Lec 1: Introduction

Subject Outline Trade Finance Policy Trade Theory International Economics Trade Policy Finance

Trade Theory Mercantilism Heckscher-Ohlin Stolper-Samuelson Factor Price Equalisation Comparative Advantage Trade Theory Trade Theory Study Guide 1 Rybzcynski Absolute Advantage Immiserising Growth Mercantilism

Theory used to explain and predict. What is International Trade? Trade Theory Theory used to explain and predict. What is International Trade? Why do nations trade? What are the gains from trade? Who gains from trade?

Trade Policy Other Trade Policies Regional Trade Agreements Tariffs International Resource Movements Tools of the Trade Policy Analysis

Finance Study Guide 3 Weeks 9-12 Exchange Rates Current Account Deficit Finance Study Guide 3 Weeks 9-12 Exchange rate theorems Interest Arbitrage

Absolute Advantage Mercantilism Trade Theory Week 1 Heckscher-Ohlin Stolper-Samuelson Factor Price Equalisation Comparative Advantage Trade Theory Trade Theory Study Guide 1 Rybzcynski Absolute Advantage Week 1 Mercantilism Immiserising Growth

Adam Smith - both nations can gain from trade. Trade Theory Why do Nations Trade? Mercantilism - zero sum game - one nation gains at the expense of the other. Adam Smith - both nations can gain from trade. Absolute Advantage - each nation should specialise in production of the good which it is most efficient at producing.

Assumptions Perfect Competition in Product and Factor Markets (P=MC) Trade Theory Why do Nations Trade? Assumptions Perfect Competition in Product and Factor Markets (P=MC) Each Country has a fixed endowment of resources that are fully used and are homogeneous Technology is Unchanging No Transportation Costs or barriers to trade Factors of Production are perfectly mobile between industries but are immobile between countries 2x2x1

The way for a nation to become rich Trade Theory Why do Nations Trade? Mercantilism Thomas Munn (1571-1641) The way for a nation to become rich and powerful is to export more than to import

Why do Nations Trade? ENGLAND FRANCE Trade Theory Mercantilism Imports Exports Exports

Introduction Adam Smith (1723-1790)

Introduction David Ricardo (1772-1823)

International Economics By Robert J. Carbaugh 7th Edition Chapter 2: Foundations of modern trade theory

Historical development of trade theory Foundations of trade theory Historical development of trade theory Mercantilism positive trade balance Absolute advantage (Adam Smith) Countries benefit from exporting what they make cheaper than anyone else Comparative advantage (David Ricardo) Nations can gain from specialization, even if they lack an absolute advantage Carbaugh, Chap. 2

International Trade Theories: Mercantilism (1500 – 1750): 1. International trade is a zero-sum game: Static view of world resources: One’s gains = Other’s losses 2. Wealth: Acquisition of precious metals—gold or silver Well-being = Accumulating gold 3. Economic growth =Enhancement of power with strong army, strong navy and merchant marine, and enlargement of foreign colonies.

4. Productive = maintaining and increasing the power 5. Regulations or restrictions on importable activities 6. Favorable positive trade balance: Exports > Imports  Inflows of specie (gold)  Money supply increases  Stimulates output and employment  Economic growth

Role of the government and domestic economic policy Mercantilism : Role of the government and domestic economic policy Control the use and exchange of precious metals (Bullionism) High tariffs, quotas on imports of consumption goods Tax exemptions and subsidies to exports Allows trade monopolies and monopsonies Pursues low wage policies Encourage large family, providing financial incentives for marriage and stimulate population growth Emphasis the important of the merchant class

1. Link between money and price: David Hume (1752): Price-Specie-Flow Mechanism Accumulate specie with internal automatic repercussions. Assumptions: 1. Link between money and price: MV = PV; Full employment; Fixed velocity of money 2. Demand for trade goods is price elastic: Stable equilibrium in trade sector. 3. Perfect competition: product and factor markets Link between prices and wages (W). 4. Gold standard exists: Gold is directly linked to money and specie.

