A2 Economics International Trade A2 Economics Presentation 2006

Paul Krugman “If there were an Economist’s Creed, it would surely contain the affirmations “I believe in the Principle of Comparative Advantage” and “I believe in Free Trade”.” Paul Krugman, Professor of Economics at MIT, Cambridge

Exports of Goods and Services

What is Free Trade? Free trade represents trade between countries without the introduction of artificial barriers Trade reflects exchange and specialization –Exchange: countries supply goods and services that they can produce relatively cheaply and buy products from other countries that they would find relatively expensive to produce –Specialization: benefits from trade are increased if there are economies of scale from production and if countries specialise their resources in producing certain commodities

What is Free Trade? In an open economy, one nation trades openly with other –Trade in goods –Trade in services –Free flow of financial capital –Free flow of labour resources

Potential Advantages from Trade (1) Increased competition for producers –Pressure on suppliers to keep costs & prices down –Dilution of monopoly power in domestic markets –Reduction in price discrimination –Improvements in allocative & productive efficiency (2) If other countries can supply products more efficiently – it is economic sense for them to do so –Exploitation of the comparative advantage –Trade is a source of economic development

Potential Advantages from Trade (2) (3) Dynamic Efficiency Gains –Trade tends to speed up the pace of technological progress and innovation across many different industries –Greater choice for consumers

Potential Advantages of Trade (3) (4) Economies of scale and higher profits (5) Trade seen as a stimulant to short term and long run economic growth –Exports - injection of aggregate demand –Boost to exports will have multiplier and accelerator effects on national income –Supply-side improvements from investment and greater factor mobility between countries

James Wolfeson on Trade Expanding trade by collectively reducing barriers is the most powerful tool that countries, working together, can deploy to reduce poverty and raise living standards. A growing body of evidence shows that countries that are more open to trade grow faster over the long run than those that remain closed

Imports of new technology – LRAS effect Employment creation in growth sectors Stimulates new capital investment and innovation Makes domestic markets more contestable Transfer of ideas and best practice - “benchmarking” Injection of AD – Export led growth – multiplier effects International Trade Summary of trade benefits

Concept of Comparative Advantage First developed by David Ricardo, one of the founding fathers of classical economics, in 1817 Comparative advantage exists when for a country –The relative opportunity cost of production is lower than in another country –A country is relatively more productively efficient than another

Factor Endowment The concept was developed further by Heckscher and Ohlin (two Swedish economists) –Countries have different factor endowments –Countries will tend to specialise in and then export products which use intensively the factors which it is best endowed

Theory of Comparative Advantage Half of each country’s available resources are allocated each industry Freezers (000s per year) Dishwashers (000s per year) Germany Italy Total Output

Effects of Specialisation Output after specialisation Freezers (000s per year) Dishwashers (000s per year) Germany Italy Total Output (previous output)

Output after Specialisation Output after specialisation Freezers (000s per year) Dishwashers (000s per year) Germany Italy16000 Total Output (previous output) 2000 (1800) 800 (700)

Reaching a Beneficial Terms of Trade A beneficial terms of trade is an agreed rate of exchange of one product for another than leaves both countries better off from trade Consider the domestic terms of trade for each country –Without trade, Germany gets 2 extra freezers for every dishwasher that is gives up –Without trade, Italy has to give up 4 freezers for every extra dishwasher it produces Is there a mutually beneficial terms of trade?

Output After Trade Has Taken Place Terms of Trade 3 freezers for 1 dishwasher Freezers (000s per year) Dishwashers (000s per year) Germany1150 (+750) 550 (-250) Italy850 (-750) 250 (+250) Total Output (original output pre specialisation) 2000 (1800) 800 (700)

Gains From Trade Using PPFs Dishwashers (000s) Freezers (000s)

Gains From Trade Using PPFs Dishwashers (000s) Freezers (000s) Italy

Gains From Trade Using PPFs Dishwashers (000s) Freezers (000s) Italy It

Gains From Trade Using PPFs Dishwashers (000s) Freezers (000s) Italy Germany It

Gains From Trade Using PPFs Dishwashers (000s) Freezers (000s) Italy Germany It Ger

Outward Shift in the PPF With Trade Dishwashers (000s) Freezers (000s) Italy Germany Germany has specialised in producing dishwashers and Italy has concentrated resources in producing freezers Trade takes place at 3 freezers for each dishwasher

Outward Shift in the PPF With Trade Dishwashers (000s) Freezers (000s) Italy Germany 3000

Outward Shift in the PPF With Trade Dishwashers (000s) Freezers (000s) Italy Germany 3000

Supply and Demand Analysis Price Output (Q) Domestic Demand Domestic Supply World Price

Supply and Demand Analysis Price Output (Q) Domestic Demand Domestic Supply P1 Q1 World Price QdQs Pw

Assumptions behind Trade Theory Poorer countries may find the terms of trade move against them Jobs are lost as well as created – structural unemployment? Trade may create negative externalities Possible risk of trade dependency? Are transportation costs significant? Exchange rate may not always be favourable Important Assumptions

Assumptions of Trade Theory Factor of production are assumed to be mobile –Occupational mobility of capital and labour –Geographical mobility of labour Transportation costs assumed to be insignificant Economies of scale – the standard theory of trade assumes constant returns to scale – welfare gains may be greater if there are increasing returns Ignores production and consumption externalities arising from trade

Comparative Advantage Costs of production Productivity of factors of production Investment in research and development Non-price competitiveness of producers Movements in the exchange rate Impact of import controls (tariff & non-tariff barriers) Comparative advantage is a dynamic concept – every country experiences shifts in comparative advantage over time

Shifts in Advantage for the UK Long term decline in comparative advantage in many areas of manufacturing industry –Lower cost producers in SE Asia and E.Europe –Productivity gap with other leading economies –Strong ex. rate has damaged competitiveness The UK still has trade surpluses in chemicals and high knowledge manufacturing Main comparative advantage lies with business and financial services