NS3040 Fall Term 2018 Trade Theories Federal Reserve Bank of Chicago, Strong Dollar Weak Dollar

Comparative Advantage The main theory of trade is comparative advantage The idea that with different shaped production possibility curves, each country can transform resources into particular products at lower cost than other countries Example: wheat cloth United States 6 10 England 2 5 or United States 36 60 England 24 60 The US must give up 36 units of wheat to produce 60 of cloth while UK only gives up 24 HOWEVER England must give up 60 of cloth to produce 24 of wheat while US produces 36 of wheat with the same 60 of cloth

Heckscher-Ohlin Theory I Basically the same idea as comparative advantage but easier to generalize: Countries have comparative advantage in those products that use in their production relatively large amounts of the resources the country has in abundance Example – Because of abundance of land, U.S. has a comparative advantage in wheat while Japan does not Countries have a comparative disadvantage in those products that use relatively large amounts of the resources that country has shortages of. Example the U.S. has a comparative disadvantage in textiles that use a lot of semi-skilled workers, while Indonesia has an advantage in textiles. Free Trade will lead to factor price equalization

Heckscher-Ohlin Theory II

Example of Comparative Advantage

Comparative Advantage Steel

Comparative Advantage Wheat

Trade: Complete Picture

Problem With Immoble Resources

Leontief Paradox When Heckscher-Ohlin first tested in 1947 by Harvard economist W. Leontief he discovered: The U.S. exported labor intensive products and imported capital intensive Explanations – Measurement problems – capital inputs hard to measure precisely Goods might be produced by different factor combinations in different countries. A U.S. capital intensive good, might be produced with much more labor in India Data to aggregative – just man-hours and amounts of capital used. If introduce idea of human capital then paradox solved – US invests relatively large amounts in humans and this is a form of capital – an area the U.S. has traditionally had relatively large amounts. Shortcomings of H-O Theory led to development of a variant approach -- comparative labor costs Labor costs function of productivity of worker and the wage

Comparative Labor Costs U.S. /UK Productivity Differential

Recent Patterns of Productivity http://www.ilo.org/wcmsp5/groups/public/---dgreports/---dcomm/---publ/documents/publication/wcms_443480.pdf

Other Variants of Comparative Advantage Theory of Overlapping Demand H-O emphasized supply side. Need demand considerations Countries of similar levels of income will trade more with each other because of similar tastes and purchashing power Explains why U.S. trades more with Canada than Mexico Product Cycle Theory Products go through various stages in their lives New product – science, engineering important inputs Mature product – management, finance important inputs Standardized product – low wage semi-skilled assembly workers important input Idea comparative advantage will shift from country to country depending on their factory endowments Flying- Geese Patterns in East Asia Transport Costs U.S retains some industries due to high-transport costs from foreign markets.

Linder Theory of Overlapping Demands

Product Cycle Phases

Product Life-Cycle Theory

Gravity Models and Brexit I “Down to Earth,” Economist, October 1, 2016 U.K. planning new trade deals outside of Europe to replace EU trade when England leaves the EU Might seem like a smart move EU’s economy weak and demand for British exports has been depressed for years Britain’s membership in EU had prevented it from making trade deals with fast growing economies like China and India However likely that turning away from EU will only restrict U.K. trade

Gravity Models and Brexit II Gravity model of trade will likely control U.K. trade patterns. The model states that 1. The bigger the GDP of the countries involved in a bilateral trading relationship, the more likely they will trade with each other Larger economies have more demand for goods and services and They offer more products supplying a broader range of consumers 2. The further away two countries are from each other the smaller the volume of trade Partially related to transport costs Cultural and linguistic differences also a factor