1 ECONOMICS 3150C Lecture 5 November 4

2 Internal and International Trade Firms – competitive advantage Mobility of factors of production Trade costs including information Tastes – language, culture Market rules – laws (domestic, international), regulations; effectiveness Currencies – financial risks Domestic policies –Taxes, subsidies, tariffs –Procurement –Ownership restrictions –National interest – politics and trade policies

3 International Trade Theory: Objectives Gains from trade Patterns of trade Volumes of trade Intra-corporate vs. inter-corporate/firm Protectionism – trade policies Free trade agreements – FTA, NAFTA, GATT

4 Critique of Traditional Trade Theory Competitive markets – underlying logic flawed Imperfect competition – competitive advantage Role of technology and risk taking – importance of market structure Culture, bureaucracy, hierarchy Politics and power – case of the US Bottom line: trade theory cannot explain RIM in Canada, Airbus in Europe, HSBC, Arcelor-Mittal in India, Dubai Aerospace, IKEA, etc.

5 Overview 2007: –Global GDP: US$ 50 T –Global trade in goods and services: US$ 16 T Canada’s trade, by country/region (2007) –Total exports: $463.1 B US: $356.1 B (77%) UK: $14.2 B (3%) Non-OECD countries: $38.9 B (8%) –Total imports: $415.0 B US: $269.8 B (65%) Non-OECD countries: $65.9 B (16%)

6 Overview Canada’s trade (2007) –Balance: $48.0 B US: $86.3B EU: -$3.9 B Non-OECD countries: -$27.0

7 Overview Canada’s trade, by product (2007) –Exports Industrial goods and materials (metals and alloys; chemicals, plastics and fertilizer, etc.): $104.4 B (23%) Machinery & equipment (includes aircraft): $93.4 B (20%) Energy products: $91.6 B (20%) Automotive products: $77.3 B (17%) Agricultural and fishing products: $34.4 B (7%)

8 Overview Canada’s trade, by product (2007) –Imports Machinery & equipment: $116.6 B (28%) Industrial goods & materials: $85.1 B (21%) Automotive products: $80.0 B (19%) Other consumer products: $54.8 B (13%) Energy products: $36.6 B (9%)

9 Overview 2005: composition of world trade –Manufactured goods – 59% Outsourcing – EMS, auto parts/components Intra-corporate – multinationals Competitive advantage vs. comparative advantage –Services – 20% Outsourcing – call centres, programming, IT support, legal, accounting, medical Tradable vs. nontradable – changing over time Competitive advantage vs. comparative advantage –Mining – 14% Oil and gas dominate –Agricultural products – 7%

10 Basis for Trade Gravity Model –T(i, j) =  Y(i)Y(j)/D(i, j) –T(i, j): value of trade between country i and j –Y: GDP –D(i, j): distance between country i and j 1% increase in distance between two countries is associated with % decrease in trade Transportation costs, similarities (familiarities) – language, tastes

11 Basis for Trade Differences in relative prices –[P1/P2] A  [P1/P2] B –Countries differ Resources Culture, tastes Demographics Incentives/motivation Differences in availabilities of products (goods, services) –Companies create competitive advantages

12 General Equilibrium: Closed Economy Model Objective: maximize production subject to resource and technology constraints  production possibility frontier Assumptions: –Two factors of production: X1, X2 –Two goods: Y1, Y2 –Full employment –Given state of technology: T –No convexities – no economies of scale, no externalities –No public goods –Production functions: Y(i) = F i [X1, X2, T]

13 Optimization Solution: 1 Maximize production: –Max Y1, Y2 –S.t. production functions [F i, i = 1,2] Maximum availabilities of X1, X2 Production functions, isoquants

14 Optimization Solution: 1 Maximize production: –Max Y1 –S.t. Y1 = F 1 [X1, X2, T] Y2 = 0 Y2 X1  0 X1 X2  0 X2 Box diagram with isoquants Production possibility frontier [G(Y1, Y2)]

15 PPF Efficient production –knowledge of production functions –producing on frontier of production function –given state of technology –full employment PPF can also be derived by minimizing costs of producing various quantities of the two products –Min: C1X1 + C2X2 –S.t. Y1  F 1 [X1, X2, T] Y1  0 Y1 [isoquant and isocosts]

16 Optimization Solution: 2 Optimal level of production of two products: Y1, Y2 Maximize value of output –Max: P1Y1 + P2Y2 –S.t.: PPF [PPF and income lines] Max utility –Max: U(Y1, Y2) –S.t.: PPF Solution: GE model with perfect competition  P1, P2, C1, C2, Y1, Y2

17 Changes in Relative Prices Equilibrium P2/P1 will change if: –Change in shape of PPF Change in relative availabilities of X1, X2 Change in production functions Change in state of technology –Changes in tastes

18 Basis for Trade Different relative prices –Different technologies – different p.f., different states of technology –Different relative quantities of factors of production –Different tastes – different utility functions –Absence of perfect competition: monopolistic markets Different products –Different factors of production –Absence of perfect competition Low trade costs –Transportation costs –Trade barriers –Other – hedging, insurance, etc.

