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 4/15 = .266 unit of tomato 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 Analysis TT 240/10 24 A 16 A TT 60 30 C C 240/8 US Mexico Mex Price under autarky = .8 US Price under autarky: .26 Production under autarky: A Terms of trade after trade: TT = .50 -Slope = relative price = MRT (Marginal Rate of Transformation)

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 Map T U5 U1 U3 U2 U4 U5>U4>U3>U2>U2 ΔUc MRS = ------- ΔUt Slope = MRS C

Mexico Under Autarky T At “a” MRS>relative cost/price At “c” MRS<relative cost/price At “b” MRS = relative cost/price MRT a b U4 U3 c U2 U1 C

Terms of Trade: A graphical Analysis TT 24 y A 16 t A 12 y TT 30 60 30 C C US Mexico US imports = Mexico’s exports = t w US exports = Mexico’s imports = w y

Terms of Trade: A graphical Analysis TT 24 A 16 A TT 60 C 30 C US Mexico Mex Price under autarky = .8 US Price under autarky: .26 -Slope = relative price Production under autarky: A Terms of trade after trade: TT = .50

David Ricardo and Comparative Advantage Again consider US and Mexico. Labor needed for one unit Output produced Mexico U.S. Mexico U.S. Rugs 10 hrs 8 hrs 12 15 Computers 40 hrs 10 hrs 3 12 US has absolute advantage in both goods! 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.

The Ricardian Trade Model US Mexico Rugs Rugs TT 30 c 24 U2 U1 1.25 c k A U2 g A f U1 g Cmp Cmp 4 h TT f 6 24

Productivity, Wage, and Price Assume 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

===> ---------- = --------- ax ay Px ax In autarky under competitive conditions where uniform labor is the only input: Wx= Wy Px Py ===> ---------- = --------- ax ay Px ax ===> --------- = --------- = MRT Py ay

Trade and Wage Recall: 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 Pr/Pc Pr/Pc S 4/5 Export Import 1/4 D D Q Q Rug Market in US Rug Market in Mexico

International Market for Rugs Pr/Pc S 4/5 1/4 D Q