1 Primary Exports Ch. 17

2 International trade is one of the most powerful forces affecting the process of economic growth. Trade influences a country’s rate of economic growth, income distribution, use of natural resources, and economic and political relationships with the rest of the world. International trade provides firms access to new markets, opens up new opportunities for labor, and gives consumers a much wider and richer array of choices in the goods they buy International Trade: Advantages

3 Trade allows low-income countries to import the latest machinery and technology without having to develop it on their own It facilitates a much greater flow of information and knowledge between countries. (China)

4 International Trade: Challenges Challenges for developing countries: increased competition from foreign firms, instability in world market prices for import and export products, structural changes inherent in the shift from primary to manufactured products

5 Export Characteristics of Developing countries Developing countries exports a wide variety of products: oil, petroleum products, minerals, copper, food and agricultural products, manufactured products... Countries tend to export products based on their own particular endowments of the basic factors of production (land, other natural resources, L, K)

6 Natural resources dictate the exports of the oil rich countries of the Gulf countries, Southeast Asia, and latin America Copper exporters such as Zambia, Zaire, Chile, and Peru Timber exporters like malaysia and Ghana Variations in climate(which maybe considered a factor of production) helps explain exports of different poducts such as rubber and cotton

7 ✴ Countries with abundant L tend to produce export crops that can be produced efficiently with labor- intensive methods: coffee, tea, rice, and tobacco as well as labor-intensive manufactures such as textiles, clothing and electronic components

8 ✴ At the same time, developing countries tend to import products that rely on factors of production relatively scarce in their countries, especially highly skilled labor ✴ Therefore, almost all developing countries import machinery and other capital equipment, as well as more technologically advanced intermediate products such as chemicals, refined petroleum products, and metals

9 ✴ Many developing countries are highly dependent on one or just a few primary commodities for the bulk of their export earnings ✴ Cases of export concentration: Major petroleum exports, Ghana in cocoa, Ivory Coast in cocoa and coffee, Colombia in coffee and “cocaine”, Chile and Zambia in copper ✴ Few countries have a more diversified export base (Bolivia, Malaysia, and Peru), where no one product dominated and at least 4 commodities each account for 5% + of total export earnings

10 Comparative Advantage ✴ Why nations engage in international trade? What goods and services they trade? and how firms and consumers gain or lose from trade? ✴ The Theory of Comparative Advantage ✴ Assuming static conditions that holds factors of production in fixed supply

11 3 Powerful Results: 1. Any country can increase its welfare by trading because world market provides an opportunity to buy some goods at relatively low prices 2. The smaller the country, the greater is this potential gain from trade 3. A country gains most by exporting commodities that it produces using its abundant factors of production most intensively, while importing goods whose production requires relatively more of scarcer factors of production.

Table 17.2

13 Assume 2 countries, both produce 2 products, vegetables and PCs, and use 1 factor of production (L), the L required to produce each product differs in the 2 countries It takes fewer labor days to produce either product in US The US is better off if it buys vegetables from Mexico ad sells PCs in return (even if it can produce vegetables at home with less L)

14 ✴ In the US, a PC is sells for the equivalent of 5 tons of vegetables, since each takes 20 L-days to produce. ✴ In Mexico, 1 PC sells for 6 tons of vegetable, since each takes 30 L-days to produce. ✴ The US is better off selling its PCs in Mexico and receiving more vegetables i return for home consumption. ✴ If L is shifted away from farming and into PC production, US firms can produce enough PC to satisfy domestic demand and export to Mexico, and US consumers can eat more vegetables

15 ✴ Mexico also is made better off through the trade. ✴ Without trade, Mexico would have to produce 6 tons of vegetables to buy 1 PC in the home market. ✴ By selling to the US, Mexico needs to give up only 5 tons of vegetables to get 1 PC ✴ Thus, Mexico is better off by switching its L into producing more vegetables and selling them to the US

