries will produce 150 bushels of wheat and 150 bales of cotton. W: 25 acres x 6 bu/acre C: 75 acres x 2 bales/acre W: 75 acres x 2 bu/acre C: 25 acres x 6 bales/acre PPF

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage25 Example 1: Continued  Expanded possibilities after trade: If countries realize that they should specialize (Australia in cotton and New Zealand in wheat) and trade, both countries could gain.  Both are now specializing:

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage26 Example 1: Continued Cotton Australia Wheat (300, 300) Wheat Cotton New Zealand (300, 300) In this situation 300 bushels of wheat is traded for 300 bales of cotton:

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage27 Example 1: Continued  Trade enables both countries to move beyond their previous resource and productivity constraints.  Both countries (after trade) can consume beyond their production possibilities (PPFs)!

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage28 Example 2: Gains from trade when one country has a double absolute advantage Production Possibilities and Consumption in a Closed Economy (same assumptions as before): NZ: 50 x 6 = 300 both wheat and cotton. A: 75 x 1 = 75 wheat 25 x 3 = 75 cotton

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage29 Example 2: Continued When countries realize that they can benefit from specialization and trade: Only partial specialization: 75 x 6 = 450 and 25 x 6 = 150

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage30 Example 2: Continued Consumption after trade: Stage 3 When countries specialize they will maximize their combined output and use resources more efficiently: both countries are better off than they were before the trade ( closed economy consumptions were 300, 300 and 75,75).  Both have moved beyond their own production possibilities. If 100 bu of wheat from NZ is traded to 200 bales of cotton from Australia

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage31 International Equilibrium with Increasing Costs Next we will extend the classical model of trade to the more general case of increasing opportunity costs and introduce demand by means of social indifference curves. Increasing Opportunity Cost Food Clothing PPF Indifference Map and Consumer Equilibrium Food Clothing I’’ I’ I’’’ a) Product specific factors. b) Different industries use factors in different proportions.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage32 General Equilibrium in a Small Open Economy

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage33 Specialization Based on Comparative Advantage (countries PPF are different) and the Resulting Gains from Trade AmericaBritain Figure 1 (a) Figure 1 (b) 1.Assume such a domestic price ratios that E (in US) and E* (in UK) are consumption and production in autarky (= no trade). 2.After trade consumption takes place at S and S*.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage34 Specialization Based on Comparative Advantage and the Resulting Gains from Trade continued Figure 1: In autarky, America produces and consumes at E, and Britain at E*. With trade, America shifts production from E to Q and consumes at S by exporting VQ units of food to Britain in exchange for VS units of British clothing. America is better off with trade because S lies on a higher indifference curve than E. Indeed, in our illustration, America consumes more food and more clothing at S than at E. Britain shifts production from E* to Q* and consumption from E* to S*. Britain’s welfare increases also. Trade triangles SVQ and Q*V*S* are identical.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage35 Same Production Technique in Both Countries, Trade Based on Different Taste Food Clothing America Britain Figure 2 In autarky US produces and consumes at A and UK at B. After free trade both will produce at Q but consume at A’ and B’, respectively. Different indifference curves! Again both countries can consume beyond their production possibilities.

International Economics Hannele Wallenius 2. Why Do We Trade? The Law of Comparative Advantage36 Trade Based on Different Taste continued Figure 2: Trade based on different tastes. America and Britain share the same production frontier MN. In autarky, America produces and consumes at A, and Britain at B. With free trade, both countries produce at Q, but America consumes at A’ and Britain at B’. Trade triangles A’VQ and QSB’ are identical.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model WHY DO WE TRADE? n 2.1The Law of Comparative Advantage: Absolute vs. Comparative Advantage n 2.2Modern Trade Theory: Heckscher-Ohlin Model n 2.3Alternative Trade Theories: Results from Practical Evidence

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 38 What are the ultimate determinants of comparative advantage? Ricardo did not bother to answer this question. He just assumed that the differences in comparative advantage depended on comparative difference in labor productivity (that is, differences in technology), but he did not explain the basis for these differences. Implicit reason in his example was climate...

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 39 What are the ultimate determinants of comparative advantage? continued  It remained to Heckscher and Ohlin to offer an explanation for comparative advantage.  And this theory has become, since 1930s, the orthodox explanation of the ultimate cause of international trade. Eli Heckscher ( ) Bertil Ohlin ( )

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 40 What are the ultimate determinants of comparative advantage? continued  Their basic idea is: 1. Commodities differ in their factor requirements. 2. Countries differ in their factor endowments.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 41 What are the ultimate determinants of comparative advantage? continued A country has comparative advantage in those commodities that use its abundant factors intensively. This is why labor-abundant countries, such as India and China export footwear, rugs, textiles, and other labor intensive commodities; and land- abundant countries, such as Argentina, Australia, and Canada, export meat, wheat, wool, and other land-intensive commodities.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 42 The Basic Assumptions of the Heckscher- Ohlin Model: 1. Number of countries, factors, and commodities are all two (often referred to as the 2 x 2 x 2 model). 2. Technology is the same in both countries. 3. Constant returns to scale 4. Strong factor intensity 5. Incomplete specialization