Exports > Imports Exports < Imports Net inflow of specie Price-Specie-flow Mechanism: Trade surplus vis-à-vis Trade Deficit Country A Country B Exports > Imports Exports < Imports Step 1 : Net inflow of specie Net outflow of specie Step 2 : Money supply increase Money supply decrease Step 3 : Prices and wages increase Prices and wages decrease Step 4 : Increase in imports & Decrease in exports Decrease in imports and Increase in exports until Exports = Imports

Laissez faire and free trade is a positive-sum game: Adam Smith (1723 – 1790)  Laissez faire and free trade is a positive-sum game: Nation’s wealth  production capacity not holdings of gold Economic growth  free environment and self-interest and competition Productivity gains  division of labor and specialization of labor Mutual beneficial  exchange and free trade

Foundations of modern trade theory 2 Foundations of modern trade theory

Historical development of trade theory Foundations of trade theory Historical development of trade theory Mercantilism positive trade balance Absolute advantage (Adam Smith) Countries benefit from exporting what they make cheaper than anyone else Comparative advantage (David Ricardo) Nations can gain from specialization, even if they lack an absolute advantage Carbaugh, Chap. 2

Absolute & Comparative Advantage Absolute advantage: each nation is more efficient in producing one good Output per labor hour Nation Wine Cloth United States 5 bottles 20 yards United Kingdom 15 bottles 8 yards Comparative advantage: the US has an absolute advantage in both goods United States 40 bottles 40 yards United Kingdom 20 bottles 10 yards Carbaugh, Chap. 2

Ricardo’s Comparative Advantage in money prices Cloth (yards) Wine (bottles) Nation Labor Wage Quant. Price Quant. Price US 1 hr $20/hr 40 $0.50 40 $0.50 UK 1 hr £5/hr 10 £0.50 20 £0.25 UK 1 hr $8 10 $0.80 20 $0.40 (at $1.6 = £1) Carbaugh, Chap. 2

Transformation schedules Comparative advantage Generalizes theory to include all factors, not just labor Shows combinations of products that can be made if all factors are used efficiently Slope, or marginal rate of transformation, shows the opportunity cost of making more of one good (how much of one good must be given up to make more of another) Carbaugh, Chap. 2

Marginal Rate of Transformation Comparative advantage Marginal Rate of Transformation A Slope = MRT = 0.5 B Wheat C Carbaugh, Chap. 2

Transformation schedules: constant opportunity costs Comparative advantage Transformation schedules: constant opportunity costs Slope = 2.0 = MRT Wheat Wheat Slope = 0.5 = MRT Carbaugh, Chap. 2

Supply schedules: constant opportunity costs Comparative advantage Supply schedules: constant opportunity costs S Canada S US Bushels of wheat per auto S US Autos per bushel of wheat S Canada Carbaugh, Chap. 2

Trading under constant opportunity costs Comparative advantage Trading under constant opportunity costs Trading possibilities line (terms of trade 1:1) B’ Trading possibilities line (terms of trade 1:1) D’ E C’ Wheat Wheat A’ C A F D B Carbaugh, Chap. 2

Production gains from specialization: constant opportunity costs Comparative advantage Production gains from specialization: constant opportunity costs Before After Net Gain Specialization Specialization (Loss) Autos Wheat Autos Wheat Autos Wheat US 40 40 120 0 80 -40 Canada 40 80 0 160 -40 80 World 80 120 120 160 40 40 Carbaugh, Chap. 2

Consumption gains from trade: constant opportunity costs Comparative advantage Consumption gains from trade: constant opportunity costs Before After Net Gain Specialization Specialization (Loss) Autos Wheat Autos Wheat Autos Wheat US 40 40 60 60 20 20 Canada 40 80 60 100 20 20 World 80 120 120 160 40 40 Carbaugh, Chap. 2

Complete specialization under constant opportunity costs Comparative advantage Complete specialization under constant opportunity costs S Canada S US Aa’ Aw Bushels of wheat per auto S US Autos per bushel of wheat S Canada Aa Aw’ Carbaugh, Chap. 2

Changing comparative advantage MRT = 0.67 Autos Autos MRT = 0.5 Carbaugh, Chap. 2