16 ✴ Both countries can gain from trade whenever the relative prices of commodities in each country differ in the absence of trade. ✴ Once the 2 countries begin to trade, the relative prices of commodities begin to shift until they are the same in the 2 countries. ✴ In our example, the relative price of 1 ton of vegetables in terms of computers settles somewhere between 5 and 6 ✴ The final trade price (the world price) is closed to the initial price in the market of the country whose economy is larger

17 ✴ The final price in both countries settles closer to 5 tons of vegetables per PC ✴ Small countries benefit more from trade because the relative price of commodities shifts more and therefore, the gains from trade are greater. ✴ To see this, consider an extreme case in which the US economy is so large and trade with Mexico so small that US prices do not shift at all. In this case, US does not gain from trade(nor lose) while Mexico gains to the full extent of the price difference.

18 ✴ Can apply this simple model to real setting: 1 product vs. all other products, 1 factor of production vs. all other factors, 1 country vs. all trading partners. ✴ Result: a country exports products that use its abundant factors of production more intensively and import products that require relatively more of its scarce factors

Fig. 17.1

20 ✴ The economy of the home country is divided into exportable goods (vegetables) that are produced using relatively land and labor intensive methods ✴ Importable goods such as PCs produced using relatively capital intensive methods. ✴ The home country is relatively well endowed with land and labor (the production frontier is skewed to the right), a greater capacity to produce vegetables than PCs ✴ Rest of the world is well endowed with K than L and land.

21 Gains from Trade A B Relative price no trade Production frontier IC 1 Exportable goods (L) Importabl e goods (K) Without trade, home country will achieve its highest U by producing and consuming at point A

22 In world market, the relatively higher production of PCs compared to demand for PCs drives its P lower than in home country. The relatively lower production of vegetables compared to demand for vegetables drives their P higher than in home country. Since only relative Ps matter: in world market: P vegetables in terms of P PCs is higher than in home country. This is an opportunity for home to improve its welfare through trade.

23 With trade, taking advantage of its factor endowment, can produce more vegetables and less PCs and sell vegetables on the world market at the higher relative P

24 Gains from Trade A B C World terms of trade Relative price before trade Production frontier IC 1 IC 2 Exportable goods (L) Importabl e goods (K) Producing more V move from A to B

25 Gains from Trade A B C World terms of trade Relative price before trade Production frontier IC 1 IC 2 Exportable goods (L) Importabl e goods (K) Home country will export V and import PCs and consumer more of both (point C)

26 Gains from Trade A B C D E World terms of trade Relative price before trade Production frontier IC 1 IC 2 Exportable goods (L) Importabl e goods (K) V Exports BD PCs Import DC Trade triangle BCD

27 ✴ Result: any country can benefit from trade ✴ As long as relative prices at home differ from those on world markets, countries can increase their aggregate welfare by engaging in international trade. ✴ Note that not all individuals or groups within each country necessarily gain ✴ V producers gain from trade because they sell more at higher P ✴ Consumers of PCs consumer more at lower prices ✴ PCs producers face competition: sell fewer at lower prices ✴ Consumers of V face higher P

28 Disadvantages ✴ Comparative advantage theory state that aggregate gains outweigh the losses for the country. How efficient? 1. The theory fails to explain growth and structural change because it excludes changes over time in the amount of K, Land, and L. As well as improvements in quality or productivity 2. No mechanism to explain how economies evolve over time and change the composition of their output. consumption, and trade. 3. Does not capture the 2-way relationship between trade and development.

29 ✴ In one direction, increased trade can lead to improved welfare and higher incomes. ✴ In the other direction, advances in development go hand in hand with more highly skilled L and higher quality K and machinery. ✴ Q: How different approaches to trade, favoring different types of exports and imports, lead to different kinds of economic development?

30 Gains from Trade A B C D E World terms of trade Relative price before trade Production frontier IC 1 IC 2 Exportable goods (L) Importabl e goods (K)

31 Gains from Trade A B C D E World terms of trade Relative price before trade Production frontier IC 1 IC 2 Exportable goods (L) Importabl e goods (K)

32 Gains from Trade A B C D E World terms of trade Relative price before trade Production frontier IC 1 IC 2 Exportable goods (L) Importabl e goods (K)