International Economics Basics of International Trade Theory Prof. D. Sunitha Raju

The International Economy : Introduction Firm/Industry Competitiveness • relative prices A country’s international competitiveness • relative productivities

Trade Theory : Discussion Issues What is the basis for trade between countries? How are gains from trade defined/ measured. Can theory explain the pattern of global trade flows.

Developments in Trade Theory Mercantilism Wealth measured by stock of precious metals When net exports rise, accumulation of wealth takes place Gain for some nations at the cost of others In the long run, not sustainable

Absolute Advantage (Adam Smith) Unless all trading nations gain, trade will not take place Cost differences determine the movement of goods between countries Countries produce and exchange of commodity in which they have absolute advantage which leads to specialization Nations gain from trade and policy of laissez-faire maximises output and welfare

Absolute Advantage: Basic Assumptions Labour is the only factor of production and is homogenous Cost and price of good depends on the labour required to produce it

Absolute Advantage: Illustration 1 UK Wheat (bushels/man-hour) 6 1 Cloth (Yards/man-hour) 4 5 US will export wheat and import cloth from UK → export 6W & import 5C (gain ¼ man-hour) UK will export cloth and import wheat → export 5C and import 6W → gains from trade 6W = 30C Supply 5C to USA & gains 25C or 5 man-hours

Absolute Advantage: Illustration 2 UK Wheat (bushels/man-hour) 6 1 Cloth (Yards/man-hour) 4 2 US has absolute advantage in both wheat & cloth UK has absolute disadvantage in both wheat & cloth Can trade take place?

Principle of Comparative Advantage (Ricardo) Comparison of relative advantage or disadvantage between countries US has 6 to 1 advantage in wheat and 2 to 1 advantage in textiles (over UK) UK has greater disadvantage in wheat than in cloth. Wheat : 1 to 6 Cloth : 1 to 2 Comparison of relative cost differences for Trade to take place

Comparative Advantage: Basic Assumptions The world consists of two nations Labor is the only input Labor is fully employed and homogenous Labor can move freely among industries within a nation, but is incapable of moving between nations All firms within each nation utilize a common production method for each commodity Costs do not vary with the level of production Transportation costs are zero

Comparative Advantage: Resource Cost US Domestically, 6W can be produced if 4C is given up (opportunity cost) 1C costs 1 W and 1W costs C UK 2C can be produced if 1W is given up 1C costs ½ W and 1W costs 2C Therefore, cloth is relatively cheaper in UK and wheat in USA

Comparative Advantage: Gains from Trade US (cloth) Import of cloth takes place if 6W can be exchanged for greater than 4C if 1C is less than 1½ W UK (cloth) Export of cloth takes place if 2C can be exchanged for greater than 1W If 1C is greater than ½ W Both US & UK gain if the price of cloth (in terms of wheat) is 1W

Translating comparative advantage into Costs Assume Wage rate in US = $20/hour Wage rate in UK = £ 5/hour Labour input Wheat (Bushel) Cloth (Yards) Quantity Price US 1 hr 6 $3.33 4 $5 UK 1 £5 2 £2.5 UK* $8 $4 * Exchange rate = 1£ = 1.60$

Trade with more than Two Commodities Goods produced in each country ranked on the basis of their domestic cost Production Costs in Two Countries with Five Goods Commodity A B C D E United States $1 $4 $9 $15 $20 United Kingdom £1 £2 £3 £4 £5 At an exchange rate of £1 = $3, the British costs converted into dollars become: A B C D E U.K. cost (£1=$3) $3 $6 $9 $12 $15

Examples of Comparative Advantages in International Trade Speciality Resulting from Natural Advantages Speciality Resulting from Acquired Advantages Canada Lumber Hong Kong Textiles Israel Citrus fruit Japan Automobiles, consumer electronics Italy Wine South Korea Steel, ships Jamaica Aluminum ore Switzerland Watches Mexico Tomatoes United States Jetliners, computer software Saudi Arabia Oil United Kingdom Financial services Wheat, corn

Where Does U.S. Comparative Advantage Lie? Industry Revealed Comparative Advantage Ratio Agricultural products +0.77 Greatest Comparative Advantage Greatest Comparative Disadvantage Chemicals +0.21 Machinery +0.02 Telecommunication equipment -0.01 Medical equipment -0.02 Industrial supplies -0.28 Civilian aircraft -0.29 Automotive -0.42 Consumer goods -0.51 Steel Petroleum -0.82

Competitiveness under Varying Production Condition Production under Constant Cost Production under Increasing Cost

Production Possibilities Schedule (PPS) PPS shows various combinations of 2 goods that a country can produce when all inputs (land, labour capital & Entrepreneurship) are used most efficiently. Under constant cost conditions, relative cost of producing one good in terms of other remains same MRT =

Production Possibility Frontier Production Possibility Schedules for Wheat and Cloth in the United States and the United Kingdom United States United Kingdom Wheat Cloth 180 60 150 20 50 120 40 90 30 80 100 10

Relative Commodity Price under Constant Cost US: 30 W = 20 C 1 W = or 20 2 C C 30 3 20 C = 30 W 30 W or 1.5 W 1C = 20

UK: 10 W = 20 C 20 C 2 C or 1 W = 10 20 C = 10 W 10 W 1 W or C = 20 2 Relative price of wheat lower in US than in UK Relative price of cloth lower in UK than in US Difference in relative prices reflects comparative advantage (specialization)

Consumption/Demand Issues Consumer demand is underlined by tastes/ preferences or utility How much of the goods produced will be consumed depends on consumer preferences Consumer Indifference Curve Slope of the Indifference Curve represents consumers’ trade off between two goods, i.e. Marginal Rate of Substitution

Indifference Curves A Y Slope = ∆ Y/∆ X = MRSA A U 2 A U 1 A U X A

Equilibrium in Autarky Consumption utility maximized subject to the constraints of Production Possibility Frontier YB Slope = -(bLX/bLY) = MRTB Slope = MRSB LB/ bLY B B YB U 2 B U 1 B U XB XB

Gains from Trade

What Would Country A Do Under Free Trade? Slope = -(PX/PY)tt Slope = -(aLX/aLY) = MRTA = -(Px/PY)A LA /aLY ∙ AC ∙ U2 A A Imports of Y A U1 ∙ ∙ XA A LA /aLX Exports of X

Trading under Constant Costs Basis for Trade Slopes of the production possibilities schedules give the relative cost of one product in terms of other Differences in relative costs provide the basis for mutually favourable trade Production gains from Specialisation A country will specialise in the production of the good in which it has comparative advantage A country will trade part of this production for the good in which it has comparative disadvantage (b)

(c) (d) Consumption gains from Trade Consumption alternatives limited by the domestic production possibilities schedules The exact consumption will be determined by the tastes & preferences Specialization & free trade care achieve post-trade consumption outside domestic production possibilities schedules trade results in consumption gains for both countries Terms of Trade Domestic terms of trade represents the relative prices at which goods are exchanged at home A country will exports/import goods internationally if the terms of trade are more favourable than domestic terms of trade (d)

Changing Comparative Advantage Technological improvements Trade restrictions High Transaction Costs