19 Basis for Trade Bottom Line: firms produce goods –Firms need info on products (characteristics, p.f.); technology –Agents need info on relative and absolute prices and access to distribution channels in foreign countries Value chain: production of final product entails various intermediate stages – examples: gasoline at retail; laptops; autos; cell phones; aircraft –Trade in intermediate products –Trade in intermediate services

20 Comparative Advantage Models 1.Single Factor, Ricardian Model Assumptions: –One factor of production: X1 –Two goods: Y1, Y2 –Constant returns to scale [  Y = F( X1), δ=1] –PF: Y i =  i1 X1 [  i1 : units of product i per unit of factor of production 1] Resulting PPF: –Y1/  i1 + Y2/  21  0 X1 –Opportunity cost of Y1 in terms of Y2:  21 /  11 –No adjustment problems since sole factor of production can move costlessly and instantaneously between products

21 Single Factor Ricardian Model Utility maximization  optimal production and consumption point, P1, P2 –Slope of straight line PFF: P2/P1  11 /  21 –Relationship between relative prices and opportunity costs

22 Single Factor Ricardian Model Two countries, two products, one factor of production –Conditions for pre-trade relative prices to differ [i.e. {P1/P2} A  {P1/P2} B ] Different production functions:  i1 (A)   i1 (B) Different tastes will not produce different relative prices Comparative advantage –Country has comparative advantage in product with lower relative opportunity cost –Country A has comparative advantage in product 1 if [  21 /  11 ] A < [  21 /  11 ] B {P1/P2} A < {P1/P2} B

23 Single Factor Ricardian Model Trade between A and B will equalize relative prices  {P1/P2} A = {P1/P2} B –Equilibrium relative prices post-trade between original pre-trade ratios –If A is large country and B a small country, equilibrium relative prices post-trade closer to pre-trade ratio in A Specialization – small country, not necessarily for large country –Transportation costs –Protection of industries Terms of trade: price of exported product relative to price of imported product –For country: P1/P2

24 Single Factor Ricardian Model Gains from trade –Consumption, production – pre-trade and post-trade –Exports, imports –Higher level of utility, higher level of real income/GDP Equilibrium in currency market will result in current account balance = 0 –Total value of exports = total value of imports –D/S of country’s currency depend upon current account transactions only –For Country A: P1 A EX(Y1) = P2 B IM(Y2)E* –With no trade costs: P1 A = P1 B E* and P2 A = P2 B E*

25 Single Factor Ricardian Model Conclusions: –Extreme degree of specialization –No impact on distribution of income within each country – no losers (full employment, one factor of production) –Gains from trade –No explanation of differences in production functions and relative and absolute productivities –Volumes of exports and imports not determined

26 Extension of Ricardian Model Many products (i = 1, N), one factor of production Assumptions: –Constant returns to scale –Perfect competition: P i = MC i –MC i = P(X1)/  i1 Allocation of production in two country world (A, B) –Product i produced in country with lower MC –Produced in A: {P(X1)E/  i1 } A < {P(X1)/  i1 } B  {[P(X1)] A E /[P(X1)] B } < {  i1 } A / {  i1 } B –Produced in B: {[P(X1)] A E /[P(X1)] B } >{  i1 } A / {  i1 } B

27 Extension of Ricardian Model Order the products 1 to N so that {  11 } A / {  11 } B < {  21 } A / {  21 } B < …….. < {  N1 } A / {  N1 } B All products 1 through K are produced in B and exported by B: {[P(X1)] A E /[P(X1)] B } > {  K1 } A / {  K1 } B and {[P(X1)] A E /[P(X1)] B } < {  K+11 } A / {  K+11 } B

28 Extension of Ricardian Model Products K+1 through N are produced and exported by A –Not all products may be traded – depends upon trade costs  non-traded products –Specialization, but if B is a large country, B also may produce, but not export some or all of the products 1 through K –Assumes that E is at equilibrium level so that value of A’s exports = value of B’s imports –If value of E changes so too does cut-off point “K”