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 43 The Basic Assumptions of the Heckscher- Ohlin Model continued : 6. Perfect competition 7. Factors are perfectly mobile within each country but perfectly immobile between countries. 8. Tastes are largely similar between countries. 9. Free trade 10. Transportation costs are zero.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 44 Heckscher-Ohlin Theorem with a Single Technique The structure of trade, in general, can be traced back to differences in factor endowments, technology, and tastes. Since Heckscher-Ohlin theory assumes that technology and tastes are similar between countries, it attributes the comparative advantage to differences in factor endowments.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 45 Heckscher-Ohlin Theorem with a Single Technique continued In summary, the capital-abundant country exports the capital-intensive commodity, and the labor-abundant country exports the labor-intensive commodity.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 46 Example 1: Factor Endowments and Production-Possibilities n One country n Required inputs per unit of output:

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 47 Example 1: Continued Steel Cloth Labor constraint Capital constraint E G M H 0 J Figure 3 JEH is the PPF

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 48 Example 1: Continued Figure 3: Derivation of the production-possibilities frontier. If the economy had an unlimited supply of capital (labor), it would be able to produce along the labor constraint JG (capital constraint MH). When the supplies of both factors are limited, both constraints become binding and the production frontier coincides with the heavy kinked line JEH. Because steel is capital intensive relative to cloth, the capital constraint is steeper than the labor frontier.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 49 Heckscher-Ohlin Theorem with a Single Technique Figure 4 Steel Cloth Figure 4 Since same tastes in both countries, only one set of communal indifference curves. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but consumes at C*.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 50 Heckscher-Ohlin Theorem with a Single Technique Figure 4: Production frontiers JQH and J*Q*H* reflect the fact that America is endowed with more capital than Britain, while Britain is endowed with more labor than America. Before trade, America produces and consumes at R, and Britain at Q*. With free trade, America shifts production to Q and consumption to C. Britain maintains production at Q* but shifts consumption to C*. Trade triangles CQV and Q*C*V* are identical. America exports steel, and Britain cloth.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 51 Heckscher-Ohlin Theorem with Many Techniques Steel Cloth Before trade, America produces and consumes at R, and Britain at R*. With free trade, America produces at Q and consumes at C, and Britain at Q* and C*, respectively. Figure 5

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 52 Heckcher-Ohlin Theorem with Many Techniques Figure 5: Production frontier JH of America (the capital- abundant country) is skewed along the axis for steel (the capital-intensive commodity); and the production frontier J*H* of Britain (the labor-abundant country) is skewed along the axis for cloth (the labor-intensive commodity). Before trade, America produces and consumes at R, and Britain at R*. With free trade, America produces at Q and consumes at C, and Britain at Q* and C*, respectively. Trade triangles CQV and Q*C*V* are identical, America exports steel, and Britain cloth.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 53 Derivation of Offer Curves and the International Equilibrium Figure 6 (a) Figure 6 (b) Food America’s exports of food America’s imports of clothing Clothing In autarky (p = 2) US produces and consumes at E. At p = 3, America shifts production to Q and consumption to S. And at p = 4, R and K, respectively. US offer curve

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 54 Derivation of Offer Curves and the International Equilibrium continued Figure 6: Derivation of America’s offer curve. At the Autarkic relative price of food (p), assumed to be equal to 2, America produces and consumes at E in panel (a), and trades at the origin of panel (b). At p=3, America shifts production to Q and consumption to S in panel (a), and trades at S in panel (b). Similarly, at p=4, America produces at R and consumes at K in panel (a), and trades at K in panel (b). Trade triangles SVQ and KGR are identical to triangles SJO and KLO, respectively. The locus of all trade points (such as S and K) in panel (b) is America’s offer curve.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 55 International Equilibrium Figure 7 Food America’s exports Britain’s imports Clothing America’s imports Britain’s exports Here the offer curves of two trading countries define the international equilibrium at K.

International Economics Hannele Wallenius 2. Why Do We Trade? Modern Trade Theory: Heckscher- Ohlin Model 56 Derivation of Offer Curves and the International Equilibrium continued Figure 7: International equilibrium International equilibrium occurs at K, where the offer curves intersect. America exports OL units of food to Britain and imports OL* units of clothing from Britain. The slope of terms-of- trade line TOT 3 gives equilibrium terms of trade OL*/OL.

International Economics Hannele Wallenius 2. Why Do We Trade?57 End of Fun! On next lecture: 2. WHY DO WE TRADE? - Part II